Biotech stocks sold off sharply on Friday and Monday, and they underperformed the markets on Tuesday.
This followed a monster 2-1/2-year long bull run that saw the sector more than triple as the S&P 500 returned around 70% (see chart). In fact, biotech was the #1 performing sector in each of the last three years.
“It’s no longer the elephant in the room: has the “biotech bubble” burst?”
That’s the question Credit Suisse’s Ravi Mehrotra and Koon Ching seek to answer in a 19-page note published on Tuesday.
It’s notoriously difficult to sniff out bubbles. It’s arguably even more difficult in the biotech sector as every company in the industry is essentially hoping their business will go from $US0 to multi-billions overnight.
Credit Suisse’s team conducted their examination by considering the last biotech bubble, which coincided with the dotcom bubble.
“When looking at the overall picture, it is clear that the biotech bull markets of 1999/2000 and 2013/2014 are notably different (now driven by an appetite for EPS growth vs. genomics/tech then, now valuation is arguably not stretched relative to other sectors). However, we also highlight that there are some similarities between this bull market and the last (generalist in-flows and pre- clinical public companies), which could drive some lingering market nervousness.”
They consider three points.
“Sentiment vs. fundamentals is the prick for speculative bubbles,” wrote the analysts.
They noted that the turning point for the last bubble occurred on March 14, 2000 when then U.S. President Bill Clinton and then British Prime Minister Tony Blair began pushing for the open access, or non-patentability of gene sequences. This triggered a 49% drop in the sector in just one month.
“Yes, the enthusiasm around biotech in 2000 was undoubtedly partly centered on the human genome project, so any negative comments on it were bound to have some sort of negative sentiment on the sector,” they said. “However, “fundamentally” we all sort of knew that raw genetic sequences were not patentable. So the market used that White House tête-à-tête as an excuse to mark down a sector on sentiment vs. fundamentals”
Today, a comparable moment may have occured on Friday when Congress questioned Gilead Sciences about the high pricing of their new hepatitis C drug.
However, the analysts say that the reaction in the market appeared to be driven more by sentiment than fundamentals.
“Our point here is that sentiment shifts tend to prick “speculative” stock-market bubbles and be used as an excuse to sell-off vs. actually fundamental shifts,” they said.
Some companies look more expensive and some look more reasonable today compared to 2000. The analysts run through numerous companies in their report. They also offer some discussion about where companies are regarding clinical trials.
As we’ve noted repeatedly, the real challenge with these companies is whether or not they will be successful in pushing their products through the pipeline and onto the market.
Based on earnings forecasts, large-cap biotech companies — including Amgen, Celgene, and Gilead — are trading at 13.5x 2016 earnings and 11.7x 2017 earnings, which is actually cheaper than 14.2x and 13.5x, respectively, for the S&P 500.
Of course, these are based on the assumption that the biotechs will recognise 21.5% annual earnings growth through 2017 versus 5.5% for the S&P 500.
Ultimately from a valuation standpoint, the analyst say “things are not black or white, but more shades of grey.”
3) Fund Flows
Considering the source of investor funds is an interesting way of analysing a market to see if its a bubble.
According to the analysts, investor dollars today and back in 2000 can be characterised as “generalist fund flows,” which means these aren’t investors that were just focused on biotechs and health care. Rather, the investment capital has been coming from people who typically invest more broadly.
In 1999/2000, generalist were attracted by all the buzz surrounding genomics. There was also the “overflows” from all the money people were making from the dotcom boom.
“This time, it is demand for quality defensive and growing earnings within the large caps (and a ripple effect into SMIDS caps) — well at least according to our “generalist GARPy inflow hypothesis,”” write the analysts. “Now, the biotech sector’s performance is driven by good “old- fashioned” product success stories from both large and selected SMID-caps.”
GARP is short for growth at a reasonable price.
With the stock market at all-time highs and interest rates at record lows, investors have increasingly found themselves drifting to riskier corners of the market in hopes for higher returns.
So, What Does All This Mean?
The authors don’t actually articulate whether or not they’re convinced biotechs are a bursting bubble.
They do, however, state the somewhat obvious and say that a further sell-off would make the sector cheaper.
“In our view, unless we see a fundamental disappointment in the “leadership” companies, we think valuation of (at least the large caps within) the biotech sector is supported and actually provides room for upside,” they wrote. “We note that if we see a further 10.5% decline in the stock across the large caps it would place the sector at 2015 PE parity to the S&P (with >4x the EPS growth). Large cap biotech is now trading at a 2015 and 2016 PE discount to the S&P500!”
A discount to the S&P 500 would certainly be good news for prospective biotech investors. Of course, one would then have to consider whether or not the S&P 500 is overvalued…