Time has made Donald Trump its Person of the Year. Its cover article contains this paragraph that has moved drug stocks Wednesday (my emphasis added):
He also suggests that some stock analysts may have misread his intentions. The value of biotechnology stocks, for example, which enjoy large profit margins under current law, rose 9% in the day after Trump's election, a rally of relief that the price controls Clinton had proposed would not happen. But Trump says his goal has not wavered. "I'm going to bring down drug prices," he says. "I don't like what has happened with drug prices."
This should be no surprise to anyone. Mr. Trump's campaign website was rudimentary for quite a long time, but one of the points it specified early was that he would work to equalize drug prices between the US and other developed countries.
That's one of the reasons that in my "Trump can win" pre-election articles, I did not focus unduly on the obvious trading implications for biotechs (NASDAQ:IBB) or drug stocks (^DRG) in general, but rather on such stocks as steels and defense stocks. On Election Day, in my second such "Trump can win" article titled, Why Trump's Odds Are Better Than Thought, And How I'm Playing That View," I commented on biotechs this way:
I was going to discuss going long a biotech index option, but Monday's surge in biotechs (NASDAQ:IBB) makes me unenthusiastic about that as a timing strategy if the market as a whole would head south.
Well, the market (NYSEARCA:SPY) headed south on his victory, but reversed around 3 AM on the futures market Wednesday morning and has headed north. Initially, Monday's surge in biotechs continued through Thursday with force, pushing above the 200-day ema, and then had a little more strength. Now, however, it has begun lagging the market. On the news of this quote, IBB has sold off to $263, basically just where it was when I submitted that article Tuesday morning.
An even weaker index is DRG, which focuses on large cap Big Pharma and other general pharmaceutical stocks. This index is around 460 now and is roughly at a 3-year low. In contrast to the more dynamic IBB, ^DRG did not come close to its 200-day ema on its post-election surge.
So, what's going on, and what may come next?
The importance of private sector dynamics in these sectors
In various articles going back over a year, as drug pricing became a campaign issue, I've been making the case for biotech stocks for the long run, and that politicians would have limited effect on each company's value. Of course, until recently, essentially all observers were fearing a Clinton victory, given such onerous ideas as her proposal to lower the period of regulatory exclusivity for biotech drugs (proteins, not small molecules) from 14 to 7 years. That was never going to happen in my view, but now the worriers, short sellers and general trader community can point to Mr. Trump's comments and sell on that basis.
Yet one unchanging factor is that in democratically-elected societies, access to advanced healthcare is an electoral winner. That's why neither major party candidate discussed cutting healthcare (or other) entitlements in the campaign. That sort of "dirty work" may or may not come later. So, if the pricing dynamics are against payors, so be it. But when supply of product becomes abundant, the years of pricing generosity can reverse. It is that, not a comment from a President or President-elect, or the head of HHS, that is driving these changes in the pharma indices.
The general rule applies to drugs as with oil: The longer a boom goes on, and the more aggressive the price increases, the greater the risk of bust or a prolonged period of flat prices.
That's just where we are. That's why various companies have taken meaningless "pledges" not to raise prices more than, say, 5%. Ha! Those sorts of pledges really reflect that they are burdened by price cuts, and they would love to get 5% increases, net of real-world discounts.
So, one does sniff at a comment such as that by the President-elect, but let's ask, what can he do that would affect the present value of pharma stocks, versus free market dynamics being dominant?
Will a President Trump be bad for pharmaceutical companies?
The idea of some sort of parallel importing, basically forcing the FDA to accept pharmaceutical products approved by a foreign regulatory agency, is more myth than realistic. Also, once the US would begin to import the drug product from, say, Spain, the pharma companies would limit very severely their supplies into Spain. So either the Spanish would go without the drug, or there would be precious little to leave their distribution channel and go to the US.
Then there are the VA and Medicaid programs. But they already receive best pricing. And generics are used wherever possible, of course. So what's left? The Obama administration has talked about some reimbursement changes that might save the government pocket change while raising issues of inappropriate, patient-unfriendly denial of access to superior drugs. That's not going to be a big winner.
So ultimately, you are left asking whether a Republican Congress is going to repeal and replace Medicare with a harsh price control system. Good luck betting on that one.
All of a sudden, if that sort of proposal arose seriously, the pharma companies would find the Democrats eager to accept their copious campaign contributions, all in the cause of long-term access to the best drugs.
Here's the truly harsh truth as I understand it...
The (legal) drug biz is just an average business
Looking at profit margins of hit drugs is the classic distracter. Just as the gold mining business has finally gotten around to focusing on more comprehensive metrics of operating profitability, what counts in pharmaceuticals is total cost of discovering or acquiring, testing, and then producing and marketing a drug. And in the era of biosimilars, every drug product is subject to end-of-life issues that, say, Coca-Cola (NYSE:KO) does not have. As I said in a year-end interview with Seeking Alpha nearly two years ago:
I have cut back my exposure to all biotech substantially. The field is immensely complicated, burdened by litigation, full of exciting possibilities, and littered with investment minefields.
