Once upon a time the City couldn't get enough of those promising offspring of campus research - biotechnology companies. Now their stocks have taken a dive. James Norman explains why such a specialised investment is best left to the experts

Biotechnology, the exploitation of new artificial techniques to produce drugs and other products, has lost some of its gloss in recent years. Most biotechnology companies quoted on the Stock Exchange - a number of which grew out of university research - are trading at some of the lowest prices ever. The sacking of the clinical research director at the Oxford-based company British Biotech coupled with allegations about its conduct of drug development have put both company and sector in the spotlight.

Harold Baum, emeritus professor at King's College London, believes biotech companies have a vital role to play in developing new medicines. But he also thinks that the story of British Biotech shows that the public needs to be dissuaded from placing its money in such high-risk ventures.

Drug discovery and development are not trivial processes. The pharmaceutical industry reports that only one compound out of every 100,000 synthesised ever reaches the marketplace. It can take 12 years to go from the original lab-bench concept through the clinical testing before the drug comes to market. By that time, pharmaceutical companies may have spent as much as Pounds 400 million for each new drug launched.

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Although biotech companies may be able to complete drug discovery faster, and consequently more cheaply, than pharmaceutical companies they still need access to money. In 1997 the global biotech industry raised about $7 billion from selling shares to fund research and development.

Baum's concern is that the only way biotech companies are able to finance their development efforts is by raising money on markets such as the London Stock Exchange. At this point the money no longer comes from experienced venture capitalists who put up the money to start new companies, but instead comes from huge institutions and ordinary people who like to play the markets.

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"While initially the buyers of the stock will be the professional fund managers, inevitably a surging share price, where the value can quickly increase some 20-fold, will attract investors who do not necessarily have an understanding of the science. In fact, most of the public - and some apparently sophisticated fund managers - haven't got the slightest idea what they are investing in and would probably be better off betting on the 3.30 at Chepstow," Baum says.

A biotech stock can see its price rise meteorically on the back of some positive news in the clinic. Baum recognises that this can make an investment look like a very attractive gamble but thinks that amateurs are at a huge disadvantage. "The layman hasn't the slightest idea what is happening. At least with the 3.30 at Chepstow you have a tipster who can tell you who is going to win based on the form book. With biotech stocks ... you won't have seen the reports on the clinical trials, or understand the technology or what the competition is. It is a very specialised field."

For much of 1995, shares in British Biotech were trading below Pounds 5 following disappointing news associated with the company's anti-cancer compound, Batimastat. But positive early news about a follow-on product - an anti-cancer drug that could be taken orally called Marimastat - prompted huge demand for the stock in December that year. By May 1996 British Biotech's share price had rocketed from just under Pounds 5 to more than Pounds 30.

"This performance attracted the attention of the general public. We were constantly asked by television and radio business programmes what was going to be the next British Biotech? Many investors, including major pension funds previously sceptical about biotech companies, felt they had missed the boat and looked to make amends," notes Shaun Brown, staff writer at business newsletter BioCentury. Other biotech stocks followed suit.

The huge demand gave British Biotech a market capitalisation of some Pounds 2 billion - higher than RailTrack, which was then being privatised. Baum thinks this was unjustifiable. British Biotech had brought no products to market and was spending shareholder money on compounds statistically more likely to fail than succeed. "Nevertheless, British Biotech was able to persuade the market that its products were worth backing and during 1996 was able to raise almost Pounds 200 million through the sale of more shares to finance its drug development," says Brown.

The euphoria surrounding British Biotech in 1996 was not sustained. The company's share price drifted downwards as shareholders became concerned that the progress of key clinical trials was not running as smoothly as it might. Last summer, officials at the United States Food and Drug Administration told British Biotech it wanted proof that a product it was developing to treat pancreatitis saved lives. This meant the company would have to spend more time and money before it could even consider a lucrative launch in the US. European regulators decided to ask for the same evidence earlier this year. Both events dented the stock price.

