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Biotechnology doesn't have to be a blue sky investment. As Christopher Spink discovers, you can get high-rate returns deploying a low-risk approach

Backing individual biotech stocks is a hit and miss affair. The majority of companies involved in this innovative area of medicine are only concerned with very specific research and most raise money from investors at an early stage of their existence, well before bringing in revenues from their potential products.

The nature of drug development, which on average lasts ten years from initial idea to completed drug, is thus fraught with risks. A project can fail at any stage of this lengthy process, effectively leaving the investors with nothing at all. Only those with money to lose and a penchant for gambling can afford to take such risks on individual biotech companies.

However, private investors who want exposure to this exciting area, where profits on successful projects can be immense, do have alternative ways of backing biotechs and reducing the risks associated with lengthy drug development projects.

Ready-made drugs

One simple, alternative strategy might be to pick a ready-made portfolio of biotech shares, already selected by a fund manager.

There are several investment trusts dedicated to the sector. The largest two, both of which are worth over £100 million, are the Finsbury Worldwide Pharmaceutical Trust and the 3i Bioscience Trust, managed by Dr Andy Smith.

Over the past year both have endured tough times as the valuations of many biotech ventures have slid dramatically. The Finsbury trust, which also contains a number of large pharmaceutical companies as well as biotech tiddlers, has seen its net asset value (NAV) drop by a third, whilst the 3i trust is down 43 per cent.

The latter's shares currently display a discount of nearly 30 per cent to NAV, which should attract investors keen to get some representation of this exciting sector in their portfolio at a possible bargain price. Both trusts tend to invest in biotech companies around the world, principally in the US rather than focusing on UK developments.

Those keen for access to home-grown opportunities might like to look at the Bioscience Venture Capital Trust (VCT). This trust, launched last year by Octopus Asset Management, raised £7.1 million.

Because the trust is a VCT, the money must back British-based ventures with gross assets of less than £15 million. This is so the trust's investors qualify for the generous VCT tax breaks, which mean subscribers for new shares gain 20 per cent income tax relief and all shareholders get dividends paid tax-free.

Outsourcing services — side-stepping the

development risks

Those reluctant to entrust their fortunes in this field to a specialist fund manager do have another route to gaining

low-risk exposure.

A number of companies that have recently joined Aim provide services to biotech and drug companies. This means they benefit from the growth of research in this sector without taking the risk of working on just one individual project. Some also take equity stakes in some of their client companies, thus building up a portfolio of drug candidates with high potential as well.

By providing outsourcing services to these cash-strapped companies they are helping the biotech ventures bring their research to fruition and receiving revenues at the same time.

Fulcrum Pharma — making profits

Fulcrum Pharma is the only Aim-listed company in the drug development sector that currently makes a profit. In the year to the end of August, Fulcrum, which will organise clinical trials for a drug candidate on behalf of biotech or major pharmaceutical players, reported a 68 per cent rise in profits before tax and exceptional items to £917,000.

This happened despite a five per cent drop in turnover to £5.74 million. Chief executive Jon Court says investors should focus on the company's gross profits figure to get an idea of how the business is growing. This rose 40 per cent to £1.93 million.

Court explains that Fulcrum takes a consultancy fee for providing drug development services, such as carrying out early clinical trials. The costs of actually implementing these services passes through the company's accounts as they are billed directly back to Fulcrum's clients, theoretically boosting turnover. However, only the fee from these clients remains in the gross profits figure. Whilst retainer fees may rise, as reflected in the gross profits, the contracts vary in size, in turn causing turnover to swing up and down.

Over the past year Fulcrum has strengthened its global operations, opening an office in the US and setting up a new legal vehicle for its Japanese operations, where a third of revenues come from. This will enable it to carry out more specialist procedures in this highly regulated area. Overall, Fulcrum now has 26 employees and has so far won 40 contracts from 25 clients. These last on average a year and a half and the largest one is worth £550,000. The first US contract has recently been signed.

Last May, the group raised £3 million via a placing with a range of Venture Capital Trusts (VCTs), including Artemis AIM, Northern and Isis Capital, which is the group's major investor. This cash was earmarked to invest in biotech companies with promising drug portfolios that Fulcrum hopes to provide services to. These would become the company's 'preferred suppliers'.

Court has not used any money so far, citing the turbulent nature of valuations in the biotech sector lately. Instead he now wants to find specific drugs within the portfolios of these research enterprises and invest in them – thus forming a group of promising drug candidates with the money. He then hopes to provide services to these companies, bringing these drugs to market. A couple of candidates are currently being assessed. Overall cash stands at £5.1 million at the year end. This compares with a market value of just £12.6 million.

