Who Knows About the Bull Market in Biotech Stocks?

Is There No End to the Biotech Bull Market?

Biotech ETFs NASDAQ Biotechnology (IBB) up 36% YTD and NYSE (FBT) up 42% YTD

Around 1998 I remember vividly two market conversations: one from a Sun Micro sales executive telling me “there is no end to chip stocks”; the other from an astute investor telling a Los Angeles Laker staff member to “load up on all tech stocks” like Intel Corporation (INTC), Cisco Systems Inc.(CSCO) and Microsoft (MSFT). Click to see long term charts compared to recent prices. The mood during those bubble days was exuberant with an explosion of new companies created by the Internet and corporate revenues booming. This ebullience spilled over to biotech stocks even though the technology boom was unrelated to medical breakthroughs. Small and mid-cap biotech stocks with no revenues and no early stage prospects in the clinic soared with multi-$B valuations . Human Genome Sciences Inc. (HGSI), which traded at $100 in 1999 was recently sold to GlaxoSmithKline plc (GSK) for $2.85B or $14 a share. However since the 1999 time frame, many biotech stocks have exceeded bubble levels and continue to roar ahead as per current prices over 10 years: Amgen Inc. (AMGN) up 101%%, Biogen Idec Inc. (BIIB) up 282% and Gilead Sciences Inc. (GILD) up 702%.

The investment environment is a lot more cautious today due to the 2008 credit meltdown and subsequent recession but equity investing overall is very bullish with 20%+ YTD returns despite all the macro issues. Monetary expansion (QE Forever) by the FED has made equities even more attractive. But ask around and you will get the impression that there is no bubble in biotech because very few money managers, investment advisors and Wall Street types even know about biotech.

What is different this time compared to 1999 is that only a small focused group of investors and funds are trading biotech stocks or even know that the sector iShares NASDAQ Biotechnology (IBB), First Trust NYSE Arca Biotech Index (FBT) is up about 40% YTD. Investors are unduly cautious due to concerns about the Europe credit debacle, the crash of the housing bubble and the fiscal cliff. Typical retail investors do not have the resources to invest or are being ultra-conservative despite a lack of yield from a bank CD or money market funds. “Wealth managers” are more concerned with preserving capital or seeking 5% returns from bonds or blue chip high dividend stocks. They are unlikely to recommend biotech stocks or funds because either they do not know them or do not take the time to understand the sector.

The biotech sector performance is being driven primarily by company executives, hedge funds, ETFs and more recently mutual funds that are diversifying their healthcare and pharmaceutical positions with high growth biotech stocks. Biotech stocks are hard to value as the classic metrics such as PE and P/S are less important than clinical news, technology value, and M&A. What is also different from 1999 is that the sector is still relatively unknown, not hyped and new money is likely to come in and drive life science stocks higher.

So what are some of the underpinnings of this bull market in biotechnology stocks?

1. The themes of medical breakthroughs, genomics, personalized medicine and new products that are cost effective and bring in new money.
2. Many large cap biotechnology stocks are now growth stocks with revenues and earnings making impressive gains. And mid-cap stocks with no earnings and no revenues are making big moves on speculation,aggressive forecasts and takeover potential.
3. The biotech sector will ride the coat-tails of NASDAQ , healthcare and technology stock strength. For example, the widely traded ETF PowerShares (QQQ)Trust tracks many large cap NASDAQ-100 stocks but also has holdings of many large and mid-cap biotechnology stocks. Moreover ETFs are a major factor for investing in today’s market and an excellent tool for balancing portfolios and trading.
4. Momentum begets momentum and institutional traders with lots of capital can ride their favorites up.
5. VC’s have not raised a lot of capital over the past five years to create new life science companies so there is a limited number of quality large cap and mid-cap stocks.Fewer companies means more stock appreciation. Despite the lack of IPOs smaller companies that go public through reverse mergers can still raise money in this bull market if they have clinical news and partnerships.As an example look at Galena Pharma, Inc.(GALE) a cancer therapeutics Company with a Phase 3 drug candidate, Neuvax, a peptide based immunotherapy. Galena went public through a reverse merger as a spin-off of RXi Pharmaceuticals while raising additional funds in Q2.
6. Large cap pharma R&D has more risk and there are more opportunities outside, spurring a steady M&A trend to fill gaps in pipeline and revenue.
7. Clinical trial success and FDA approvals are increasing with 18 approvals in 2012 and 345 in 2011.
8. The trading and fast money mentality of the current stock market is drawn to biotechology.Why? People are always concerned about their health and clinical news in the industry creates interest and stock appreciation. The industry is more mature and product innovation on the increase. Last week for example in a New York Times article researchers using genomic tools identified four genetically distinct types of cancer. As the molecular basis of disease and tumor types is better understood, new targeted therapies for cancer will be developed.
9. NIH investments over the long term has created innovation in the molecular basis of disease.
10. Niche markets such as “orphan drugs” create huge profits with high prices and no competition. For company examples look at Alexion Pharmaceuticals (ALXN) Biomarin Pharmaceuticals (BMRN) and Genzyme recently acquired by Sanofi-aventis (SA).Orphan drugs for rare diseases are a $50B market with a high growth rate according to Thomson Reuters and has become a popular strategy for the industry since the success of Biomarin and Genzyme products. An article in the Wall Street Journal reported a scientific breakthrough and ongoing clinical study on a fatal,rapid aging disease related to the protein progeria, which was originally studied as a cancer therapy.

So what can derail this bull market at 10 year highs?

Nobody knows but these stocks are highly dependent on sentiment rather than fundamentals. A severe correction in the overall market especially NASDAQ would bring biotech indices down but less so because the sector is not earnings and macro driven. Other issues might be reimbursement changes (see Questcor Pharmaceuticals, Inc. (QCOR) as the insurer Aetna (AET) said it would limit reimbursement of its top selling multiple sclerosis drug H.P. Acthar. Also be wary of a major product failure that could affect overall sentiment or cause investors to look at extreme valuations.

So what investment strategies are to be considered in the life sciences at the current highs YTD?

• Build a portfolio of stocks with diversification in biopharmaceuticals, diagnostics and tools. Use ETFs and funds to balance the portfolio.
• If you are not in the sector add a fund (Fidelity Select Biotechnology Fund FBIOX, T.Rowe Price Health Sciences PRHSX) or an ETF (FBT,IBB, XLV).
• For new stock buys stick with large and mid caps with a strong balance sheet. Small cap, more volatile stocks are for full time traders.
• As a review of three year performance and selected stocks look at the Rayno Life Science Portfolio of focus stocks.