Framing the problem
It's difficult now to even define precisely what a biotech company is and is not. "Biotechs" used to just genetically engineer individual cells to make therapeutic proteins. Now, makers of oral meds that might just be called pharmaceutical companies, not biotechs, are also called biotechs. These prominently include Celgene (CELG) and Gilead (GILD). More confusingly, most Big Pharma companies now develop and/or market traditional pharma products and some genetically-engineered products. Even though Merck (MRK) is not a biotech overall, its growth path is felt to be so tied to one major biotech product, Keytruda, that its 17% plunge in six weeks in good measure due to Keytruda made it in a sense part of the problems of the biotech sector.
There are issues with popular biotech indices, so it is not even. The well-known iShares NASDAQ Biotechnology ETF (IBB) is a managed fund that happens to own a non-biotech, Mylan (MYL) as well as a non-drug company, Illumina (ILMN). It owns the ADRs of Shire (SHPG) but none of the world's largest biotech, Roche (OTCQX:RHHBY). IBB's largest holding, Biogen (BIIB), is not one of the highest market cap biotechs, so its recent outperformance reflects good stock-picking rather than how the average biotech portfolio has done. The oldest biotech index I know, the NYSE Arca Biotechnology Index (BTK), is an unweighted index of 30 mostly small biotech stocks. I believe it is tracked by a First Trust fund (FBT), which has Alnylam (ALNY) listed as the largest and Juno (JUNO) as the second largest stock. In other words, there is no really good way to chart how "biotech" has been doing lately. Plus, everything in markets is relative as well as absolute, and with the S&P 500 (SPY) sporting a great chart, and with tech stocks getting hot again, biotech's performance has lagged a rising group of comparators.
Given the number of disappointments in biotech lately, I wanted to express some thoughts about the context. My conclusion is that on the one hand, supply-demand factors suggest that it will be a challenge for the sector as a whole to get hot for some time, but that on the other hand, many leading biotechs, as we know, have below-market P/Es, so the process of repair may already be underway.
First, my thoughts on a very picture reason that optimism about the general economic future is helpful in being a biotech investor.
Biotech in the longer view
I believe that biotech thrives during prosperous times. For it to advance in a big way, society must have sufficient resources well beyond feeding and clothing the population and must be motivated to treat such things as rare genetic diseases, aging cancer patients, and other people who may never individually generate production back into society. So, unlike development of antibiotics that saved lives of children, workers, etc., biotech products as they exist today are more elective for a society to develop and pay large sums for. This in turn adds risk, as countless people writing and commenting on biotech on Seeking Alpha have pointed out, with valid reasons. For example, in prolonged difficult economic times, will US Medicare continue to pay for cancer treatments that statistically prolong the lives of 80+ year old retirees by, say, six months? One can go on and on about cost-benefit considerations, and I make no predictions or recommendations on these difficult policy matters.
I will just comment that when countries feel richer and are actually getting richer, then biotech tends to become a leading sector along with other growth stocks. And since I have liked the US and global economy since mid-2016, I like the biopharmaceutical sector from that standpoint.
But one precondition for a great sector move in the stock market is often a prior period of relative investor neglect. IBB, for example, barely moved on balance between August 2003 and August 2007, while the SPY went up a lot. So, there was some catch-up to do subsequently.
With the persistent sputtering of the global economy after the Great Recession ended in mid-2009, and slow growth in the US, biotech became a lot more appealing relative to economically sensitive stocks, and by 2015, when the latest QE's effect had worn off, there was an awful lot of speculation in biotech, both large and small caps. This was less extreme than the 1999-2000 period in tech, but it may have been similar in extent to the still extreme 1997-8 period in tech. The NASDAQ composite index peaked in the 1,400s in January 1997 and bottom in Q1 2009 below 1,300. So, there was no need to participate in the final 3+ years of the tech boom to get in lower and much more safely. At this point, the IBB and most other biotech indices are less than 2 1/2 years after their peak. Could we be in for many more years of churning in the sector?
Perhaps. Here's why I've been keeping exposed to the sector but not heavily.
