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Imagine that, like Merck & Co’s (MRK) Kenneth Frazier, you are a big pharma chief executive with $15bn knocking around. Do you acquire some red-hot biotech assets or simply buy back your own company’s stock in a bid to pre-empt a hemorrhaging share price?

This is, of course, a light-hearted question. But there is a very serious lesson in Merck opting for the latter option. The malaise that has swept through big healthcare stocks in the past week will trickle down to smaller players soon, and Merck’s caution shows that biotech valuations have departed from reality, throwing up red flags to those who think the junior sector can only keep on going up.

Make no mistake: big-cap stocks had a horrible first quarter. Amgen’s (AMGN) disappointing earnings caused a 7% share price fall, and were closely followed by poor performances at Pfizer (PFE), Bristol-Myers Squibb (BMY), Merck, and today Sanofi (SNY) (Calling the top? Ever-rising valuations spark biotech worries, April 25, 2013).

Pfizer’s tribulations caused the world’s biggest pharma group to drop 4% – roughly an $8bn market cap change – so we are not talking about minor re-ratings here. Little wonder then that Merck wants to shore up its share price at a time when its financial underperformance has been accompanied by R&D setbacks and a regulatory threat to its blockbuster Januvia franchise.

The common theme for the multiple earnings misses and guidance reductions has been adverse foreign exchange rates, buying patterns and wholesaler inventory movements. In Merck’s case, the embarrassment is compounded by missing the guidance it issued just three months ago, but overall, the setbacks can be explained away as “one-off factors.”

So what does this all have to do with biotech? Does it not simply underline the end of big pharma’s days as a safe haven, and underscore the role of big biotech – companies like Gilead Sciences (GILD), Celgene (CELG) and Biogen Idec (BIIB) – in this new capacity?

Perhaps. But for smaller biotech, which is still enjoying a surge of popularity to match the genomics-driven 2000 bubble, the omens are bleak. After all, big pharma is biotech’s lifeblood, and at the core of any biotech investment lies the thesis that the company will be acquired.

Yet, rather than acquire, Merck has decided to commit an amount equal to the gross domestic product of Jamaica to buying back a 10th of its entire share capital. If this is not a sure sign that biotech is hugely overpriced, then it must be seen as a total lack of imagination on Merck’s part.

But Merck is not the only one. According to Factset, the healthcare industry was the second-most prolific buyer back of stock, after IT, in the first quarter.

ISI Group’s Mark Schoenebaum called Merck’s monster buyback “the second bone that management has thrown to the angry shareholder mob” after announcing the departure of its head of R&D, Peter Kim, following pipeline disappointments. Meanwhile, sellsiders covering biotech stocks have moved into overdrive to persuade investors that all is well.

But with every setback, the problems are becoming ever more difficult to contain. And yet biotech bulls simply put their heads in the sand; despite wobbling, the Nasdaq biotechnology index remains buoyant, sitting on a 21% year-to-date increase. Clearly this will not continue forever, no matter how much we might want it to.

All it will take now is a couple of big regulatory setbacks – numerous key events are due by the mid-year – to remind everyone that the FDA is not, after all, a soft touch, and biotech is just as failure-prone as it ever was.

True, to call the top of the market would be as foolish as calling the bottom. But the warning signs are there, and the smart investor will be ahead of the game in deciding that enough is enough.

Source: Biotech Bulls Can Ignore The Warning Signs At Their Peril