- The Fed has now complained of overvaluation amongst smaller biotech stocks.
- On this news, large cap biotechs were slammed as well.
- This is reminiscent of Alan Greenspan's "irrational exuberance" comments in late 1996, a great buying opportunity.
Background: When the Fed noted some froth in "smaller" biotechs last week, large ones also got slammed. Biogen Idec (NASDAQ:BIIB) fell more than 7% after that statement. Gilead Sciences (NASDAQ:GILD) fell 5% peak-to-trough. Small ones got dumped big-time. Is it but a passing storm, though?
There is precedent for it being exactly that:
Fed Chairman Alan Greenspan argued that stocks had become irrationally exuberant in December 1996, and followed up with a more substantial critique a few months later. Stocks sold off sharply after each speech. Later he changed his tune, and spoke and acted like a true believer in the New Economy, seeming to cheerlead the markets and especially the NASDAQ to greater and greater heights.
Did the Yellen Fed similarly mark the continuation of a great boom in biotechs with its comments?
This article reviews the earlier boom/bubble and compares it to today's biotech stocks, beginning by defining "biotech."
Introduction: "Biotech" is a word with variable means. It used to refer to proteins created by cell culture based on genetically-driven techniques. That's why Amgen (NASDAQ:AMGN) and Biogen Idec have the "-gen" in their names. More recently, biotech includes a much broader category of high tech drug discovery techniques. In recognition of this, the term "biopharma" has come into use. These are all sort of undefined, which is a bit of a problem. Nonetheless, I am going to attempt to talk about this undefined group of companies as if they were a defined group. Basically, as Justice Potter Stewart once said about pornography, we know a biotech (biopharma) company when we see it. For ease of discussion, when I use the term "biotech" from now on, I also intend it to include biopharma companies. Basically, these are science-driven companies that develop pharmaceuticals and biologics using advanced molecular techniques, but not necessarily ones involving direct investigation/manipulation of nucleic acids (DNA and RNA).
I now want to lay out the thesis that biotech is roughly where information technology, IT, was in the 1990s, and that it is not close to 1999-2000 (a major top).
To do this, we need to look at IT to allow parallels to be drawn to biotech.
The history of IT: From perhaps the 1960s into the 1980s, IT comprised International Business Machines (NYSE:IBM) and everyone else. IBM was easily half the IT (computers and peripherals) industry into the '80s. Software was a triviality. Then an acceleration that now appears inevitable - i.e., in retrospect - started. Perhaps it began with the desktop revolution led by IBM and Apple (NASDAQ:AAPL), and with Intel's (NASDAQ:INTC) focus on the X86 line of microprocessors. Concomitant with these was the growth of Microsoft (NASDAQ:MSFT) and Oracle (NYSE:ORCL), amongst others, creating new business lines where none had previously existed. Then came the growth of the Internet and inexpensive cell phones in the 1990s, and the NASDAQ got hot for real. Biotech has a similar rhythm, as I see it.
Let's look at the NASDAQ chart, noting both price and volume:
Since the NASDAQ's founding in 1971, the total return for its index has been about 9.1% annually. Of course, the NASDAQ (or, the 'NAZ') is much more than tech, especially in the '70s when there wasn't much non-IBM high-tech around.
By the time the NAZ became a reasonable proxy for IT, in the mid-late '80s, the index rose at a rapid pace year after year, then accelerated as the facts emerged that the Internet, which had under 100,000 users in the late '80s (3 billion today) was going to be for real. Cell phones were going to supplant land lines, computers were going to be everywhere, and both ordinary investors and institutions could likely profit by buying in and waiting for the future to happen as it could. Every correction was a buying opportunity.
There's no way to know, but I think I sense something similar going on with biotech now.
Relevant, I think, to biotech today, investors were in retrospect well advised to buy and hold the strong new tech names that IPO'ed in the 1980s. Old names that had become large companies before 1980 such as Digital Equipment (acquired by Compaq), Wang Computer, Sperry Rand (now Unisys (NYSE:UIS)), IBM, etc., were chancy for the new era. IBM had to reinvent itself, after all, to get where it is today.
The clear leaders at the time turned out to generally have staying power. These included Apple, Microsoft, Intel and Oracle. In real time in the later 1980s, it was apparent to a somewhat casual observer such as myself that these were strong horses.
Thinking of biotech investing today, I would point to staying power in the tech field as most important. Apple was always special, even during its troubled period after Steve Jobs was forced out and before he led its turnaround. Microsoft always seemed important, as did Intel and Oracle, after each went public.
ORCL is a great example of the risks to investors of not being in a stock or sector due to valuation concerns such as the Fed has raised. Unlike certain other stocks, such as AAPL, ORCL never crashed after Y2K in the Tech Wreck even to where it began 1999. The same is true for the younger company Qualcomm (NASDAQ:QCOM), one of the greatest "real" stocks of 1999. If you owned stock in one of these great companies, it was difficult to know when to sell.