Mechanism of the Tech Wreck and recovery repeating in biotech
What happens in prolonged stock market and business booms, as with tech and telecom in the 1990s, is a flood of new money coming into the field. The result was overcapacity and lack of relative pricing pressure. There are only so many ways to improve on a search engine, only so many new software programs that the world needs, and to make things worse, investors did not fully take account of all the other people doing similar things. Investors were in concept right, but many years too early. Rather than high tech inventions, Old Economy sectors such as housing and oil became hot. In 2000, who could have guessed?
While values in biotech by 2014/5 did not reach crazy levels in the large cap stocks in biotech, the analogy holds in general because we did see biotech as the leading subsector of the industry each year from 2010 to 2014. (That information is from a Gavekal blog I read probably in 2015.) Even Internet stocks had not done beaten the market so steadily in the 1995-99 period.
By 2015, I was commenting that too many junior biotechs were going public. Some were not even beyond Phase 2 studies, which is the proof of concept stage. No doubt these were worthy enterprises deserving of funding, but they were in general unsuited to be marketed to the public. This was bubble-like and thus indicates a lot of demand coming into the field. We saw a great deal of M&A, as well, often at very high prices.
The end result: this science-driven, illness-driven, relatively narrow field from a commercial standpoint saw tons of investment up and down the R&D chain. (Ultimately, this is good for patients, but this is an investment website.)
One ongoing result: many solid companies are right now forced to reach for riskier projects to stay ahead of the larger number of competing products. Thus: more clinical trial failures.
Another ongoing result: that much more in the way of early-stage development. This provides more competition for the successes
From what I read, this may be occurring in the "PD" sector now, with five drugs on the market and perhaps many more at some stage of clinical development. Will any of these have a superior quality to Keytruda and the sales leader, Opdivo from BMS (BMY)? And, if many similar drugs reach the market, what will happen to pricing?
This sort of thing is going on all over the biotech sector as I see it.
Next, some examples in the very recent past of how that may be manifesting itself in stock market action.
Some examples of how the Tech Wreck analogy may be manifesting itself
These are some examples of how I see what might have left to moves up in growth-oriented by stronger biotech stocks leading instead to sell-offs. Note, I am completing this at 2:10 PM Wednesday, and the next two stocks discussed have moved down over the several hours it has taken to write and complete this article. So, their prices might change a lot again by the close of this day.
Take Incyte (INCY), which I bought at $104 early this year and luckily sold shortly thereafter at $129 after it was added to the S&P 500. It has been higher and lower than $129 since I sold, so I claim nothing but good luck in a speculative trade. In any case, it came out with Q3 earnings Tuesday that were a "beat and raise" report. The stock looked to open up in pre-market trading and reversed. As of Wednesday AM, it is down to $107. This is below the price at which I recall flipping it a couple of times in 2015, when I knew I was in much of biotech for a trade only.
Yet INCY's flagship, Jakafi, has been on a tear since Q2 2015 when my trades were accomplished. Its RA drug Olumiant (baricitinib), which Lilly (LLY) markets, has come to market in the EU and Japan, and is hoped to finally gain FDA approval next year. Another drug licensed to Novartis (NVS), capmatinib, may gain approval for cancer in 2019, with royalties to INCY. And since 2015, INCY's now-Phase 3 lead cancer candidate, an "IDO" inhibitor, has entered numerous collaborative trials with BMY, MRK and elsewhere. This drug (epacadostat) could have blockbuster potential.
So, why has the stock slid on good news? A headline I'm looking at on Yahoo Finance from yesterday in fact continues to say that "INCY rises on a beat-and-raise."
A possible answer, without having studied the entirety of the conference call and so on, is that investors know there may be success at BMY, MRK, and others with next-generation successors to epacadostat. Maybe they are cooperating with bringing it to market both to help sales growth now of Opdivo and Keytruda, with the plan that their IDO inhibitors can sail through Phase 3 studies if epacadostat works, and then they can bundle their IDO and PD-1 inhibitors together. Maybe investors do not love INCY doing a deal for access to yet another PD-1 inhibitor. There are many reasons, but this is corrective action following a tremendous multi-year performance by INCY. After all...
