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No profits? No problem for biotechs!

June 10, 2014: 1:19 PM ET
Biotech stocks have catapulted into the stratosphere thanks to optimism about growth and merger speculation. Who needs earnings?

The biotech stock slingshot: Optimism about growth and M&A speculation have boosted the sector. Who needs earnings?

The opinions expressed in this commentary are solely those of Paul R. La Monica. Other than Time Warner, the parent of CNNMoney, Abbott Laboratories and AbbVie, La Monica does not own positions in any individual stocks.

Earnings are supposed to matter. But that little bit of Investing 101 may need to be thrown out of the window when it comes to biotech stocks.

The biotech sector has staged a remarkable comeback from its lows earlier this year. The group was sold off hard along with other momentum darlings as the market worried about high valuations. That's no longer a concern. For now, at least.

Just look at the acquisition announced Monday morning: Merck (MRK) agreed to pay $3.85 billion in cash for biotech Idenix (IDIX), an unprofitable developer of a hepatitis C drug. The deal valued Idenix at ... wait for it ... a nearly 240% premium to its Friday closing price.

Take a minute and think about that. The stock finished last week at $7.23, By Monday morning, Merck had decided it was worth $24.50.

Idenix was already up more than 20% this year before the Merck deal. It's not the only money-losing biotech to surge lately either.

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Achillion (ACHN), another maker of a hep C medication, has surged more than 125% in the past two days thanks to good news from the FDA about its own hepatitis C drug as well as speculation that it too could be acquired.

MannKind (MNKD), which is developing drugs to treat diabetes and various types of cancers, has more than doubled this year. And InterMune (ITMN), which works on lung-disease drugs, has soared more than 180%.

The big moves in all these stocks have helped fuel the gains in two key biotech exchange-traded funds: the iShares Nasdaq Biotech ETF (IBB) and SPDR S&P Biotech (XBI) ETF.

And the rally may not be over. John Eade, a health care analyst and president of Argus Research, said the biotech sector is in the midst of a "research and development renaissance." The companies that Big Pharma will covet the most are those that are working to treat infectious diseases like hep C as well as those focusing on diabetes and oncology.

Eade mentions Incyte (INCY), a maker of oncology drugs, as a more speculative biotech that could attract some interest. The company already has partnerships with Eli Lilly (LLY) and Novartis (NVS).

Craig Callahan, CEO of ICON Funds, said another reason more biotech buyouts make sense is because Big Pharma has the marketing and sales expertise that smaller biotechs lack. And Big Pharma is desperate for new blockbusters in their pipeline. In fact, a certain 80s hit by Huey Lewis and the News could be the industry's theme song.

Callahan added that the biotech sector is now the largest in the ICON Long-Short fund, mainly because there are few other areas that offer as much potential for growth over the next few years.

But investors need to be really, really careful.

"There are going to be more deals between Big Pharma and biotech," says T.J. Qatato, co-manager of the Frost Growth Equity fund. "But we are looking for more consistent, stable growers with proven trial results." His fund owns big biotechs Biogen (BIIB), Celgene (CELG) and Gilead Sciences (GILD).

Paul Condrat, co-manager of the Davidson Multi-Cap Equity fund, agrees. He thinks larger biotechs are better investments for the long-term than the more speculative ones. They also can benefit from deals. He owns Amgen (AMGN) and points to the company's purchase last year of cancer drug developer Onyx.

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Condrat also owns Gilead, which already has a hepatitis-C drug on the market -- a drug that it acquired the right to when it purchased biotech Pharmasset in 2011. Shares of Gilead fell on Monday due to concerns about the Merck-Idenix deal. But he thinks that's an overreaction.

Callahan recommends that investors take on a little more risk though. He thinks that the biotech sell-off earlier this year was just a blip. Fears that the market may have topped and that the U.S. economy was heading into a more pronounced slowdown have faded.

"The theme of investors embracing recession-proof, high dividend stocks may be behind us. Investors are back to buying last year's winners, high-growth stocks like biotech as well as cyclical companies," he said.

With that in mind, Callahan owns more speculative, small cap biotechs such as Emergent BioSolutions (EBS) and Ligand (LGND) as well as biotech blue chips Biogen and Celgene.

Still, investors must remember that biotech is extremely risky. You need to know more about the companies than their earnings growth rates and valuation metrics. Smaller biotechs often rise and fall based on clinical trial results ... and that's the kind of information they teach in medical school as opposed to an MBA program.

That's why Joe Costigan, director of equity research at Bryn Mawr Trust, thinks that investors may be better off with larger, more mature (i.e. profitable) biotechs like Amgen as well as Big Pharma firms that may look to scoop up smaller, riskier biotechs, such as Novartis and Pfizer (PFE). His firm owns all three stocks.

Those companies can afford to pay 240% premiums for smaller biotech firms because the downside is limited if the deals doesn't pan out. If you're an average investor trying to pick the next Idenix, it's not easy to do so. And you probably don't want to lose your shirt trying to figure out what unprofitable biotech could get bought next.

"If you own the right biotech company, you can do well. There will be a couple of home runs, even grand slams. It is a land grab for Big Pharma," Costigan said. "But the vast majority of companies will not be hits -- and you need to understand the underlying science."

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Paul Lamonica
Paul R. La Monica
Assistant Managing Editor, CNNMoney

Paul R. La Monica is an assistant managing editor at CNNMoney. He is the author of the site's daily column, The Buzz, and also tweets throughout the day about the markets and economy @LaMonicaBuzz. La Monica also oversees the site's economic, markets and technology coverage.

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