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Let's set out to design, from scratch, a group of stocks that would have least appeal to today's cautious investor:

  • It would be in an industry requiring advanced, highly specialized expertise
  • Achievements in this field could not be judged according to a universally accepted standard, but would in fact involve risk-benefit tradeoffs subject to learned dispute and interpretation
  • Success would also be dependent on an opaque approval process by risk-averse government regulators
  • The market capitalization of the stocks would be relatively small, and subject to abrupt shrinkage in response to research setbacks and regulatory snags
  • Many of the companies would have little or no current revenue, forcing investors to base their opinions on the highly uncertain prospects for future sales
  • The only constant in the business would be change with unpredictable and volatile consequences for investors

If you haven't already guessed, I've just tried to describe the biotech group and its efforts to develop new medicines. Humans developed loss aversion for sound evolutionary reasons, and perhaps one of those was to make sure we stay away from speculative biotechs.

And yet at a certain price, even the riskiest investments become attractive, as others pile into steady dividend payers with limited upside. I believe that moment is at hand for three speculative biotechs.

Because the overwhelming majority of their drug sales and profits remains on the horizon, they're at least shielded from the ups and downs of the global economy. They're effectively call options on a brighter future, and given the likelihood that recent accomplishments will eventually translate into much more value than currently acknowledged, I believe those options to be in the money.

Vivus (NASDAQ:VVUS)
This company is the developer of Qnexa, the most promising of the three weight-loss drugs now under consideration by the Food and Drug Administration. The FDA was due to act by April 17, but has just given itself another three months to consider a revised risk-management strategy Vivus recently submitted at its request.

Although the FDA has not approved a weight-loss drug in more than a decade, the delay seems to have cemented the impression that it will green-light Qnexa in July, after working closely with Vivus to allay safety concerns. (Qnexa would not be prescribed for pregnant women because of association with cleft palate, and has been tied to modest increases in the heart rate, although that risk is offset by its tendency to lower blood pressure.)

In January, the FDA encouraged Vivus to include women of child-bearing age in its application for approval. In February, an FDA advisory panel of outside exerts voted 20-2 to recommend Qnexa's approval with only a post-approval study of heart risks rather than a preliminary one delaying approval.

An estimated one in three American adults is obese, and there is nothing now on the market in wide use, or boasting a safety-efficacy profile, as promising as Qnexa's. It could be a blockbuster, though of course nothing is guaranteed, just as no one can be sure what problems might crop up if Qnexa does end up getting widely used.

Shares have more than doubled since the advisory committee vote, but remain 23% below the Street's median target of $30, to say nothing of the $45 foreseen by the most bullish analyst. Perhaps coincidentally, JPMorgan (NYSE:JPM) also ran the recent secondary offering of shares, raising the funds Vivus will need to launch Qnexa.

The company is currently valued at $2 billion, which might not stick in the throat of a bigger drug company looking to grow fat on America's hunger for thinness.

The FDA's delay means Qnexa could potentially be approved first in Europe, in June. Less controversially, Vivus has an erectile-dysfunction drug coming up for approval by April 29. Though Avanafil would be entering a crowded market, it does have certain advantages over entrenched competitors.

Affymax (AFFY)
Of course, one of the biotech stocks' many charms is that you never know how they might react to good news.

Witness Affymax, which is down 22% since March 27, the day the FDA approved its anemia drug for kidney dialysis patients, breaking a longtime Amgen (NASDAQ:AMGN) monopoly. But before that profit-taking plunge, the stock had more than doubled in the two months leading up to the FDA decision.

The Affymax drug has several advantages over Amgen's standard, notably that it will need to be injected just once monthly, rather than up to three times weekly, potentially saving money for dialysis centers under pressure from Medicare to cut costs. Amgen's anemia dialysis drug currently contributes $2 billion to annual sales, after a 20% decline due to safety concerns last year.

Amgen has tried to lock-up the two largest dialysis chains with long-term deals to fend off Affymax, as well as Roche and generic manufacturers who will be entering the market in a couple of years. So Affymax enters a declining market dominated by a powerful monopolist, but facing the prospect of even more competition relatively soon.

On the other hand, the number of dialysis patients is likely to grow over time all over the world, as obesity takes its toll on kidneys. Affymax's Omontys drug offers clear advantages, and should win considerable market share if it continues to prove as effective as Amgen's Epogen.

Affymax will be splitting Omontys profits with Japanese partner Takeda, and stands to receive further payments should the anemia drug win sales overseas. Takeda has just paid Affymax $50 million for securing US approval, leaving the company valued at roughly $250 million net of cash. Omontys might garner annual revenue of $700 million or more in the US alone within a few years.

The stock enjoys broad institutional support, notably from Fidelity, whose funds own a combines 13% of outstanding shares. More recently, the well-regarded Visium Asset Management disclosed a 9.1% stake after apparently purchasing shares on the FDA approval date. Visium is a specialist healthcare hedge fund manager that's delivered a 13% annualized return over its seven years in business.

Agenus (NASDAQ:AGEN)
My third biotech pick has also run very hard of late, and may be overdue for a rest. Agenus is even smaller than Affymax, at all of $144 million in market cap. And that's after the stock has more than tripled since the beginning of the year.

Agenus is using proprietary technology to develop vaccines, notably a personalized one for brain tumors and a generalized one for genital herpes, both of which are showing promise in preliminary trials.

More to its immediate benefit has been interest from GlaxoSmithKline (GSK) in licensing from Agenus a key ingredient of many vaccines known as an adjuvant. Glaxo was already testing Agenus's adjuvant in clinical studies of vaccines for malaria, melanoma, lung cancer, and shingles.

It recently paid Agenus a further $9 million to add another undisclosed vaccine candidate to the list, and for a five-year right of first refusal to buy Agenus or its assets.

That wink-and-nod might mean nothing at all, but given the relative means of the maybe-suitor, it's certainly excited the three analysts who follow the company. Roth Capital recently slapped a $18 price target on the stock, making it by far the biggest booster.

It's notable that Agenus traded at such peaks briefly in 2009, before a series of reversals dimmed its prospects. But then, Affymax was a $24 stock less than two years ago. This is the kind of volatility that saps capital and tests faith, and it comes with the biotech territory.

Given such risks, the upside can obviously be hugely rewarding from time to time. I believe that's the case for each of the stocks I've described, such that they're attractive notwithstanding the daunting risks.

As Jim Jubak recently noted, chronic diseases like diabetes, obesity, and kidney failure are growing problems for mankind. and a promising growth area for pharmaceutical companies. You could just as easily add cancer and herpes to that list. The companies I've described can each claim to have best-in-class technology within their specialized field.

Disclosure: Igor Greenwald is long Affymax shares, and has purchased Affymax as well as Vivus and Agenus in portfolios he manages for relatives.

Source: 3 Biotechs On The Verge