INCY is a stronger company than it was in 2015, but at about 16X trailing sales, simply forecasting lots of competition for all its products except Jakafi can bring the P:S ratio down a lot.
I think we saw things like this in much of tech in the years leading to the Great Recession.
Another example from Tuesday was the report from Regeneron (REGN) and Sanofi (SNY) about Dupixent and their pursuit of an asthma indication to join the drug's eczema indication. The latest information was about the third pivotal trial for asthma. The main issue for me was whether this would have an effect on "low eo" refractory asthma. The first pivotal trial, a Phase 2b study reported a long time ago, showed the drug working in the high eo asthma where many other drugs are effective. The surprise in this study was that it was similarly effective in the low eo group; it was the first drug to show this effect. However, the first Phase 3 study (the second pivotal study) was disappointing in that regard.
Then, we got this quote from the Tuesday press release about this LIBERTY ASTHMA VENTURE study:
- First study with a biologic to show benefit in severe steroid-dependent asthma population that enrolled patients regardless of blood eosinophil levels or any other Type 2 biomarkers at baseline
- Pivotal program is first with a biologic to show consistent reductions in asthma attacks and improvements in lung function across a broad population of uncontrolled asthma patients.
That looks pretty hopeful, and the stock was indicated up perhaps 1.5-2% pre-open.
But it closed down a little on the day, and is down another 1.5% to $397 as I write this.
Why? My take from the press release is that the effect in low eo patients was a lot weaker than in high eo patients. Beyond that, I just do not know how this will shake out at the FDA. Maybe the low eo effectiveness will in fact be a positive marketing (and of course medical) factor.
There has been a great deal of investment in various antibodies for asthma, including some by novel mechanisms that just might supersede Dupixent in this indication.
Whatever the reasoning - and there may be something unrelated that also is moving the stock - this is not typical action during an ongoing bull market. It is much more of what is seen when a sector has been blazing hot and continues to cool.
One last example of many involves CELG. I believe that in 2014-5, its board and leadership were concerned about the Revlimid and other patent cliffs coming next decade. Unfortunately, to obtain breakthrough drugs that could be generating profits by 2020 and growing into large enough blockbusters to make up for the patent expirations, risks were taken. The price paid for mongersen reflected the exuberance in the biotech marketplace when the deal was struck, H1 2014. The prices paid in 2015 for the several deals made reflected froth in the biotech sector. Related or not, by Q1 2016, the CEO who did all those deals was suddenly an ex-CEO. Prices for the same assets would have been much lower in a quiet biotech market, and CELG has to live with those deals as they prove out. Deals made at market tops, when deal volume is heavy, can weigh on a sector for years to come.
The other material bit of bad news for CELG recently was the sharp decline in Otezla sales in Q3 from projections. Management being blindsided and not communicating the change in the sales picture in a timely manner to investors is not part of the Tech Wreck analogy. But where the analogy holds is that right now, competition is giving the buyers of drugs more of an even break, rather than just suffering price increase after price increase, as CELG had done aggressively after Otezla reached the market.
If less investment had gone into psoriasis drugs, with a lot more treatments potentially coming this decade, price increases could have stuck much better. So, the pendulum is turning to favor consumers, as I see it. More supply, same demand.
Ultimately, that will benefit the biotech sector - but the cycle may have further to run.
Success in biotech-land allows patients and insurers to benefit. Producers receive negative feedback and rethink their next R&D projects and the price they are willing to pay for the next deal. More patients benefiting from biotech drugs does, however, continue to fuel greater demand for more and improved drugs treating existing diseases better and also treating currently untreatable diseases.
Next, a side comment about some of today's sector outperformers, then some final words about biotech investing.
