Why I Don't Buy Biotech

by: Dana Blankenhorn

Bristol-Myers fell hard because of a failed trial of Opdivo against lung cancer.

Merck rose because it has a competing drug called Keytruda.

Both moves miss the point.

I am a small investor, and I have a broad range of stocks in my portfolio.

I don't have biotechs.

I should. I know. I recommend some here like Regeneron (NASDAQ:REGN). I like Illumina (NASDAQ:ILMN). My thesis is you want to invest in companies with a broad front, with a system for finding cures rather than single cures. There are so many things that can happen in drug trials, from Phase I to Phase III, and even beyond. Can a drug get approval? Can it become part of the standard formulary? What about pricing?

So if you're depending on one drug for your future, you're going to be a speculator. The problem is, as we have seen today, that this speculation can impact even big companies.

Take Bristol-Myers (NYSE:BMY). Down 20% because a Phase III trial on its immunotherapy drug failed for Stage One lung cancer. That is silly. What's sillier is the 6% rise in Merck (NYSE:MRK) because it has a competing drug, Keytruda.

Bristol-Myers should not be an exciting company. It's a steady state pharma giant, about as boring as such companies get. Revenues have barely moved for three years. Margins have been decreasing. Yet, the stock has been rising steadily for the last five years, and when the news hit, it was valued at a Price/Earnings multiple of 44.

The adjustment expected in early Friday trade does not make Bristol-Myers a bargain. It cuts the P/E down to the mid-30s. That is still higher than the P/E of Pfizer (NYSE:PFE), than AbbVie (NYSE:ABBV), even of Merck itself, which opened Friday at an earnings multiple of about 32.

What's really going on? Both Opdivo, and Merck's Keytruda, have been approved for use against some of the worst cancers. Keytruda was used on Jimmy Carter because he was dying, with a very late-stage cancer that had resisted other therapy. The struggle for immunotherapy is to get these drugs, and others still in the pipeline, approved for use against earlier-stage cancers.

Traders got way ahead of themselves with BMY because lung cancer is one of the most common types of cancer, it has a high mortality rate, and the standard treatments are both horrible and expensive. The Checkmate-064 study that failed, however, dealt only with using the drug as the exclusive agent against non-small cell lung cancer, where a specific protein called PD-L1 is in a high concentration.

Using Opdivo against one type of cancer, and only one sub-type, did not deliver results. This says nothing about its efficacy against other types of cancer, against other sub-types, or against later-stage cancer.

Opdivo had sales of $942 million last year, several times more than Keytruda. This is how investors got caught offside. BMY designed its trials to enroll a wider swath of patients, and to skip the diagnostic tests required before patients are prescribed Keytruda. This is why Opdivo was winning the market. The real lesson here is that you should do the diagnostics, and it has little to do with the merits or demerits of the two drugs (Please note. I am not accusing anyone of anything dishonest. This was a rational business choice).

What the previous analysis probably told you was to buy BMY and sell Merck. But here's the thing. There are now hundreds of immunotherapy drugs in clinical trials. So far, only six have been approved for use, and investors are rushing to buy the companies making them.

That is the mistake. I think we're not only missing the trees for the forest, but we're missing the fact that, as more of these drugs are approved and go into the market, competition is going to create pricing pressure, and none of the makers may get the kinds of home runs they're now expecting.

Better for investors to buy an ETF, IBB. Anything else looks a lot like gambling.

Disclosure: I/we 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.