The Running of the Biotech Bulls

Written By Briton Ryle

Posted May 30, 2013

If the S&P 500’s rising over 23% over the last 12 months has you a little nervous, then the biotech sector would have you itching to hit the sell button and lock in even heftier profits.

The chart below compares the S&P 500 index to two biotech indexes – the NASDAQ Biotechnology Index (NASDAQ: NBI) (beige) and the SPDR S&P Biotech ETF (NYSE: XBI) (blue) over the past 24 months. As hot as the S&P broader market has been, the S&P Biotech ETF has doubled it, while the NASDAQ Biotech Index has nearly tripled it.

biotech etfs 5-30Source:

Though the upward momentum of biotech is likely to continue for a few years longer, many are beginning to worry about more than just a short-term correction. Many are getting worried over an increasing appetite for too much risk in biotech leading to a potential repeat of the 1990’s boom-bust scenario.

Due For A Breather

The biotech industry has been benefiting from three strong impetuses over the past two years. The first, of course, is that which has been assisting markets all over the world – government stimulus, particularly low interest rates. Deutsche Bank calculates that borrowing rates for the larger biotech companies are about 2% lower today than they were before stimulus began 5 years ago, helping them cut costs by a substantial amount.

biotech researchThe second thrust lifting biotech is faster production cycles thanks to easier regulatory requirements for new drugs. Getting drugs into the testing phase and onto market faster reduces costs even more.

Thirdly, a glut of genome-inspired drugs a decade in the making are finally hitting the market. The mapping of the human genome over 10 years ago created a long pipeline of new drugs that are finally coming out the other end in quite a concentration, sped up by improvements in research technology over the years.

But analysts are anticipating a little bit of a pause over this summer, as Nathalie Flury, manager of Swiss & Global Asset Management’s Julius Baer Biotech Fund, tells Reuters:

“The biotech industry is in good shape, but there’s going to be a pause in news from medical conferences after ASCO (the American Society of Clinical Oncology) [scheduled for early June in Chicago], and I am thinking of taking profits on some of the large biotech names and switching some of the money into mid-cap companies. There are no big conferences to provide catalysts between June and August.”

Plenty To Prescribe

But even if there is a summertime collective breather for biotech and the markets in general, the future still favors the biotechs, as brokers prescribe them probably as often as doctors prescribe their drugs.

“The reason is because [investment funds] are looking for significant earnings growth, driven by new products over the next few years at Gilead, Biogen and Celgene,” Michael Yee, an analyst at RBC Capital Markets, explains to Reuters.

Pointing to shares of Gilead Sciences (NASDAQ: GILD), which currently trade at 26 times 2013 earnings and 12 times 2015 earnings, Yee praises the company’s prospects. “That type of earnings growth is very impressive,” he remarks, “and it all comes against a backdrop of a really tough macro-environment.”

Comparing the current performance of biotech companies to where they were when the last biotech bubble burst in 2000 shows them to be nowhere near the lofty evaluations they were at then. A notable example is Amgen Inc. (NASDAQ: AMGN), which is currently trading at 14.4 times its P/E, compared to 59 times in 2000.

Biogen Idec Inc. (NASDAQ: BIIB) and Celgene Corporation (NASDAQ: CELG), noted by Yee, also trade at lower than historic multiples, currently in the low 30s. The sector may be hot, but it is clearly not overheating, and it should still have plenty of room to advance for a while yet.

“These companies seem to be earning a much better return on their capital,” healthcare analyst David Heupel underscores. “They are not off-the-charts expensive.”

Lower Criteria Increases Risk

Yet fund managers may be getting a little too eager to get at biotech in their relentless ambition to beat the market. If the general marketplace is rising robustly, they have to venture into super-robust sectors to outperform the broader markets. And as the best pickings run out, fund manager criteria become laxer as they look for what’s cheap, not necessarily what’s best.

“The general rule that a biotech company had to have hit a certain phase of progress is no longer true,” Michael Zeidel, a capital markets attorney at Skadden, Arps, Slate, Meagher & Flom. explains to the Financial Times. “There are certainly more deals getting done now from companies in the earlier stages of drug development.”

It really doesn’t matter that only 1 in 10 biotech companies successfully launches a drug to the market. Fund managers are willing to give biotechs a lot of time to deliver on their future earnings expectations.

We are getting back to “a promise is good enough” mentality, as funds are willing to invest in anyone and anything who promises to deliver in the future. It was this trading in “promises” that fuelled the tech bubble of the 1990’s and the mortgage bubble of the 2000’s.

Perhaps when the general marketplace starts to slow in a few years, money managers will start to get a lot more demanding on their holdings and will finally want to see some competitive operating profits.

But until then, as long as the Fed won’t budge on interest rates, biotech will continue to soar given easy financing and even easier fund managers looking for the greatest reward-to-risk potential they can find. As long as the Fed continues reducing risk, investment money will continue to reduce its standards.

It may not yet be as it was in 2000 when the last biotech bubble burst. But it certainly seems a lot like 1996-98, when risk was continually piled on. Now as then, risk is seen as nothing to be afraid of… yet.

Joseph Cafariello


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