Biotech Proper Is Overbought, Time To Look At Alternatives

by: Austrolib

A true bubble is formed only when a certain sector or sectors attract the attention of the general public and novice retail traders start taking positions following the herd, having little to no idea what they're doing. The last time we saw this in full swing was 1999/2000, when the Nasdaq started going completely ballistic. It has barely recovered three fifths of its former glory. I doubt we will see something on the order of magnitude of the Nasdaq bubble in the next few generations, but the sector that is mimicking this sort of behavior on a smaller scale right now is biotech. I do not believe it will deflate like the Nasdaq, but it is in for at least a decade of up/down crisscross consolidation, just like it was between 2000 until the beginning of 2012. There is an alternative for biotech investors, which I will get to shortly.

One need not look further than the biotech ETF IBB to see the basics of this analysis played out.

As you can see here, the sector was hit by the 2000 Nasdaq bubble which fully deflated in 2002, but not irreparably so. From 2000 until the beginning of 2012, biotech did nothing but consolidate. There were ups, there were downs, 2008 was bad but not so bad, and suddenly, for no glaringly obvious reason, it just took off at the beginning of 2012 and we're at all-time highs. A look at a chart of IBB's largest holding, Regeneron (REGN), will give you a more concentrated idea of what's going on here.

As you can see, the 2000 Nasdaq bubble barely made a blip compared to what is happening now with REGN. I do not mean to minimize Regeneron's accomplishments since the beginning of 2012, which have been astronomical. Its revenues from last quarter almost equal those from all of FY 2011. And its earnings last quarter are nearly equal to its losses in all of 2011. That is certainly nothing to sneeze at and absolutely deserves its gains. But that's it.... the run is over now. Its P/E ratio is over 90. Let's face it, anyone who wants to buy now is too late. But there is an alternative for those who love biotech. Call it biotech's cousin, the "biotech hardware" subsector.

What I mean is, any drug that has to be approved by the FDA I would consider biotech software as opposed to hardware. Much like a computer program, a company spends enormous sums programming a drug and testing what it can do. Most, however, forget about the hardware, the testing equipment, the diagnostic services that each and every hospital requires just as much as the drugs themselves.

The positives of diagnostic equipment are that they are much easier and less expensive to pass through government regulations. The Clinical Laboratory Improvement Amendments (CLIA) program, passed by Congress in 1988, is what regulates diagnostic hardware, and it only requires two clinical phases to meet approval. In terms of stock trends, the diagnostic companies are on a completely different wavelength from biotech. Let's take a look at the big names in the industry and see what they've been doing over the past decade.

One of the biggest in biotech hardware is Quest Diagnostics (DGX). It has been consolidating since April 2002. Keep in mind that before its big breakout, biotech consolidated for a similar amount of time. This is the stuff that makes big breakouts possible. That, and its net income is down since 2009, though its revenues are steadily up since then. This dissonance, I think, creates the conditions for a buy, as it is easier to cut down operating costs than it is to generate new revenue. That, and its quarterly dividend has tripled since last year, so the company is looking for investors. Rather than get distracted by biotech, I'd look for stocks like this, begging for holders.

Another staple of biotech hardware is Lab Corp. (LH) The story here is similar to Quest. Taking the very long view, this stock hasn't done much since 1992 when it topped at $70 a share, totally off the radar of most other stocks and the entire market in general. For the past 5 years, Lab Corp. has followed biotech proper almost to a tee, when all of a sudden at the beginning of 2012 the two began wildly diverging and biotech proper broke away. Don't be distracted by the disproportional gains of biotech. Focus on the continual consolidation of biotech hardware and you'll see in it a call of opportunity.

Here's another: Bio Reference Labs (BRLI), a $768M company, almost a total enigma. It has never followed general market trends and seems to be plotting its own rhythm totally independently. It was hit a lot harder in 2011 than most stocks were hit in 2008. The Nasdaq bubble barely had any effect on it at all. BRLI is what I would call a leader in the biotech hardware sector, eventhough it is not a large cap, as it has grown steadily since 2003 and continues on an uptrend. Taking a more recent snapshot, revenues are up 18% since last year, and income up 16%, indicating steady growth year over year. BRLI is the example I expect the rest of this lagging market to follow in the next 5-10 years.

To end off a rounded survey, we have Amarantus Bioscience (OTCPK:AMBS). This stock is not for investors simply out to catch the next trend. Rather, I mention it here as a speculative play based on the fact that it is a penny stock microcap with the rare quality of having feet in both biotech subsectors at once. Unlike most development stage biotech companies, Amarantus is focusing on both hardware and software. Hardware being inordinately easier to pass through government regulations, it is the key to maintaining a steady revenue stream while the big potential money makers, the drugs themselves, push through clinical trials.

Right now, Amaranatus is in the late stages of CLIA approval for its Parkinson's and Alzheimer's diagnostic tests. Assuming these pass and it starts generating a steady revenue stream from sales (certainly not a given) that don't rely on research grants from Parkinson's foundations, the company will have an easier time pushing through its main product Mesencephalic Astrocyte-derived Neurotrophic Factor (OTC:MANF). Amarantus is researching this product candidate mainly as a treatment for Parkinson's disease, as it is designed to correct protein misfolding in the brain, which is speculated to be a main cause of Parkinson's onset.

What the future has in store for MANF I do not know. It is certainly not going to make Amarantus any money in the near future. But what is certain is that a company like Amarantus needs a steady revenue stream to have any chance for its big bets like MANF for Parkinson's, still a long way from approval. It has a chance at accomplishing that with the sparsely regulated hardware approach to making it in biotech, an approach I believe, considering the lengthy consolidation the subsector has had for over a decade, will generously outperform the biotech sector proper over the next 5-10 years.

In order to take advantage of this, the safest approach would be to buy a basket of biotech hardware companies in proportion to proven stability and hold. In terms of risk, we've seen from the charts that in times of market turmoil, biotech hardware has generally been less affected overall.

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. I have no business relationship with any company whose stock is mentioned in this article.