More devastating for investor confidence in British Biotech is the lack of progress of clinical trials - now being investigated by the House of Commons Select Committee on Science and Technology. MPs are investigating whether British Biotech intentionally misled shareholders by being too optimistic about the progress of its compounds in the clinic. They are particularly concerned about the possible detrimental effect the experience may have on the rest of the UK biotech sector - still Europe's largest, employing 10,000 people, but now a little under the weather.

The market value of biotech companies listed on the London Stock Exchange is more than 55 per cent down from its peak in May 1996. It is facts like these that prompts Baum to argue that the public needs to be protected from investing in biotech companies. "There are just too many variables that can prompt a stock to crash. First, there is very little guarantee that a compound will make it to the market. Second, medicine is moving so quickly there is a danger that any one approach by a company may be overtaken by scientific developments."

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Research analysts employed by City firms to pick winners argue that they take such variables into account. Nevertheless, according to Stephen Ewing, biotech analyst at Panmure Gordon, evaluating biotech companies is notoriously difficult. "We can come up with a value after making certain assumptions. At times these can look a little toppy but it is worth remembering that the potential upside could be huge."

And it is true that, although the biotech sector is relatively young it has delivered some blockbuster products. Amgen, a Californian biotech company, has discovered and marketed two drugs worth $1 billion each.

Nevertheless, Baum finds support for his view that the public should be wary about dabbling in biotech stocks. And he does not restrict his concerns to the fate of the inexperienced speculator. "The other thing I feel strongly about is that unlike most companies on the stock market these companies do not have products. I think it is a scandal that any director of such a company be allowed to cash in share options until they have a product on the market, because it opens up the possibility of corruption," he says.

But this is not a popular view among those linked with the industry. Peter Keen, managing director of Merlin Ventures, a venture capital firm involved in establishing new biotech companies from British universities, argues that founders may not be around when the company moves into the commercial phase and that it would be unfair for them not to get some rewards for their efforts.

Baum recognises that the initial backers - usually venture capitalists - want to see a return on their investment in a reasonable time and that drug development requires lots of money, two needs the public market can meet. As an alternative he proposes a pretty unfashionable solution - more state involvement in the biotech sector. "Perhaps the government could buy an interest in these companies which might control the whole issue of patenting against the public interest," he suggests.

OXFORD'S MILLIONAIRE WHO WON'T HANG UP HIS LAB COAT

Oxford University chemistry professor Steve Davies is a millionaire don, at least on paper. The bioscience company he set up, Oxford Asymmetry International, was floated on the Stock Exchange earlier this year and now enjoys a market capitalisation of some Pounds 190 million. But Davies has no intention of swapping his white lab coat for the pinstripe of the executive board member.

"My motivation for setting up the company was not to get rich but to access unrestricted funds to spend more time doing what excites me most and that is research." Before establishing Oxford Asymmetry, which produces the molecular building blocks for drugs, Davies said he was spending about 60 per cent of his time writing grant applications, 40 per cent of his time in administrative and teaching duties and hardly any time on research.

Davies made a conscious decision to stay an academic although he does have an important role in helping shape the company's science as a non-executive director. "It is not really possible for an academic to be an executive director. Executive directors need to devote all their efforts to running the company. Academics should devote all their time to their work. It is not possible to do both jobs," he says. Importantly, the company has no control over the chemistry Davies and his team of postgrads and postdocs do.

Apart from the financial support given to the university's Dyson Perrins Laboratory, Davies is also proud of the company's achievements. In six years it has grown from one to 120 employees and is extremely profitable. "What I like best is the fact that the company employed more chemistry graduates than any other British firm last year."

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Oxford Asymmetry provides Davies's department with a percentage of profits. The University of Oxford is also a beneficiary as it is a shareholder with a stake valued at nearly Pounds 12 million. "I am hoping to persuade the university to use some of the Oxford Asymmetry money for a new building in the chemistry department," Davies adds.