The next year (this year), Seeking Alpha was kind enough to re-interview me, and the title of the article says it all:
DoctoRx Positions For 2016: My No. 1 Risk Factor Is The Flood Of Money Into Biotech.
In other words, I have been trying to balance my long-term opinion that biotech was going to overcome the "Tech Wreck" syndrome that hit "tech" 15 years ago, but the path was unpredictable. Overinvestment in a sector, which then can hit some R&D dry holes, will have predictable results on product pricing and profits, and if the stocks have gone up for years, you get what we are seeing.
If members of Congress need education about the real, unexciting economics of drug discovery, and how China and India will take over from the US given a chance, both Big Pharma and large and small biotech leaders have lots of proof that, in the end, the return on invested capital in these industries is average - with lots of risk and long timelines.
So, in the end, I just do not expect much favorable or unfavorable out of a Trump administration and the incoming Congress. I could be wrong, of course - but that's my story and I'm sticking to it (for now).
Technicals are weak across the board
Whether it is IBB, or the DRG index, or a small-cap-oriented biotech index (NYSEARCA:XBI), the charts are depressingly similar. They look like every boom that is going, but has not gone, bust. The prices are up substantially over 5 years ago, but they are in downtrends. Fewer and fewer buyers want to get in. There is no pressure to buy. Jim Cramer has moved on. This year, the momentum-oriented Value Line system has featured such top-ranked subsectors as electric utilities, gold stocks and now all sorts of energy and mining stocks.
These are pretty much the opposite of moderate but steady growth companies that do well in periods of moderate inflation and restrained cyclical economic growth, which characterize general drug stocks as well as biotechs (which can grow faster on an individual basis).
There's no question that the deterioration in the technicals accelerated with the NYT/Clinton article/tweet/speeches over a year ago, but I was highlighting the elevated possibility of a major, 1998-type selloff in the sector in July, before all that hit the news.
So I continue to hold the view that what politicians are doing is joining a trend that was going to happen anyway, as they are wont to do.
How to invest in biotech?
I continue to like the Tech Wreck analogy. How many traders got out and then got back in with good timing? Thinking this way, I have maintained a moderate exposure to biotech on a permanent basis, but only with retained profits from summer 2013-2015 trading. My personal goal is to be ready to enlarge my positioning when the sector looks more classically cheap. However, as I said in the first quote above, winners and losers can change unpredictably.
If Sanofi (NYSE:SNY) cannot manufacture sarilumab, it suffers a little, but Regeneron (NASDAQ:REGN) suffers more. If, subsequently, SNY has misled REGN about its ability to get the more important dupilumab product out the door by its PDUFA date in late March, REGN really suffers. So everybody is frozen about REGN, and the stock is subject to fundamental downward pressure in addition to tax loss-related year-end pressure.
Nonetheless, FDA has allowed the affected SNY plant to continue to produce currently-marketed products, so the defects should be remediable. Given a robust pipeline and at least the possibility that Praluent for high cholesterol could swing from a loss center to a profit center, I look at REGN as a potential big winner with, now, reasonable risk for new money - if it's patient.
I mentioned that first because of the unpredictable manufacturing issue that came up with the otherwise-approvable sarilumab, not because REGN is the best stock in the sector right now. It has patent issues with Praluent, so that's a negative as well. But REGN has something special that worked in looking at tech companies: some unique products as well as a discovery engine. That's something that Apple (NASDAQ:AAPL) had by the time it was bottoming in 2002-3. So I think that REGN has AAPL-like upside potential.
More clear-cut as having unique products is the larger, safer Celgene (NASDAQ:CELG). There is only one Revlimid for myeloma, and its other two high-growth products, Pomalyst/Imnovid for myeloma and Otezla for psoriasis and psoriatic arthritis are unique. Unless there are outright price controls, how easily can Uncle Sam harm these particular products?
Then there is at least the goal of the CELG pipeline, which is for the most part aimed at developing best-in-class new drugs or T-cell products, or important new uses for existing drugs. To deny a successful product a good return on investment will shut down future development and send the industry packing to friendlier shores - which are certain to welcome it.
So does it make much sense that on publication of the Time article, the price of CELG dropped several percent?
Not directly, but that brings me to the final point before summing up:
These stocks are not dirt cheap, and junior biotechs are especially not cheap
I can paint as pretty a picture of the future for REGN or CELG as I want, but one can look at their established price:sales, price:book or price:earnings ratios, and their lack of dividends, and conclude: maybe. I say this because I have been surprised by how selectively the stocks of strong companies with dividends, Gilead (NASDAQ:GILD) and Novo Nordisk (NYSE:NVO), and to a lesser extent BMS (NYSE:BMY), have seen their P/E's shrink to ordinary levels.
This can happen to any stock in the future. That especially can happen to CELG and REGN, which for now are largely or almost entirely one-product companies. CELG could have trouble sooner than expected from the Revlimid patent challenge from Dr. Reddy's Labs (NYSE:RDY), for example. REGN could see serious problems occur competitively or payment-wise for Eylea. And so on.