Where pricing power and relative shortages may exist
Mr. Market has been voting for Old Economy stocks since Q1 2016. I began voting that way beginning in June of the same year. Why? It's simple in a way. The prolonged sluggish US and weak global economy since the Great Recession had taken both pricing pressure and volume from important companies. Take Deere (DE). Per Value Line, sales peaked at $35 B in 2013; sales per share were $94. Sales bottomed well below $30 B. Forecasts per Yahoo Finance are for sales to rebound in the current fiscal year, which ends next October, to $28 B. DE is largely the same company as in 2013. Shares outstanding have shrunk notably. DE's long history routinely involves higher peak sales from one growth cycle to another. There are more global and US mouths to feed now than in 2013. There likely will be more next year and the year after. I doubt that tractor (etc.) prices have suffered severe deflation. So, naively perhaps, I assume that since DE continues to have a leading position in its industry, it can see sales rise over time above $35 B, with sales per share rising much higher than that. Maybe, in that case, dividends will increase and/or share count will shrink further, and the stock price may rise at an acceptable pace. This has been DE's pattern over many decades. I've been betting on it continuing and see the market liking this story.
Compare that to biotech: DE has more predictable product cycles gyrating around a rising trend line, and it has no serious patent issues. DE routinely makes its own old machines semi-obsolete, but no generics come at the old inventory at 1% of the price as occurs with generics.
So - DE and its cousin Cat (CAT): up, with resilient stocks, and in favor for now.
Another example of changing trends toward Old Economy businesses involves Thor Industries (THO). This is the leading manufacturer of recreational vehicles. By units sold, the industry peaked in the 1970-80 decade, then shrank severely. But it is now back to or near record levels of units sold, and THO and its smaller competitor Winnebago (WGO) see their stock prices go up most days right now. Why? Apparently, there is a demand:supply imbalance, so pricing and profit margins are high. THO has its HQ in Elkhart, Indiana, which suddenly is experiencing a labor shortage; THO is expanding manufacturing in Idaho now. Who would have guessed this would be occurring in Q2 2015? Certainly not I. But here we are.
I think this also fits the post-Tech Wreck pattern, where after 20 years mostly in the investment wilderness, oil and gold (GLD) stocks, and the commodities, felt investor love. High tech was not forgotten, but except for such examples as Apple (AAPL) and the IPO of Google (now Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL)), one did not get much sustainable alpha from tech. Remember the rallies in Nokia (NOK) and BlackBerry (BB) into the 2007/8 peaks? Who could have known that a similar crash was not going to happen to AAPL until the iPhone was released?
Some additional views are expressed in the conclusion.
Biotech investing for the 2020s
Thinking of the Tech Wreck, I have been hoping that CELG would be this period's equivalent of AAPL. Well, we shall see on that.
For now, it appears to me that it is time for inflation to seep out of biotech and go elsewhere. Perhaps basic industries will see a catch-up in pricing. The sharp rise in copper prices (JJC) over the past year, up nearly 50% yoy, suggests this may have begun.
Thinking longer term, though, just as the main reasons to love the emergence of the Internet were valid, just wild at the top of the cycle, I remain confident that something like that is true of biotech, which again did not experience a 1999-2000 sort of insanity as tech-telecom did.
What I am looking for in the ongoing and eventually accelerating growth of biotech has three main themes. These are:
- gene therapy and related technologies - but without a rush to invest in this theme alone; owning GILD with its CAR-T/Kite growth goals satisfies me
- broadening of biotech's patient base to larger markets, such as heart disease as the PCSK9 inhibitors might have done
- acceleration or quantum jump in dosing methods from injectables to oral.
There will always be stocks among the many public biotechs that are rising, and one or more could be the next AAPL or GOOGL of the early post-Tech Wreck era. The sector remains investable in my eyes.
Also, most leading biotechs have P/Es below that of the SPY while investing heavily in R&D to fuel future growth. So, a long-term investor may right now be set up for alpha in some time frame, though that time frame may be deferred into the 2020s. This point of view also supports continuous exposure to the sector if one believes as I do that the US and global economies are generating greater wealth again, and that biotechnology can meet growing hopes and expectations for improved treatment of the ills that flesh is heir to.
Thus, I think that what we have been seeing with difficult results in various parts of the biotech sector are not unexpected and do not change the case for exposure to this sector given a long-term time frame. P/Es below market, heavy and partly optional R&D expenditures, and in my view above average long-term growth prospects are how I look at biotechs looking past ongoing fundamental and technical challenges.
Thanks for reading. I look forward to reading any comments you wish to contribute.
Disclosure: I am/we are long CELG, GILD, BMY, RHHBY, AAPL, DE.
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.
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