This Is The Problem With Listening To Janet Yellen About Biotech Stocks

Janet yellen papersREUTERS/Jonathan ErnstU.S. Federal Reserve Chair Janet Yellen

Puma Biotechnology shares are going nuclear right now, surging by almost 300% after the company announced encouraging results from its recent breast cancer drug trial.

Odds are, you’ve never heard of this company before. But that’s the nature of these tiny biotech firms that are developing drugs. They typically are very small, they lose lots of money, and they deal in a business riddled with the terrifying chemistry jargon.

But here’s what you need to know about these biotech firms: sometimes they find success. And when they do, the sky’s the limit.

These firms don’t start making money until they’re able to get their drugs approved for the market. As a result, valuations often seem extraordinarily high. For example, the price-earnings ratio, the most widely cited measure of value in the stock market, will be inflated because the denominator is so low.

However, those valuations quickly collapse when a drug goes from making $US0 to making a billion dollars after approval.

Goldman Sachs’ Jami Rubin recently estimated the potential revenue that could come from the drug development pipelines of seven major biotech firms.

By 2020, Rubin said that they could add between $US72 billion to $US113 billion in annual revenue on top of the roughly $US205 billion coming from existing drugs.

When you consider this upside, you can begin to understand why people pay so much for a piece of the action.

But, it’s also a mistake to characterise the biotech sector as a bubble.

“It’s certainly very speculative, but speculation alone doesn’t make a bubble,” said stock market expert Richard Bernstein earlier this year.

This is not to say you should start buying these stocks haphazardly. Indeed, many if not most of these companies see their stock prices fall to zero as their drug pipelines go nowhere.

However, traditional measures of valuation are probably not the best way to judge the state of the industry.

“Valuation metrics in some sectors do appear substantially stretched — particularly those for smaller firms in the social media and biotechnology industries, despite a notable downturn in equity prices for such firms early in the year,” said Federal Reserve Chair Janet Yellen earlier this month.

Yellen can say what she wants about social media stocks. But her assessment on biotechs is arguably just wrong.

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