The last two years or so have seen the entire biotech sector catch fire. The SPDR Biotech ETF (NYSEARCA:XBI) is up over 45% in that time, after only appreciating 26% in the six years prior.
The sentiment change around biotechs appears to be linked to the record number of FDA approvals for new drugs in 2012. Specifically, the FDA approved 35 new biopharma products in 2012, which was more than double most previous years. The pace has definitely fallen off a bit in 2013, however, with only 20 approvals for new drugs this year so far. Nonetheless, that is still high compared to the innovation drought that occurred over the past decade.
As a result, investor enthusiasm for biotechs is at fever pitch, with a number of clinical stage biopharmas seeing their market cap soar into the billions before they've even sold a single pill or therapy. Some critics are thus calling this dramatic appreciation in the biotech sector a bubble, akin to the tech bubble that brought ruin to unsuspecting investors in the late '90s.
Per usual, I have a different view.
My take is that individual stocks within the sector are definitely "bubbly-ish," but the sector as a whole is not forming a bubble per se. The main difference between the rise of biotechs and the tech crash in the '90s is that a fair number of biotechs are actually creating new, innovative products. If you recall, the tech bubble burst mainly because most of the companies weren't actually doing anything. Their stocks rose as a sector wide effect.
Biotechs, by contrast, only appreciate if the company has a compelling clinical candidate. And when the candidate fails at some point along the way, the company's stock price implodes. Simply put, there is a Darwinian "survival of the fittest" phenomenon going on in biotechs that keeps the sector as a whole from forming a bubble.
Individual stocks, however, are a different story altogether. Over the past two years, we have seen companies like Amarin (NASDAQ:AMRN), Sarepta (NASDAQ:SRPT), Vanda (NASDAQ:VNDA), among many others, appreciate several fold based on the potential of their flagship drug candidates. When I see companies rocket up 900% before a drug is even approved (ahem, Acadia Pharma (NASDAQ:ACAD), I suspect that most investors new to this sector have no idea about how much risk they are taking on. In the world of biotechs, "potential" is interchangeable with "risk," and I'll show why next.
Potential or risk comes in 3 forms in biotechs
The reason we see biotechs explode and implode with frightening regularity is because investors simply don't understand that these companies offer three ways to fail. Instead of viewing potential as risk, most investors dabbling in this sector appear to think it equates to a good chance of getting rich quick. Nothing could be further from the truth.
The first risk in the biotech game is clinical. Review articles have shown that new drugs fail close to 90% of the time during clinical trials, with the majority of the failures coming in Phase II studies. Basically, they frequently fail to show a clinically meaningful effect, or fail to outperform a therapy that is already approved. So if you put your money on a clinical stage biopharma, you have about a 10% chance of success. Not great odds. Yet, I've seen far too many message board posts and articles framing this stage as a drug's clinical "potential," when it should be "risk."
The second risk is regulatory. As we've seen from the recent Amarin, Sarepta and Vanda cases, the FDA is hard to predict on this front. I personally thought Amarin's Vascepa would be approved with a tight vote for its Anchor Indication and the market seemed to agree with me. Nonetheless, the panel was grumpy that day, and ended up questioning almost everything about the trial. The end result was an overwhelming no vote.
Vanda's tasimelteon got a completely different response earlier this week despite serious question marks hanging over its trial design. I think most people felt a rejection was forthcoming based on the precipitous fall in Vanda's share price leading up to the review, yet the committee ended up giving a unanimous yes vote anyways.
Finally, Sarepta's eteplirsen's hopes for accelerated approved were dashed last week, which shocked the market. The stock dropped over 60% in a single day as a result.
What's important for investors to understand is that the market grossly misjudged the regulatory risks in each of these cases. Indeed, regulatory risks are essentially a wild card in the biotech game and should be treated as such. Calling FDA decisions either way is extremely difficult to do, and investors should be aware of this fact.
Finally, the third risk is perhaps the least appreciated of the bunch - commercialization. Bringing a new drug to market takes boat loads of money. Amarin, for example, is on track to spend roughly $120 million for Vascepa's first year on the market, and that is typical for a new drug. For companies transitioning from a clinical to a commercial operation, these costs can be tough to accept. Unsuspecting investors all-too-often think their charmed biopharma that got its drug approved is finally about to turn the corner into profitability only to find out that they are facing dilution on unprecedented scales. Why? Because these companies need hundreds of millions to raise a sales force often from scratch, educate doctors, market the drug, etc. Indeed, these expenses are such a burden that many clinical stage companies simply choose to license out their lead clinical candidate, and forgo a big portion of the revenues to do so.
To top it off, many of these biotechs run up so high that they are projecting a market cap based on peak sales for the new drug. I find this hilarious because peak sales often take years to achieve, and investors are often shocked to learn that the new drug is only generating a fraction of their expectations after the first few quarters into a launch.
By misjudging each of these three risks and instead viewing them as possible rewards, the flock of new investors in the biotech sector have undoubtedly created localized bubbles. When reality sets in, however, these bubbles inevitably pop, which is healthy for the sector as a whole. This is why the sector has appreciated an average of 32% per year over the last two years, whereas some individual stocks have blasted off into the atmosphere.
So what's your advice on investing in this hot sector?
Frankly, I think picking individual stocks in this sector, for most individuals, is too difficult. Investing in biotechs requires an understanding of clinical trials, science, statistical analysis and don't forget, business. That's a tall order.
But not investing in this sector means giving up on possibly some of the best prospects for growth. So not investing is a bad idea as well.
My humble suggestion is to spread out your risk by buying a basket of biopharmas. If history serves as any guide, we can predict that roughly 63% of New Drug Applications will be approved by the FDA. So selecting a handful of companies with pending NDAs could be one easy way to gain exposure to the handsome rewards of the sector, while minimizing risk.
The worst thing you can do, however, is to bet heavily on any one biotech. As I mentioned earlier, the majority of investors bet incorrectly on Amarin, Sarepta and Vanda. Let these three cases be a cautionary tale in terms of putting your money at risk. Remember the number one rule of investing is to NOT lose money. So while I know it's fun to brag that you just made a 400% gain on some biotech, it's more likely you will be taking a loss on any individual stock in the sector. Diversification is your best friend in biopharmas and greed is your enemy.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.