2 Buys, 1 Sell In This Year's Biotech Surge

Includes: ACOR, CELG, IBB
by: Options Markets

As traders contend with the central benchmark stock indices at all-time highs, some of the key stories in individual sectors have fallen by the wayside. One of the most important themes in this category of misses can be seen in this year's biotech surge. The 14 IPOs in the sector so far this year have created some of the biggest rallies in biotech since the industry (and term) was invented in the 1990s. When we look at the broader trends this year, the best measure of performance can be seen in the NASDAQ Biotechnology Index, which has seen gains of 36% so far this year. This roughly doubles the overall performance of the S&P 500, so it is highly surprising that these recent trends in biotech have not gotten more attention.

But even with these massive gains, the real story can be seen in the changing standards for the development stages achieved by companies looking to enter the market. To be sure, what we have not seen so far this year have been medical headlines showing major advancements or cures for some of the most dangerous diseases. This creates the need for important questions: What is driving this year's incredible performance in biotech? Are these valuations warranted? What are the actual chances most of these new companies will be able to successfully put drugs into the market?

Understanding the Broader Risk

Industry data shows that roughly one in 10 new biotech companies are able to complete each stage of the development process and sell products in the market. This creates an investment scenario with high levels of risk. The reality is that most new biotech firms (still in the clinical stages) focus most of their time and resources toward the development of a single drug. Potential returns when these products are successful can be massive. But most companies fail to meet their mark, and drag early investors down in the process.

Investing through the Optimism

The overall investment presents a good deal of risk, but this does not mean strong returns are not possible. We have to only look at the market performances this year to see the immense potential for returns. One way to avoid some of the volatility is to use established ETFs, like the iShares Nasdaq Biotechnology ETF (NASDAQ:IBB), which help to diversify exposure and reduce potential volatility (given the large liquidity that is associated with the fund). The stock is still trading near its highs for the year but with a P/E under 5, valuations still look excellent.

For those willing to take on some added volatility (and potential for increased risk based on less diversification), investors can look at Receptos Inc. (RCPT), to play this year's momentum in IPO entries. Enhanced expectations for the company's IPO drove the company to raise its initial share offering to 5.2 million shares. Receptos has reached late-stage development for its oral treatment for multiple sclerosis (NYSE:MS). MS treatments are dominated by industry heavyweights but MS pills are expected to surge in the next few years because oral treatments are becoming more efficient than injected therapies, and can cater to a broader consumer base. Being a new company, the Receptos chart only offers limited incite, and will not be included here.

Not All That Glitters

With any rally, some examples of over-extension can be found. One stock to sell on the short side can be seen in Acorda Therapeutics (NASDAQ:ACOR), which to some will look cheap with its low P/E ratio of 9.6. Looking at the fundamentals, product stories some potential obstacles. Looking at the walk-test data in the company's central offering (Ampyra) have been largely uninspiring. Because of this, further Phase IIb trials will likely be required before we can see a move into Phase III. This will almost certainly stall the development process - by as much as 2 years. This story will continue to drag on projections and create downward revisions in both sales growth and earnings projections and sales growth. Upside potential for this stock remains limited, and short selling opportunities await on any rallies:

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.