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Is There Opportunity in Personalized Medicine?

Although we're in the early innings of the personal-medication revolution, the stock prices of most biotech companies are sky-high.

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The Human Genome Project was declared complete in April 2003 and, while genomic mapping might not explain your fondness for yodeling, it may help cure you of any number of really awful diseases. But does the personalized-medicine revolution present opportunity to investors today?

Personalized medicine is the ability to match the right medicine at the right dose for your particular genetic set. The Human Genome Project, an international effort to sequence and map all the genes of our species, was the first step in personalized medicine. It took about 13 years and $3 billion to map one full genome--the order of the 3 billion or so molecules that make up a human's DNA.

Genetic mapping has moved much faster since then. Last year, Illumina (ILMN) rolled out a gene sequencer that can map 18,000 genomes per year at a cost of $1,000 per genome.

And it's low-cost sequencing that makes personalized medicine truly personal, because many diseases, including cancer, have a genetic component to them. "Usually, if you have a genetic element of disease, you have something wrong with a genetic mechanism, and drugs can be targeted to correct that," says Morningstar stock analyst Stefan Quenneville. Ideally, genetic testing leads to the drug that's most effective for you.

One success story is Herceptin, produced by Roche (RHHBY). The drug is extremely effective in treating breast cancer for those with the genetic biomarker Human Epidermal Growth Factor Receptor 2-Positive (HER2+). More recently, researchers at the University of California have completed a study on levels of two genes in patients with colorectal cancer, suggesting different treatments for those with high and low levels of the genes.

The one-two combination of gene sequencing and drug therapy has also moved to rare diseases that affect just a few people globally. "There has been an explosion in the focus on rare diseases," Quenneville says. "A lot of them involve a key gene that doesn't work and causes problems for patients."

While there are relatively few patients, drugs can often command very high prices. Kalydeco, for example, is a drug for treating cystic fibrosis, a lung disease, in patients with specific gene mutations. The drug is manufactured by Vertex Pharmaceuticals  (VRTX) and can cost $300,000 a year.

At the leading edge of personalized medicine is gene therapy, which involves adding a healthy gene or replacing a defective gene in a patient's body. It could be promising for genetic diseases, but gene therapy is still experimental and a long way off.

What inning are we in in the personal-medicine revolution? "I would say the players are still in the bus on the way to the stadium to warm up," says Edward Yoon, manager of Fidelity Select Health Care Portfolio (FSPHX). "A lot of what is being done now is at the basic research level."

The path to approval for new treatments is arduous. "These are antibodies that deliver drugs to kill tumors without killing the healthy cells alongside them," Yoon says. "They have to go through the clinical trial process. It's not like an app you can distribute to cell phones."

The problem for investors: While the revolution in personal medicine is likely a multidecade trend, prices for many biotech companies are sky-high after a nearly five-year-long bull market. Health-care stocks have gained an average 24.55% in the past five years, as of this writing, versus 16.59% for the S&P 500.

A few examples: Illumina, mentioned earlier, sells for 52.5 times its expected earnings for the next 12 months and is currently trading at its fair value, according to Morningstar. Vertex Pharmaceuticals, maker of Kalydeco, sells for 29.8 times expected earnings and also trades around its fair value. Foundation Medicine (FMI), which uses genomic information to assist researchers in finding novel targets for drugs, has no earnings, but has soared 60% this year.

Funds that specialize in biotech are pricey, too. The SPDR S&P Biotech ETF (XBI) has an average forward price/earnings ratio of 33.1. The fund's top holding, Synageva BioPharma, lost $60 million in the first quarter of this year, so it has no earnings. Nevertheless, it has soared 130% this year, the result of a buyout by      Alexion Pharmaceuticals (ALXN).

Yoon has been reducing his biotechnology exposure since 2012 as prices have soared. "The biotech tape has been incredibly strong the past five years," he says. "I love what I own, but I want to make sure I'm invested in the best companies that have the best risk/return profile," he says. "I'm trying to build a portfolio that will be more stable going forward."

A more sedate way to play the biotech revolution would be through larger pharmaceutical companies, which tend to buy promising biotech companies and their products. Morningstar equity strategist Karen Andersen notes that Roche has a solid drug portfolio as well as advanced diagnostics--a combination that makes it a formidable force in personalized cancer treatment. "As the market leader in both biotech and diagnostics, this Swiss health-care giant is in a unique position to guide global health care into a safer, more personalized, and more cost-effective endeavor," she writes. Wide-moat Roche sports a 2.75% dividend yield, sells for 18.3 times expected 2016 earnings, and is currently trading below Morningstar's fair value estimate.

In some respects, the boom in personalized medicine mirrors the dot-com boom of the 1990s. The Internet was, indeed, a revolution in the way information is delivered and business is transacted. And the personalized-medicine boom is an incredible shift in the way patients are treated. "It's a multidecade trend," says Yoon.

But buying at high prices can mean a long time to wait for a payoff--if there is one. And choosing the long-term winners is tough, too. Many of the smaller companies in the dot-com bubble went bust, and a few became behemoths. It's awfully difficult to tell which companies will succeed and which will fail.

If you own a broadly diversified stock fund, such as  Vanguard Total Stock Market Index  (VITSX), you'll probably own some of the next-generation members of the health-care revolution. And you'll have 14% of your portfolio in the health-care sector. If you want to speculate on personalized medicine, a larger pharmaceutical company with a wide moat, such as Roche, seems like a good bet. Otherwise, you're speculating on stocks with high prices or no earnings.

John Waggoner is a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.com.

John Waggoner does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.