The other mega-cap biotech, Amgen (NASDAQ:AMGN), fell 3+% Wednesday to $140. At that price, it is trading at 14X TTM GAAP EPS. Yet most of its revenues and perhaps a greater percentage of its profits come from old (not just aging) "legacy" products. These profits may largely vanish in the next 5 or fewer years, and there is little visibility regarding how they can realistically be replaced. So, is AMGN worth 14X, or 10X, or even a GILD-like 7X trailing profits?
I cannot even guess how the traders are going to run with this one - but I feel safer with GILD at 6.7X than AMGN at 14X.
So, my thoughts are, again, that the winners are just as in the information technology, or tech, sector. If a company has a defensible product or product line with a niche, or place in the economy, that is durable and large, the company and therefore the stock has staying power. That certainly describes Microsoft (NASDAQ:MSFT), Intel (NASDAQ:INTC), Cisco (NASDAQ:CSCO) and Oracle (NASDAQ:ORCL) going into and coming out of the boom-bust of the late '90s and subsequent Tech Wreck. That may represent GILD today. Whereas, the Verticalnet-type stocks that vanished were never a bad "sell" at any price on the way down.
That's how I see GILD, assuming success with its latest and greatest anti-HIV drug combo: too late to sell, probably too early for traders to buy. And I think that certain REGN products in development, including dupilumab but also others, have enough differentiation to turn the company into better than what MSFT and the other names mentioned above turned into -survivors with boring stocks after the excitement and tremendous success of the '90s.
As far as the juniors, this analogy has guided me to just be glad that I kept my losses this year below my gains of 2014 and H1 2015. I think they are very risky and that this is the one sector of biotech that entered an actual bubble. The surge in IPOs of biotechs that were barely into the IND stage, basically just Phase 1 research shops, in 2014 and 2015, was excessive and reminiscent of 1999 in the Internet stocks.
So I've decided that other analysts are better suited to invest in and write about these stocks. For me, there's enough risk and uncertainty - and upside potential - in companies with at least one established product.
Clinton, the Times, Trump - and then the next politically-driven or media-driven downdraft in the pharma and biotech stocks - it's almost all noise and catalytic action moving the cycle along, in my view. As with Internet and other tech stocks 15 years ago, different stocks bottom at different times. Amazon.com (NASDAQ:AMZN) peaked ahead of the market, in late 1999, and bottomed ahead of the market, in late 2001. CELG could have seen its bottom; the same for REGN, or not. I cannot guess, but within my own risk limits, I see each as having more upside potential than risk with CELG at $112 and REGN at $355. But each has risk of permanent loss of capital, in my view. The same also goes for GILD at $72-73.
That biotech was the leading subsector of the many subsectors of the stock market, according to GaveKal, for 5 years straight, an unprecedented achievement, is both promising and troublesome. It's promising because it occurred in the setting of innovation and real economic profitability. It's troublesome for the reasons we see playing out: great run-ups produce great unrealized profits for those who got in early or midstream, and Wall Street lives to rotate amongst sectors.
So, my view remains unaltered by politics. I believe that what matters is innovation. If GILD has both the best hepatitis C product line and succeeds in developing an even better single tablet regimen for HIV/AIDS, then it has two potentially immense product lines that will be difficult for even a cost-strapped set of governments to destroy economically, and thus downside risk to shareholders exists but may have limits. More aggressive companies such as CELG that do not pay dividends, reinvesting in growth, have somewhat different metrics.
But overall, at some point, the over-investment in the sector that I mentioned at the beginning of this year as the biggest risk to biotech will fade. Funding for Phase 1-level companies will disappear, and the big players will pick and choose from the rubble. Then the cycle will pick up again. The usual pattern takes a while, just as it did with tech after 2002.
That's why I've been emphasizing, and continue to emphasize, a patient, multi-year approach to the larger, stronger biotech stocks. The same approach that John Bogle of Vanguard takes about the market as a whole can be taken for these volatile names. The big guys will all be there next year, and the year after (barring M&A activity or other corporate realignments).
When and why Mr. Market decides to like these names again is to be discovered, but I believe that what's highly likely is that he will like them again, and eventually love them. In the intervening time, the challenge for investors who believe in the future of the for-profit biotechnology industry is to deal with shrinking multiples and challenged charts.
As far as most Big Pharma goes, I see it as a mixed bag. The underperformance of the chart of the DRG index versus IBB reassures me that in the main, it's been correct to focus on the biotech/biopharma sector over Big Pharma. Only time can tell how that decision plays out, though.
As with tech, some big players may not go to new highs. Others may be the next AAPL. Yet other winners of the future may still be private; think Alphabet (NASDAQ:GOOGL) and later Facebook (NASDAQ:FB). So, the field remains open, full of minefields and opportunity. Many investors will want to have a core position in one or more funds; others in individual names; others in a mix of funds and individual stocks.
I think it's possible that just as the tech industry created products that changed the world after the Tech Wreck, the 2020s may see similar amazing things from biotech. Perhaps many investors will reap rewards therefrom.
Thanks for reading and for any comments you may wish to share.
Disclosure: I am/we are long GILD,CELG,REGN,AAPL,INTC,NVO.
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.
Additional disclosure: Not investment advice. I am not an investment adviser.