Is Biotech Getting Too Frothy? Investor Sentiment Suggests Irrational Exuberance

by: Stephen Simpson, CFA

Investors with many years of experience in biotech know there's something to the idea that the best time to prepare for war is during peace (and vice versa). With the biotech sector heading for its second straight year of strong returns, it's worth asking whether investors are getting a little too cavalier about risk and whether investors in the sector are getting set up for a sizable correction.

Anecdotal Data Is Still Data

One of the least scientific measurements I use when thinking about and assessing the biotech sector is reader/investor feedback. When investors are running scared and too scared to touch biotechs, bargains often abound. On the flip side, when investors seem to have dollar signs in their eyes and a "What? Me worry?" attitude toward risk, I get a little more concerned.

To that end, I'm finding more and more readers taking me to task for being insufficiently bullish on their favorite names. I've written positively and bullishly on names like Celldex Therapeutics (NASDAQ:CLDX), Exact Sciences (NASDAQ:EXAS), and Lexicon Pharmaceuticals (NASDAQ:LXRX) only to be accused of being bearish or even "secretly short" because I don't think the stock in question is worth a bazillion dollars (I'm rounding up here, of course).

At the same time, I'm getting an increasing volume of emails and messages telling me to write on this or that biotech - often a tiny company with, at best, one drug in Phase I studies. That suggests to me that investors are focusing virtually all of their attention on the potential of a biotech, and very little on the risks of the drug actually getting through clinical trials and/or succeeding in the real-world commercial market.

Trials? I'm Just Here For The Trade

I'm also a little concerned by the influx of traders into the market. It's not that I have any problem with those who see trading opportunities in biotech stocks, but rather that those sectors that attract traders' attention tend to have already had their best runs, and the involvement of new traders adds a lot of volatility to the market.

The hepatitis C (HCV) sector may be the easiest example of this phenomenon. Stocks like Gilead (NASDAQ:GILD), Achillion (NASDAQ:ACHN), and Idenix (NASDAQ:IDIX) have gotten batted around for over a year now as incremental data on efficacy and/or safety leads to this or that company being crowned as the next big winner. Now, the early stage of development in this sector (many drugs are still just in Phase II studies) can certainly explain some of the volatility, but I know I've gotten more questions on trading opportunities (as opposed to investment opportunities) in this sector than any other.

Well-known biotech "frequent flyers" like MannKind (NASDAQ:MNKD), Hemispherx (NYSEMKT:HEB), and XOMA (NASDAQ:XOMA) have all come to life again over the past six months or so. Likewise, a host of investors seem to be happy playing in low-quality names popular with retail investors on the idea that bullish press releases can continue to fire the stocks.

Irrational Exuberance?

Last and not least, I'm seeing more and more investors, analysts, and company managers talking about a commercial market that just doesn't seem to resemble the real world. Even though there have been several recent examples of highly anticipated drug launches going south (including some that represented real breakthroughs), there still seems to be a "get it approved and the customers will come" approach to the market. It's absolutely true that the medical community wants and needs a real leap forward in cancer, autoimmune, or cardiovascular disease but a "me too" drug that is barely distinguishable from generic options is a much harder sale.

Likewise, reimbursement and market share are both limited factors. Yes, there are some cancer and rare disease drugs that get (and deserve) six-figure reimbursement rates, but no insurance company or national health system has a bottomless pot of money for barely differentiated drugs. That's particularly so given the near-certain growth of biosimilar drugs in the coming years. In fact, I will go as far as to suggest that recent issues like the European rejection of Vivus's (NASDAQ:VVUS) Qsymia and the statement that GLP-1 diabetes drugs don't offer meaningful clinical benefits may be motivated at least in part by financial considerations.

When it comes to market share, it increasingly appears that the numbers just don't add up. I've seen multiple examples of a sell-side analyst projecting biotech drug revenues that either require 125% market share or unprecedented growth in the number of people with the disease(s) in question. At the same time, the word "blockbuster" continues to be tossed around as a hot-button keyword that fires the imagination of investors, even though adjusting for inflation suggests that blockbuster should now refer to a drug with sales more on the order of $2 billion.

All Is Not Lost

Lest I be called a biotech hater, I want to make it clear that I still have a lot of faith in the long-term prospects for biotech. In fact, I have about 10% of my own portfolio in various biotechs. I do believe, for instance, that HCV will be a multi-billion dollar market in a few years, and I likewise believe that "better mousetraps" can turn today's small-cap biotech into tomorrow's big winner.

Along those lines, Achillion could still be a great future acquisition for Big Pharma, Rigel (NASDAQ:RIGL) could have a great oral rival to Abbott's (NYSE:ABT) Humira, and Celldex could have two important (and differentiated) cancer therapies for currently hard-to-treat diseases with poor survivability. And it's not just the small caps - big boys like Biogen Idec (NASDAQ:BIIB), Celgene (NASDAQ:CELG), and Regeneron (NASDAQ:REGN) could all have many good days ahead.

That said, a lot of biotechs have jumped 100% or more this year, and two straight strong years for the sector should make long-term investors pause a bit. While biotech trading may indeed reward bravery, successful biotech investing often requires a healthy appreciation for the bear side of the story and an appropriate discount for the risk.

So by all means, I think investors can continue to buy and hold good biotechs on the hopes of even better gains. I'm just suggesting that it may be time to remember that risk is always a co-pilot in these investments, and that the results of the last two years aren't exactly normal for this industry.

Disclosure: I am long LXRX. 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.

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