- M&A theme is back for small and mid caps.
- Rally re-traces Q1 correction up to mid-point.
- Bullish sentiment enables traders.
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 (NYSE:MRK) $3.9B deal for Idenix (NASDAQ:IDIX), we see a strong follow-through with smaller caps. Achillion (NASDAQ: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; 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 deal for strategic reasons, i.e. buying Intellectual Property and the 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 (NASDAQ: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 leaders Alexion (NASDAQ:ALXN) and Biogen Idec (NASDAQ:BIIB) up even more. Our recommended ETF, the First Trust Amex Biotechnology Index (NYSEARCA:FBT) is up 15.2% YTD. Even laggard Celgene (NASDAQ: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 Biotech ETF (NYSEARCA: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 (NASDAQ:MNKD) and InterMune (NASDAQ:ITMN).
- Small and mid cap Rayno Life Science picks are coming back, especially over the past month: Alkermes (NASDAQ:ALKS), Seattle Genetics (NASDAQ:SGEN) and Vertex (NASDAQ:VRTX). Oncology names that were quiet during ASCO are rallying: Acceleron (NASDAQ:XLRN), Agios (NASDAQ:AGIO), Celldex (NASDAQ:CLDX) and Epizyme (NASDAQ: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 (NASDAQ: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 Gilead Sciences' (NASDAQ:GILD) reaction to Sovaldi pricing of its 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.
- 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.
- The Fidelity Select Biotechnology Fund (MUTF: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.
- 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). We will provide more details on these companies later, but we own both.