Todd Harrison put up an interesting chart (below), asking whether biotech was bubbly (see: Todd Harrison: Is the Biotech Bubble About to Burst?
), so I thought I'd weigh in.
Biotech is highly valued right now. There is no denying that. Stuff that used to trade for $100 million cap is trading for $500 million cap. $300 million companies in a "normal" market are over $1 billion. As the PM for a new fund, trying to find places to put money to work is hard -- from the long or short side.
But is it a bubble? That's a tougher question.
First, the iShares Nasdaq Biotechnology Index ETF
(NASDAQ:IBB) is a skewed example of the sector since just a handful of its member companies comprise 50% of its weighting. I prefer the SPDR S&P Biotech ETF
(NYSEARCA:XBI), which is much more equally weighted. That said, the charts won't look that much different even if we use the XBI to eliminate the IBB's weighting problem.
Second, the word "bubble" suggests "overvalued," and I'm not sure that fits for biotech. Tick off every worry that brought our "Armageddon" (Thanks, Jeff Saut
!) 3% decline and biotech is immune to every one. It has substantial pricing power in its major market, astoundingly favorable demographics, robust R&D to drive higher future revenues, and margins that dwarf every other legal business. While price controls will come in the US, by legislation or otherwise, that will not happen any time soon -- and will happen last in oncology and orphan segments which are largely driving the recent market cap increases.
Third, there are indeed signs of froth. Generalists and momentum traders (mo-mos) are flooding into the sector based on multi-year outperformance. Watch each quarter's 13G parade and you can see where generalists are piggybacking on what established funds did the prior quarter. My Twitter feed is awash with folks who obviously have far more cash to invest in biotech than they have biotech sense. This is absolutely bearish, but here's the deal: Mo-mos and generalists can drive valuations higher for a long, long time. If a $30 billion fund decides to broadly overweight consumer goods, nobody notices. If a $30 billion generalist fund decides to broadly overweight biotech, we're up 5-15%.
Fourth, almost nobody makes money persistently investing on a this-time-it's-different thesis. But this time it actually is
different in biotech. The combination of the Death of the Blockbuster Drug
and the Orphanization of Drug Development
are serving to make clinical trials in oncology and orphan diseases less likely to implode in late-stage trials. More importantly, we're seeing much more positive results in Phase II (mid-stage) trials with a higher likelihood of translating to Phase III (pivotal) success. We're not seeing these stats show up in the literature yet, but I'm seeing positive results from companies who are smart enough to take their targeted drugs into targeted populations. Trial implosions and FDA rejections are what poke holes in biotech valuations, and the rush toward targeted populations is reducing these failures.
Fifth, none of my buddies in the biotech space think the sector is under
valued. When they are buying, they are fully cognizant of the high valuations -- but they'll (we'll) keep buying until buying no longer works. I think we're all secretly hoping for a big pullback so we can buy all these great companies at discounts, but we all know what happened to funds who stayed on the sidelines after big 1H-2013 and 1H-2012 runs -- they missed half the move both years. Multiple-year underperformance means unemployment on the buyside. You have to remember this when trying to determine whether biotech valuations can go higher.
Sixth and last, there is a ton
of supply coming Q1-2014. Many, many companies are raising money. We have around two dozen IPOs filed. By mid-year, nearly every company that came public in 2013 will be off lockup. Of all my worries, this one is the biggest. Generalists flocking in always make the market go higher, but they love to invest in deals since most of biotech is relatively illiquid. When deals start soaking up all that capital, not enough money goes into moving the stocks higher. When the gains slow, mo-mos exit to other sectors. Specialists like us get twitchy to lock in profits. Then something with a lot of generalists blows up, because something always blows up in biotech, and they can't get out before they are down 50%. That makes them twitchy in their other names, too. Twitchy specialists plus twitchy generalists plus exiting mo-mos? Whoosh. Truth told, this happens whether biotech is bubbly or not -- but the whoosh is a much bigger deal when we're at these levels. So far, all the supply is being absorbed -- but we're only a month in to this new fundraising cycle.
I'm not sure I gave a real answer to whether biotech is a bubble. There are good reasons why it isn't and good reasons why it is. Ultimately, the bottom line is this: As long as investors are interested in "risk on," biotech will outperform. When risk becomes a four-letter word, the selling will start. There is nothing in current biotech valuations suggesting the sector can't go higher as long as people are interested in risk. Biotech valuations are high enough, however, that when the market decides it is time to take risk off, biotech won't be immune.
No positions in stocks mentioned.
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