It is difficult for investors to do much with the Fed's opinions. Leading biotechs are not even close to the valuations tech stocks reached in 1999 and 2000. Also, by Y2K, bonds and cash were intrinsically attractive relative to inflation, and this situation is unfortunately not the case today, as the Fed well knows.
Since the Fed always has a point, I agree that it makes sense to differentiate between small and large biotechs (just as it made sense to differentiate between small and large techs in the 1995-2000 run). The following analysis differentiates between biotechs by market cap.
Large cap biotechs: Let's look at the largest biotechs, which can be viewed as either the Apples, Microsofts, Intels, Oracles of today - or negatively perhaps the DECs and Novells. Does the Fed's caution suggest investors refrain from putting new money in these stocks at these prices? Because the focus of this article is on biotechs as a class, I will run through a summary of leading stocks in the field to see how their investment metrics look, then sum up before moving on to the little companies that the Fed specifically took aim at. Here are four profitable biotechs ranked by market cap, with capsule comments and valuation metrics.
1. Gilead Sciences : Market cap $137 B. Trailing P/E (TTM) 33X. Forward P/E ? 12X. PEG: Below 1.
Comment: Rationale for low forward P/E: Uncertainty of staying power of blowout earnings from its hepatitis C franchise.
2. Amgen : Market cap $90 B. TTM P/E about 16X, forward P/E about 14X. Note: Pays 2% dividend.
Comment: Mature, being affected by biosimilar competition and is getting into manufacturing biosimilars.
3. Biogen Idec : Market cap $72 B. TTM P/E 32X. Forward P/E: 21X estimated CY 2015 earnings.
Comment: Dominates multiple sclerosis treatment market, royalties on major B-cell malignancies represent large stable source of cash flow. Just launched two innovative treatments for hemophilia. High R&D spending as a percent of sales.
4. Celgene (CELG): Market cap $68 B. TTM P/E 27X ("operating" earnings, which differ materially from GAAP earnings). Forward P/E: 18X.
Comment: Dominates multiple myeloma market. Has new anti-psoriasis product out with blockbuster potential. High R&D spending as percent of sales.
General comments for the above: I did not give growth rates, but all of the above except for AMGN are expected to have rapid compound growth rates. (GILD is tricky because of the gigantic boost to EPS that has begun with this year's Q1 and everyone's uncertainty about its future sales growth from here.) There are some issues about GAAP vs. non-GAAP EPS, but all of the above stocks have strong short- and long-term growth potential. They lack much book value, but book value ignores the value of patents as well as other things of real value to an acquirer such as a sales force and specialized regulatory and scientific expertise. That fundamental negative aside, those four companies cannot be looked at as close to bubbly. I think all four stocks are in fact quite attractive compared to almost any other growth stocks outside of a few IT stocks.
Middle capitalization biotechs: Valuations are more stretched in some of the biotechs that fall into the mid-cap to smaller large cap segment. Because of varying accounting methods and earlier stage in a life cycle than the large to mega caps discussed above, I will simply mention several roughly in the $5-30 B market cap range. These include Alexion (NASDAQ:ALXN), Regeneron (NASDAQ:REGN), Vertex (NASDAQ:VRTX), Pharmacyclics (NASDAQ:PCYC), and United Therapeutics (NASDAQ:UTHR). Some of these stocks have quite high valuations, but the companies have all developed important products. In a generally high market, with high competing bond prices (i.e., low interest rates and low to negative "real" interest rates), my assessment of these stocks and others in this valuation range is that overall, risk and reward are roughly evenly balanced.
Small cap biotechs: There are so many of them, of acknowledged riskiness, that I am only going to name the one I wrote about very recently, just before the sell-off. This is Portola Pharmaceuticals (NASDAQ:PTLA), a risky name that I believe has strong potential. The stock tumbled about 20% on the Fed comments (I added to my holdings of it as it plummeted). Nothing has changed. It had a big move up on news, then it fell sharply on the Fed. So it goes. The company's value, or lack of value, has not changed, and only time will tell what it's worth. The Fed's comments added nothing of value; the stock is simply more attractive than before - or less unattractive, as we shall find out in due course.
No one needs the Fed to tell us that money-losing companies with no revenues from product sales are risky stocks. Is the risk-reward from these speculative stocks better than money in the bank, given the Fed's "guarantee" that a bank deposit will lose ground to inflation? I don't know, and neither does the Fed. It's the devil you know (CASH) versus the one you don't know (early stage biotechs).
Again, my view is that company-by-company analysis is needed to answer the above question.
Broadly speaking, I think that many biotech companies have stock that looks attractive to potential acquirers at and above current levels. The spate of pharmaceutical M&A activity we are now seeing supports that view. If accurate, this would support biotech stock prices.
General comments: In my opinion, the drug discovery industry is maturing. There are more and more promising, and strong, biotech companies. There are more and more "-mab" (monoclonal antibody) products reaching the market, without as many clinical trial failures as in the past - at least so it seems.
