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“These bold and foolish lambs are lured by noise to every treacherous abyss”

- Lee Monson (with a little help from Friedrich Nietzche)

All of us know that the major pharmaceutical manufacturers are struggling to find new blockbuster drugs to replace the billions of revenues soon to be lost to the generic manufacturers. We also know that many future blockbusters will have their roots in biotech, as the industry will turn the knowledge of life science into products that will change our lives.

With just this basic knowledge of this relatively new industry as a starting point, spurred on by the public service campaign of the Biotechnology Industry Organization’s 1,100 member firms (combined with the fact that the NASDAQ Biotech Index is up 17.4% this year through July 7th), many of you will become one of the “bold and foolish lambs” lured by this industry’s hype in hopes of striking it rich.

Every new industry throughout the modern era of financial markets ultimately resulted in hundreds (if not thousands) of failed ventures, with just one or two big winners. I know you think you can pick the winner – as did those individuals who bought a few shares of the railroads, autos and airplanes in their infancy. So did those individuals who bought a few shares of those new radio and televisions manufactures. So did those individuals who jumped into the electronics industries during the sixties. A decade or two later individuals just knew that their computer company would make them rich. And just a few years ago, those companies that were spawned by the internet would do the job. By the way, how was your record in choosing an internet company?

Our definition of common sense is to look at things the way they really are, not the way you hope they will be, so here are a few facts taken from Zack’s Research Wizard database to think about as you consider an investment in biotech:

    • There are 293 companies in the Biomed/Genetics Industry Group
    • Only 37 of the 293 companies were profitable over the past 12 months
    • Only 37 of the 293 companies are expected to turn a profit in the next twelve months
    • Only 7 of the 293 companies had revenues in excess of $1billion last year
    • Only 8 of the 293 companies are expected to have revenues in excess of $1billion this year
    • Only 34 of 293 companies had positive cash flow last year

As you consider these facts also consider the fact that research and development of any new product is expensive. The research and development cost of the medical field is substantially greater than other fields as it includes very expensive human capital in addition to the cost of time from the discovery process through the regulatory maze of bringing a product to market. This takes cash … a lot of cash according to a study by Project Hope in 2006 – anywhere from $500 million to $2 billion depending on the product.

A common sense approach to finding a winner in biotech is to own shares of a business that can afford the cost of R&D and have access to the brightest minds in the field. Novartis (NYSE:NVS) is one that can meet these requirements. In 2010 Novartis net sales exceeded $50 Billion more than all 37 of the profitable biomed/genetic companies combined. Their R&D spend last year exceeded $8 billion, more than the total market value of all but 7 of the 293. Granted, this is not exclusively spent on biotech research, but what they do spend exceeds the budget of all but a few in the biomed/genetics industry. Their commitment to biotech research is well known, especially by the next generation of scientists. The company sponsors the Novartis International Biotechnology Leadership Camp (BioCamp). This camp brings together 60 selected top students from science and business universities from around the world. These students will interact with key Novartis scientists, learn about new medicines, explore career opportunities in the pharmaceutical and biotech industries and network with other great young minds at the full of expense of Novartis in the company’s Basel, Switzerland headquarters. There is no doubt that a few of these top students will find their way to a Novartis Lab.

Best of all, as an owner of Novartis you are not paying anything for the biotech component, the market is giving you that for free. At the current price, Novartis is valued at just 12.19 x trailing 12 month earnings and just 11.05 x estimated 12 month forward earnings a 34% discount to their 10 year average of 16.7x. The current net dividend yield to U.S. investors is 3.23%. There are 37 companies in our biomed/genetics industry that are expected to earn a profit next year, the average P/E is 29.68. Only one of these companies pays a dividend.

A few other facts you should consider about Novartis: The company has raised its dividend every year for the past 10 years. The company has increased sales per share every year for the past 10 years. The company has increased its cash flow per share every year for the past 10 years. Only once in the past 10 years has earnings per share declined and just as important, shareholder equity on a per share basis has increased every year of these past 10 years.

If your goal is to make money in pharmaceuticals, then buy a few shares of Novartis. Our fair value calculation is $88.97. If your goal is to win the lottery but you won’t buy a ticket, then take a flyer on one of those 200 plus biotech companies that have good intentions but no cash – the odds of making money is about the same.

Disclosure: I own shares of all companies referenced. Any opinion and/or information contained in this commentary are derived from sources believed to be reliable, but Kendall J. Anderson, CFA or Anderson Griggs Portfolio Management cannot make representation as to its accuracy or completeness. This commentary does not specifically address individual investment objectives and any conclusions may not be suitable for you. As in all common stock investing you can incur a profit or loss of capital. Past performance should not be taken as an indication or guarantee of future performance. I am long NVS.

Source: Novartis: A Common Sense Approach to Biotech