Standing over a microscope at Regeneron Pharmaceuticals recently, Andy Acker and his fellow portfolio managers marveled as scientists created what would become a veritable litter of genetically modified “knockout mice”—key in the study of gene function—in under five minutes. It used to take two years to create just one.
To Acker, the moment was emblematic of the countless ways in which the biotechnology industry is breaking new ground. “We’re practicing science fiction today,” says Acker, whose $3.6 billion Janus Global Life Sciences Fund has returned nearly 14% annually for the past 10 years, propelled by biotech winners. “The excitement level for the sector I think has never been higher.”
Indeed, biotech companies are churning out innovations at a breakneck pace, from near cures for cancer and hepatitis C to unprecedented achievements in editing a person’s actual DNA. And the sector’s stock performance has been almost as exciting: The Nasdaq Biotechnology index has nearly quintupled over the past decade and returned 34% last year alone—easily eclipsing the S&P 500’s gain of 11% for 2014.
The bullishness is palpable. Even President Obama, in his State of the Union address, exalted a cystic fibrosis drug by Vertex Pharmaceuticals (VRTX)—signaling to some analysts that a golden era of pharma regulation had dawned. The FDA approved 100% of the 41 novel drug applications in 2014, the most new drugs in any year except 1996. “Pipelines across the industry as a whole are richer than anything I’ve ever seen,” says Robert “Dr. Bob” Deresiewicz, a partner at Wellington Management and a onetime physician who helps oversee the USAA Science and Technology Fund.
Biotech has helped drive the recent outperformance in the health care sector. When all 2014 earnings reports are tallied, health care companies are expected to have had the highest earnings growth (16.5%) of any S&P 500 sector and double the index average, spurred by an 85% surge in biotech, according to S&P Capital IQ.
That hot streak has stretched stock valuations to the brink. Trading at 49 times projected earnings for 2015, the Nasdaq Biotechnology index is more than twice as expensive as the overall Nasdaq. Those teetering heights have tested investors’ nerves—especially since nearly three-quarters of the companies in the biotech index are not yet profitable. “You’re giving a lot of credit to a company that has no approved products but has something in the pipeline that’s interesting,” says Artisan Partners’ Matt Kamm, who helps manage some $24 billion. “And that can be dangerous.”
Biotech investing is largely an all-or-nothing kind of activity: Drugs either work or they don’t, says Deresiewicz. And when they truly benefit patients, they can deliver explosive, grand-slam growth. “My belief is firmly that the real sweet spot for making money in biotech is in the transition from obtuse asset to asset,” he says.
As a result, most biotech bulls try to focus on companies with huge future growth potential rather than worrying about today’s meager or nonexistent income. “Where are the pockets of unmet need in the world today? Is it another app for our smartphone, or is it going out and curing one of the diseases that has plagued humanity for centuries?” asks Finny Kuruvilla, a doctor-turned-investor who runs the No. 1–ranked $1.3 billion Eventide Gilead Fund, with 25% in biotech (the fund bears no relation to biotech behemoth Gilead Sciences (GILD)). “For me, what’s exciting about biotech and health care investing is that it’s much more challenging.”
A part-time venture capitalist, Kuruvilla is betting on experimental companies such as Bluebird Bio (BLUE), which has reported encouraging results in modifying the cells of patients with blood disorders, reducing the need for transfusions. He also likes Chimerix (CMRX), which is working on an antiviral drug for Ebola. To limit his risk, Kuruvilla sticks to small stakes on individual names and keeps a close eye on clinical-trial papers. A regular investor looking for exposure might consider a diversified ETF such as iShares Nasdaq Biotechnology.
The volatility in biotech can be vexing even for industry veterans. Witness Wen-Tse Tseng, a former Amgen research scientist who manages $9 billion for AB (previously AllianceBernstein) and is currently underweighting biopharma because of the sector’s high failure rate. One stock Tseng is betting on now is Puma Biotechnology (PBYI). But he bought in too late to score big when the stock quadrupled in a single day last summer after encouraging breast cancer trial results. Missing the occasional bonanza, however, bothers him less than riding along on the crashes. “If you have a disappointing outcome, you pretty much wipe out the valuation of the whole company,” he says.
Kamm of Artisan Partners tries to avoid that type of setback by opting for companies that already have FDA-approved drugs on the market, as well as more up their sleeve. “We always prefer companies that have multiple shots on goal,” he says. A couple that he likes in that category are Incyte (INCY) and Isis Pharmaceuticals (ISIS), both of which have already brought a drug to market and have others in the pipeline. “It gives us the confidence that a company is not a one-hit wonder,” says Kamm.
A mix of strategies has worked for Acker of Janus. He has owned two of his favorite stocks, Celgene (CELG) and Alexion (ALXN), since before they began selling now-blockbuster drugs. Both are still finding new indications for those medications, expanding their potential. Celgene, for one, recently forecast that it will grow earnings 23% annually through 2020. “Very few companies can do that,” Acker says. Then there is Regeneron (REGN), which, in addition to making mice, has impressed Acker with its ability to manipulate genetic material to create highly targeted treatments. He expects the miracles to keep on coming.
This story is from the March 15, 2015 issue of Fortune.
