After several years of decidedly substandard performance, the share prices of life sciences firms appear set for a rebound. This is especially true of the biotechnology sector — made up of firms that rely on genetic engineering to try to cure everything from Alzheimer’s disease to cancer.

“We expect 2007 to be a relatively strong year for biotech,” wrote Bret Holley, an analyst with CIBC World Markets Inc. in New York, in a research report published on Jan. 16. “The relative underperformance of the sector in 2006 presents buying opportunities.” As a result, CIBC is advising clients to overweight in the biotech sector.

Biotech shares have a lot of catching up to do. From the beginning of 2004 to Feb. 12, 2007, the Nasdaq biotech subindex returned only 13.4%, compared with a 29% gain in the S&P 500 composite and a 25% rise in the Nasdaq composite.

Shares of Big Pharma- companies did somewhat better than their smaller biotech cousins. (Big Pharma firms are fully integrated drug giants, such as Pfizer Inc. of New York and Johnson & Johnson of New Jersey, which make most of their money selling pills developed through the application of chemistry rather than biology.) Most of the Big Pharma companies can be found in the New York Stock Exchange health-care subindex, which returned slightly less than 21% from Jan. 1, 2004, to Feb. 12, 2007.

The gap between biotech and other stocks was even more pronounced in Canada, where the TSX health-care subindex — which consists predominately of biotech firms — actually lost 20% in the same period. In comparison, the S&P/TSX composite index returned 69% over the same period.

Nevertheless, there are several factors pushing analysts to recommend biotech shares. The most important is that Big Pharma firms are producing fewer blockbuster drugs each year — not least because it now costs in excess of US$1 billion and takes more than a decade of trials for a major drug to receive regulatory approval.

In addition, the industry generally is moving toward more targeted medicines that aim to cure less common diseases. In part, this reflects the mapping of the human genome (our genetic code) in 2000 — an event that prompted thousands of biotech start-ups to develop more drugs that target people with specific genetic flaws.

Not surprising, Big Pharma firms have been acquiring dozens of nimbler biotech companies or forming partnerships with them. This trend is expected to intensify and, along the way, push up biotech valuations. It should also prime the pump for initial public offerings.

Burrill & Co. , a San Francisco-based investment-banking firm speciali-zing in life sciences, predicted in January that more than 30 biotech firms will go public this year in the U.S. alone — compared with 19 IPOs in 2006.

But while there is plenty of scope for sharp gains, potential investors in this sector should be aware of the risks. For example, Burrill & Co. points out in its Feb. 7 research report that, of the 71 biotech IPOs completed in the U.S. since 2003, 30 of them were still trading below their IPO price at the 2006 yearend.

Volatility within the sector is exceptional. One of the best recent examples is Onyx Pharmaceuticals Inc. , an Emeryville, Calif.-based biotech firm that develops therapies designed to reverse the impact of gene mutations that cause cancer. The company’s share price on Nasdaq tumbled 30.4% on Dec. 4, 2006, to US$12.18, when Onyx revealed that using its anti-cancer drug, Nexavar, together with other anti-cancer drugs had little impact on skin cancer in patients enrolled in a Phase III trial.

But on Feb. 12, Onyx shares almost doubled to US$24.15 after the firm announced that a different Phase III trial of Nexavar had enhanced survival rates in liver cancer patients with very few side effects.

The remarkable part about these swings in value is that Onyx is a significant entity, with a market capitalization of US$1.1 billion.

The risks are there for even the very biggest firms — ones with dozens of different drug candidates in the pipeline. When Pfizer announced on Dec. 2 that it would cancel all clinical trials related to Torcetra-pib, its next-generation cholesterol fighter, its shares dropped 14% to US$24.90, resulting in a loss of US$21.3 billion in market value.

@page_break@Pfizer’s investors can take some comfort from the fact that the firm has more than US$20 billion in cash on hand it can use to acquire new drug candidates — assuming Pfizer can pick correctly.

The key to investing in pharmaceutical and biotech firms is diversity. That advice — given a couple of years ago by Sam Isaly, the fund manager of Eaton Vance Worldwide Health Science Fund of Boston to readers of Fortune magazine — remains solid. At the time, Isaly picked five of the best 15 Big Pharma companies for 25% of his portfolio and held 40 others at an average of 2.5% each. The highest-risk firms contributed no more than 1%-2% each.

A quick check of Isaly’s holdings as of Sept. 30, 2006, reveals he has stocked up on big biotech firms (Genentech Inc. of San Francisco, Amgen Inc. of Thousand Oaks, Calif., and Genzyme Corp. of Cambridge, Mass.) His top pharma picks are Novartis AG of Switzerland and Wyethof Madison, N.J. The fund holds 30 stocks, for an average of 3.3% each.

The shift to biotech is in keeping with this year’s investing theme. This is especially true of the situation in Canada, where no life science company, even specialty pharmaceutical firm Biovail Corp. of Mississauga, Ont., is large enough to be considered Big Pharma. In fact, the vast majority of the 144 health sciences firms listed on the Toronto Stock Exchange and TSX Venture Exchange qualify as small- to mid-cap biotech firms.

Only 36 of these had a market value in excess of $100 million at the end of 2006; only 11 were worth more than $500 million.

In this special report, Investment Executive examines analysts’ sentiments for the biggest of the Canadian firms — “lukewarm” and “cool” would be the best way to describe them. We also culled more than 100 companies to find those most favoured by the analysts who cover them. (See tables on page 42.)

Also in this report, IE looks at how to invest in biotech through life sciences funds (pages 44-45), and at some of the most interesting Canadian picks, such as Biovail, Neurochem Inc. and QLT Inc. (pages 46-47). IE