Rally Retraces Correction Up To Mid-Point YTD

Up until this week we have focused on large cap biopharmaceuticals because of revenue momentum, fair valuations and earnings. A risk -off sentiment due to lack of ASCO buzz and the Q1 speculative bubble downdraft has curbed gains. This week with  news of the Merck $3.9B deal for Idenix (IDIX) we see a strong follow through with smaller caps. Achillion (ACHN) one of our picks from 2012 is a case in point, rising 187% over 2 days. The question is whether this is a trading rally or another leg up from the April lows. The tape has been very strong for small and mid cap life science stocks over the past 5 trading days with the sector up 3% or more outperforming the NASDAQ up only 2%.

M&A has always been a basic thesis of the biotech bull market but we challenged this in October of 2013 but valuations soared beyond realistic financial parameters in February 2014 . Investment bankers had a “hit list” of five $6B+ market cap oncology stocks that could be acquired. Most M&A has been financial or “tax inversion” related so the Merck (MRK) deal for strategic reasons i.e. buying Intellectual Property and HCV product pipeline offers a bullish rationale going forward.The sweet spot for M&A should be in the $5B range not mega-deals.

  • The bottom for biopharmaceutical stocks was reached in April 2014 followed by two higher lows in May. The rallies have been weak until May 30 when the iShares NASDAQ Biotechnology Index(ETF) IBB hit a two month high of $240 and now is up 9.4% YTD at $248. So the first assumption for the bull market is that April is the low for the year after the exhaustion of rampant speculation.
  • Large cap biotechs have held up very well during this correction. Our focus list of eight stocks is up 10.8% YTD with Alexion (ALXN) and Biogen Idec (BIIB) leaders up even more. Our recommended ETF the First Trust NYSE Arca Biotechnology Index (ETF) FBT is up 15.2% YTD. Even laggard Celgene (CELG) is up 11% over one month.
  • Small and mid-cap speculative stocks led the way up through February then went into free fall as the bubble deflated. But with this week’s rally momentum is back and some big winners that are different from that of February. We have reviewed and tracked many funds and ETFs and this current rally shows a comeback of the small cap weighted SPDR S&P Biotech XBI which is up an amazing 14% in five days to $149.5  and 15% YTD. At its peak in late February the XBI hit $171.Unlike many other funds and ETFs you will not see the top five large cap biotechs in its top five holdings rather holdings like MannKind (MNKD) and Intermune (ITMN).
  • Small and Mid-Cap Rayno Life Science   picks are coming back especially over the past month: Alkermes (ALKS), Seattle Genetics (SGEN) and Vertex (VRTX). Oncology names that were quiet during ASCO are rallying: Acceleron (XLRN), Agios (AGIO), Celldex (CLDX) and Epizyme (EPZM). The mid and small caps are the core of the biotech market so if they can recover with good volume the sector looks healthy.
  • Momentum has returned to growth stocks like Illumina (ILMN) which is up 22% over 30 days approaching its old all time high of $183.30.Illumina, the leader in DNA sequencing and life science tools has been on our focus list for many years since $29 but now has a Price to Sales ratio of  14.9.

The market is more educated on biotech valuations so it is unlikely that a new bubble can develop. Nonetheless there is a lot of money following biotech with a limited supply of  companies with a broad pipeline. Most innovative biological drugs on the market have been developed by smaller companies and acquired by big pharma. The one big issue going forward is pricing and reimbursement as we have seen from the Gilead  Sciences (GILD) reaction to Sovaldi pricing of their HCV drug. This issue of pricing was raised once again at the ASCO Meeting.

The fundamentals of the biotech bull market are intact and now we get a little support from M&A. The technicals look much better and momentum is coming back to mid-caps. Stock picking should get better but we advise, as always using a portfolio approach.

  1. A medium term investment approach is to focus on large caps supplemented with an ETF like FBT. In a rally mode the XBI offers more upside just keep in mind that it is more volatile on the downside.
  2. The Fidelity Select Biotechnology Fund (FBIOX) has underperformed both the FBT and IBB over the past 3 months by about 5% probably due to its growing assets now $8B and volatility caused by rebalancing during the downturn. It is still weighted toward larger caps.
  3. Now that sentiment has improved it may be time to test the waters with new trades. Two buy ideas to check out are Fibrocell Science (FCSC $3.70) and Pacific Biosciences (PACB $5.30).More on these companies later but we own both.

Chart foriShares Nasdaq Biotechnology (IBB)

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