The FDA is friendlier now to these companies than it was, but this based on science, and I'm all for its new attitude. One example is that Gilead is awaiting an FDA decision on its idelalisib anti-cancer oral drug for refractory non-Hodgkin's lymphoma - based on an open label phase 2 study. The idea that this drug could come to market in such a fashion was mind-boggling to an industry veteran I lunched with recently. It's a new ballgame at the FDA - a better one in my humble opinion.
There are now large numbers of experienced executives in the biotech industry who understand the rules of the FDA and investment games and who know how to win. This is what one sees when an industry is ready to enter the mainstream of our lives and therefore of a sound investment plan. You need lots of talent that knows what it's doing to make the possibilities turn into real, profitable, desirable products.
Also, science has made amazing advances. The drug discovery process has begun to be predictable. It is early enough in this process that the "gee whiz" nature of the clinical advances is so strong that the (inevitable) deflationary forces on pricing are not in the ascendancy, in my opinion.
The move to deliver anti-cancer drugs orally benefits the industry in a double-barreled manner (as well as being much better for patients). This is because, as I see it, the premium pricing that genetically engineered proteins (which must be delivered parenterally) required has carried over to oral products such as Sovaldi (Gilead) and to Imbruvica (the Pharmacyclics product for B-cell malignancies) that are much less costly to produce than proteins. Thus the industry can drive greater utilization than chemotherapy - who won't take a pill when given a cancer diagnosis? - and benefit from a notably lower cost of goods.
Might this pricing anomaly last a long time?
I think so, and this is one of the reasons I am bullish on biotech stocks.
Per the above discussion, there appears to me to be a coalescing of scientific and market opportunities that could allow a golden age of biotech investing.
Historical valuations: Barron's and others have noted that biotech analyst Mark Schoenebaum wrote an open letter to Chair Yellen, a chart from which is reproduced below (see link for his open letter):
The Barron's piece quotes Mr. Schoenebaum's letter to clients, in which he explained:
I'm not arguing that biotech is "cheap." Rather, I'm arguing that there is little empiric evidence to support the conclusion that we are in a valuation "bubble."
The Barron's blog went on to list biotech ETFs, which readers may wish to note:
The (Fed's) commentary knocked a few percentage points off funds such as SPDR S&P Biotech ETF (NYSEARCA:XBI), which is chock full of small-sized biotechs, as well as iShares Nasdaq Biotechnology ETF (NASDAQ:IBB), with a bias for larger stocks, and Market Vectors Biotech ETF (NYSEARCA:BBH).
Here are two relevant charts. First, a likely subject of the Fed's biotech concerns:
Next, an index of larger cap stocks:
IBB's strong performance since inception is no big deal when compared to the long run of IT stocks that basically ran from the 12/74 bottom until Y2K. Neither IBB nor XBI looks at all like the NAZ circa 1999 or 2000.
Risks: Don't fight the Fed.
The market is entering its seasonally weakest time of year, and has gone almost straight up for the past two years. On top of that, QE is very likely ending. There goes the "free" money, some of which has "gone into" XBI, IBB etc. (the reality is slightly more complicated, therefore the quotes).
Biotechs are volatile stocks, and high to very high selling prices for the industry's products are not guaranteed. Pipeline failures could occur; valuations could come down. There is no dividend support from any biotech stock except AMGN; some companies such as Gilead, Biogen Idec and Celgene have shrunk shares outstanding, though.
Permanent loss of capital can result from biotech investments.
Concluding comments: My judgment is that the Yellen Fed may bring short rates to the level of inflation very slowly, if at all. In such a circumstance, real interest rates will continue to be negative and thus will make cash continue to seem to be trash, stimulating speculation. Such a monetary environment is "good" for biotech stocks, more likely than not.
But the case for biotechs with the right marketed products or the right products in development, at the right share prices, does not depend on bubble psychology.
In fact, the large cap biotechs described above have more attractive P/E/G ratios than slow growth icons such as Colgate-Palmolive (NYSE:CL), Procter & Gamble (NYSE:PG), IBM, ORCL, MSFT and probably even AAPL.
The mid-range biotechs I listed in the second group give us a lot more world-class research than toothpaste or soap require, even if their trailing P/E's are very high. The chance of a multi-bagger is also present if one gets lucky with them, and at their market caps, any of them could be taken over tomorrow at a premium even without any profits. This upside is not necessarily the case with many stocks about which the Fed did not complain.
With the Fed likely to continue negative real interest rates for some time to come, I wish to stay with established growth industries that are changing the world. The two industries I know and have done well investing in remain information technology and biotech.
I am wary of the next couple of months, and one never knows if a 1987, 2001-2 or 2008 sort of storm could appear - generally during hurricane season for some reason - but those unpredictable and transient risks aside, I like the set-up for shares of quality biotechnology stocks for many years to come.
Thus, while I respect the Fed and appreciate its concern for my financial health, my response to its biotech stock warning is to maintain my substantial exposure to biotech stocks, and to continue to buy the dips if not fundamentally justified.
Disclosure: The author is long GILD, VRTX, BIIB, PTLA, PCYC, IBM, ORCL, AAPL, QCOM, YHOO. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Not investment advice. I am not an investment adviser.