The shares stand at 10.4p. House broker Seymour Pierce predicts 1.3p of earnings per share, after excluding exceptional items, for the current year, which gives a prospective p/e ratio of eight.

Cyprotex – testing drugs

Cyprotex also provides services to drug developers, but generally before their drug candidates reach the trial process. The company, set up by former Astrazeneca scientist Dr David Leahy, advises drug companies on how their compounds, which they hope to turn into drugs, will react in the body and whether they will work as intended.

This is done through extensive tests to see how the compound will be absorbed, distributed around the body, metabolised and eventually eliminated. Apparently, over 50 per cent of drugs fail at Phase I of clinical trials because the drugs cannot be absorbed or accepted by the body for one of these physical reasons.

Cyprotex is also in an earlier stage of its life than Fulcrum. The group raised £5.8 million net via an Aim flotation mired with controversy surrounding a spread bet taken out by major shareholder Paul Davidson, a long-term supporter of the venture, who has also been involved with two other Aim companies: Oystertec, the developer of a revolutionary radiator fitting; and Galileo Innovation.

Cyprotex is using the money to bolster staff numbers, from 17 to 38 by the end of last June, and upgrade the technology in its laboratories. The group has developed a mechanical testing process to predict these properties a compound will display. It uses technical software and robots to screen these potential drugs.

The shenanigans surrounding the float means the company has a reluctant institutional shareholder, which is proving a drag on the share price. Since admission the shares have fallen 38 per cent from their 29p float price to just 18p, valuing the group at £16.3 million. However, the company is hoping to raise more money soon, which should help to remedy this problem.

In the eight months to the end of June the group registered a £1.72 million loss on revenues of £382,000. This reflects the early-stage phase the company is at. However, Cyprotex also signed two major contracts in this period with Astex Technology and Roche to provide them with their research facilities. In addition it has opened an office in the US.

Chief executive Dr Mark Egerton reckons Cyprotex has enough cash to get to break-even. He hopes to sign up other drug companies to use Cyprotex's testing technology in coming months as well.

Cobra Biomanufacturing – making DNA

Cobra joined Aim last year, raising £6.6 million as it was spun off by fully listed ML Laboratories, which was experiencing cash flow problems. The company specialises in making DNA and other biopharmaceuticals, such as viruses and proteins, for biotech companies wishing to develop novel genetic therapies. It also has the ability to ensure that its strains are not resistant to antibiotics – an increasing medicinal problem.

The shares, floated at 100p, now sit at 77.5p, valuing the company at £10.1 million. Like Cyprotex, it has yet to make a profit and is at a relatively early stage in its business life. Maiden final figures as an independent entity showed the company had made a £937,000 pre-tax loss in the year to the end of September, significantly reduced from the previous year's £4.65 million deficit.

This happened after turnover increased 124 per cent to £2.54 million during the period as fresh supply contracts were signed. Chief executive David Thatcher said the group was cash-flow positive in the fourth quarter as well. This year the company needs to pull in £4.9 million of revenue to break even. With the orders already agreed, this looks possible.

The group has signed contracts to supply DNA to the Medical Research Council in South Africa, which is attempting to find an HIV vaccine, and Australia's Mayne Pharma, which is making a cancer gene therapy product. Cobra's products will be used in early- stage trials and a further supply deal can be negotiated if the drugs proceed to Phase III trials and commercial production.

However, these are just two examples of Cobra's 22 contracts, many of which are bound by confidentiality agreements. This strong order book, worth £3.2 million at present and with £1.2 million extra likely to be signed soon, when combined with Cobra's healthy cash position means the group can look forward with confidence to this year and beyond.

House broker Collins Stewart predicts a £1.1 million pre-tax profit in the current year, which would lead to 8.4p of earnings per share, putting the stock on a p/e ratio of just 9.2.

The broker does point out risks though, saying Cobra has not got the facilities yet to produce DNA in large enough quantities for a Phase III trial. More money would need to be raised to build such a plant. Major shareholder ML Laboratories may also want to sell its 46 per cent stake after its year lock-in ends this June, which could send the shares down.

Another factor worth considering is that the US market is proving hard to crack. A patient in an earlier drug trial using genetic therapies died and the US authorities suspended trials using DNA in 2000. They have now begun again under stricter rules and so far only larger chemical producers have taken orders.

Nevertheless, Cobra is the only UK company in this field and offers lots of potential to those investors prepared to take more risks than most.