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Summary

  • Biotechnology indices were overbought and needed a correction.
  • Short-term prices are particularly sensitive to sentiment.
  • The biotech industry is not overvalued; its growth and profitability warrants sustained premium valuations.
  • The correction should be over soon and you should buy the dip while you can.

It's been a rough couple of weeks for biotechnology investors. Those of us who didn't hedge have been in a world of pain and many of us are still wondering why. My view is that the indices got ahead of themselves in January and February and are now correcting to their previous channel. I also think it's likely we "overcorrect" because of the role sentiment has in market prices (as I will discuss later), and that the new bullish channel will be lower than the old one.

Some point to the recent congressional letter to Gilead (NASDAQ:GILD) Sciences regarding its Hepatitis C drug pricing as the spark to the selloff, but there are several other contributing causes for what I believe to be just a temporary and healthy correction. Biotech indices like (NASDAQ:IBB) and (NYSEARCA:XBI) exploded above their long-term channels during January and February, leading to overbought conditions and rising vulnerability to a correction. The extent of the recent gains was a major factor to the sell-off, and the congressional letter was the "spark" that ignited the impending profit taking with such severity that it fueled speculative short selling and eventually panic selling amid fears of a "popping bubble." Anyone looking at the charts could have seen the many warning signs, but unfortunately myself and many others ignored what we saw and piled on like everyone else in what was an exciting start to 2014.

The Technicals

Source: freestockcharts.com.

A chartist would tell you the RSI started giving off sell signals in late February and early March when the negative RSI divergence with price became very apparent, and there was what is called a "false swing," which is when the RSI leaves the overbought condition, bounces off the overbought line, then makes a lower low. This chartist would also say the on balance volume "OBV," which measures volume divergence and represents accumulation started giving off signals in late March, particularly after Friday the 21st and the following Monday, and has been ugly ever since. And of course there's the break of the almighty 100MA, numerous support levels, trend lines, and the overall bearish MACD divergence.

But we need more than charts of course, we need to evaluate fundamentals and sentiment. I'll start with fundamentals because they highlight the importance and role of sentiment in short-term prices.

The Fundamentals

The challenge with company fundamentals in the biotech space is that they require extensive specialized knowledge to fully understand. My academic background with conventional valuation and financial analysis means little valuing companies that derive value from complex science and regulatory processes. Even if a company has predictable cash flows now, the industry evolves so rapidly it's often difficult to conduct a reliable competitive analysis.

As a result of highly uncertain cash flows and unpredictable competitive environment, discounted cash flow "DCF" valuations are extremely sensitive to input estimates, most importantly growth and risk. Identifying the risks is challenging but can be reflected with reasonable accuracy in the discount rate based on factors such as the number of products in the pipeline, time until market, strength and progress of clinical trials, among others. Estimating the growth rate is more challenging as it depends on industry, regulatory, and competitive factors that themselves are highly unpredictable. Although more sophisticated investors can utilize methods such as option pricing models and simulations, a conventional DCF approach is most common. And because of the difficulties presented by DCF approaches, many market participants favor relative value approaches based on multiples of earnings, sales, or potential sales with adjustment made based on competitiveness and cost structure to reflect differences in growth and risk.

The lack of market consensus regarding appropriate valuation methodology and input estimates contributes in a major way to the volatility of short term prices. These factors combined with the massive growth potential and inherently high risk compound the role that sentiment has in driving market prices in the short term. The end result is large volatility among stocks and their indices that do not accurately reflect changing fundamentals, but rather short-term perceptions. As I will demonstrate, I believe the fundamentals are still highly attractive and this correction is purely a temporary change in sentiment that should reverse itself shortly. I do, however, believe that sentiment may remain irrationally negative, and therefore the correction is likely to "overshoot" to the downside before we see a restoration of confidence in the industry and a resumption of the bull market. But I hope I'm wrong about that.

I will now present my analysis of biotech industry valuations. Although valuing a bio stock using DCF or justified and peer group multiples is common, attempting to use these methods to value the bio industry has significant problems that make them virtually unusable. Instead I will present a "valuation trend analysis" that evaluates the history of valuations in comparison to related sectors, as well as historical growth, risk, and profitability. I will use these relationships to argue why I believe bios are not overvalued, but I will also note that they aren't particularly cheap. I will then discuss in qualitative terms why the industry deserves these high valuations by briefly describing the drivers of long-term growth and profitability of the industry.

My source for all the following data was my neighborhood Bloomberg Terminal. I use "mature bios," which is the weighted average of the largest bio companies like (NASDAQ:AMGN), (NASDAQ:CELG), (NASDAQ:BIIB), GILD, (NASDAQ:ALXN), (NASDAQ:REGN), (NASDAQ:VRTX), and others. I believe this is a good valuation proxy because they represent long term achievable economics for the industry as a whole.

Chart 1: P/E and P/S ratios of mature bios are near their 10-year averages. Also note that the average leading P/E ratios of GILD, BIIB, AMGN, and CELG is only 15.1, which is actually below the current S&P500 P/E ratio of ~17.

Click to enlarge images.

Chart 2: Bio valuations move with healthcare and information technology (IT) sector valuations, which have been below long-term averages and have only recently begun to rise.

Chart 3: Profitability is still rising, and net income among mature bios is expected to grow significantly faster over the next five years compared to the previous five (expected to quadruple in five years, about 25% growth YOY). Risk, measured by annual standard deviation of weekly returns for the IBB ETF, has been declining since 2008 and is similar to the 2005-07 period.

Long-Term Drivers of Industry Growth: Why These Valuations Are Not Excessive

  1. Aging populations and growing prevalence of "lifestyle" diseases, as well as many other industry-boosting health care trends. The key word here is demographics. As people grow older, live longer, and acquire more diseases, the total amount of drug spending is likely to continue growing at a fast rate for a very long time.
  2. Biotechnology could eventually replace the massive market for many conventional pharmaceutical products. Pfizer and Johnson & Johnson alone had combined sales of about 120B in 2013. This fact alone helps to illustrate the massive market that biotechnology could eventually access by replacing conventional pharmaceuticals.
  3. The immense profitability and growth avenues presented by M&A activities provide further justification for sustained premium valuations.
  4. The political climate is likely to remain favorable for bio companies, at least in the U.S. Despite the congressional letter to Gilead, U.S. policy makers know that drug pricing controls would crush innovation in biotechnology and have terrible consequences for society. The big pharma lobby, in my opinion, is unlikely to accept these type of regulations that negatively affect potential profits without a serious fight.
  5. The untapped emerging markets provide massive growth potential over the very long term.
  6. The "nowhere else to go" phenomenon encourages higher valuations among equities in general. I describe this in my last article, but essentially the relative unattractiveness of other asset classes and international equities makes U.S. equities the most attractive place to be invested.
  7. The U.S. equity bull market is still in full force. Until I see some fundamental evidence of a market top beyond the correction of some momentum stocks with P/E ratios above 100 and some bearish technical indicators, I will remain convinced we are in a bull market.

Conclusion

We all know is there is massive growth here. Biotechnology is the future, just ask Ray Kurzweil or Michio Kaku. The main problem is that nobody seems to agree on the value of that growth, and as a result speculation and sentiment dominate short-term valuations which encourages dramatic swings in prices despite fundamentals staying relatively constant.

Furthermore, the overreaction by the market due to this changing sentiment has provided a "buy the dip" situation where market inefficiencies have created the opportunity for very lucrative short-term and long-term profits.

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.

Source: Biotech Is Not A Popping Bubble: Buy The Dip While You Can