The case for biotech
I am the poster child for biotechnology
Biotech stocks have traditionally been linked to the performance of what I call "hard" technology stocks like software, chips, telecom equipment, etc. The various biotech indices generally, therefore, orbit the path of the NASDAQ. A notable exception to this, though it is not completely obvious on the charts, was the performance of biotech stocks in 2000.
When MicroStrategy's (MSTR:NASD) accounting fraud broke the back of the bull market, tech fund managers were desperate to place their money somewhere. Hard tech was obviously getting killed, so they ran to the only other place that arguably met the investment thesis of their fund: biotech. Unfortunately, biotech was experiencing a bubble of its own as rookie biotech investors mistakenly believed genomics companies (biotech's version of the "picks and shovels" trade) had similar timelines as telecom equipment companies. This rotation to biotech ended badly and these tech managers got their hats handed to them.
The late-2000 attempt at delinking biotech from the rest of tech had a notable side effect. So many people were burned in that trade that biotech has been verboten for them ever since. The biotech space became the province of a relatively small group of funds - many of which have serious financial firepower behind them.
Differences are good
Biotech - specifically development-stage biotech - has little in common with technology companies. Therefore, there are few reasons beyond convention for biotech and technology to trade in tandem.
Below is a listing of obvious differences between hard technology and biotechnology. The list is not designed to be exhaustive. It's designed to get you thinking about what I see as a serious logical flaw in the linkage of biotech and hard tech indices.
Technology companies have serious innovation risk. A leading software package or chipset can be made obsolete nearly overnight with little or no warning to investors. Patents are useful in this space, but the pace of technology advancement is so fast that patents are made obsolete nearly as fast as they are granted.
Overnight obsolescence is nearly impossible in biotechnology. The 10-year development path from first human trial to FDA approval gives investors plenty of warning about competing products. This development path is populated with dozens of looks at competitive data in a manner only corporate espionage could duplicate in the hard tech sectors.
The Hatch-Waxman Act provides market exclusivity beyond traditional patent protection for marketed drugs. Rules embedded in certain FDA approval pathways (orphan drug and accelerated approvals) require drugs to be competitively superior before approval. No such protections exist for hard technology.
Technology company valuations - at least in 2004 - are hostage to the economic cycle. Lack of consumer spending eventually results in decreased business spending. Both events decrease the needs for chips and software.
Development-stage biotechnology is immune from cyclicality in the economy. In fact, these companies are counter-cyclical because the technology they consume is generally cheaper to acquire in tough economic times. Ditto for employees. This is significant since R&D and human resources are among the largest expenses at these companies.
For those biotech companies that do have revenue, healthcare has long been considered counter-cyclical. In good economic times or bad, people still get sick. The business of treating these individuals steadily increases independently of economic considerations.
This was a big topic of conversation in 2000-2002. The topic has resurfaced recently on the Minyanville site. PE ratios used to calculate the fair value of a stock depend upon a "multiple" to complete the calculation. This multiple is affected by psychology. In a positive psychology market, a company may be ascribed a multiple of 30. In a negative psychology market, the exact same company (with exactly the same P&L) may be tagged with a 15 multiple. There is no difference in the company, the only difference is the multiple has been compressed because of psychology.
Development-stage biotech companies are immune from this. They have no earnings so the calculation of PE ratios is a moot point. Granted, some people go through an exercise of creating discounted cash flow models involving multiples to get to a stock price. In my experience, these are exercises in rationalization of a predetermined target price. Even if you disagree with me on this point, a review of analyst research over the past few years shows discount rates have remained fairly constant at 25% and multiples have remained fairly constant around 30.
This one might be a draw. Development-stage biotech companies are sponges for money with most needing to raise between $300-$500 million to get a single product out the door. In a low liquidity environment, it would theoretically be tough for these companies to raise the money necessary for them to continue operations.
I'm not sure I believe that liquidity affects biotech companies the way it does hard tech, however. I think a side effect of lower liquidity - dampened psychology due to declining market values - is the more likely culprit.
Rising interest rates are tragic for technology companies. Not only do rising rates make it more expensive to carry their own debt, rising rates increase the all-in prices of their products. Rising rates shift the balance between using electronics and using humans, as Professor Succo has pointed out on more than one occasion, away from electronics. Decreased use of electronics, of course, decreases tech revenues.
Biotech companies love it when rates increase. None of these companies has appreciable debt. What debt they do have is usually in the form of convertible notes with generally low fixed interest rates and whose interest can be paid in shares. Furthermore, these companies depend on investment income to extend their cash. Higher rates mean increased income from these investments.
One impact of higher rates is the return on equities begins to pale in comparison to the return on interest-bearing investments. I can't fathom a time when interest rates are high enough to challenge the returns achievable from biotech investing.
This is a clear draw. Technology company valuations depend on upbeat investor psychology. Biotech also depends on psychology. With few tangible metrics with which to value them, hope is the largest component of biotech valuations.
I can argue the depression in biotech values that comes with sharp declines in psychology is really a symptom of the improper linkage between hard tech and biotech. I can also argue dampening psychology is a result of some of the issues dealt with above. However, it would be naïve to suggest biotechnology valuations will ever be free of psychology.
The conventional wisdom here is this is biotech's soft spot. The ability for a single news release to vaporize 50% or more of your investment before you have a chance to fill an order is sobering for long and short investors.
I will point out the same risk exists for hard tech investors. MicroStrategy lost 65% of its value overnight. Enron, WorldCom, etc. are all examples of significant overnight risk.
To be clear, there is a key difference. Overnight risk exists for every development-stage biotech company as a regular part of investing in this sector. In hard tech, it is a potential risk likely to affect a few companies.
Advantage to hard tech here.
That serves as a good segue into issues unique to biotechs - the rest of the story, as Paul Harvey would say.
Drug companies depend on insurance reimbursement for their revenues. The drugs are sold at a profit margin that is unsustainable without some sort of insurance program in place. Governmental and insurance company reforms will always be a big part of that equation.
Development-stage biotech companies are theoretically immune from this because they have no products and are unlikely to have products for some time. Nevertheless, they will trade in response to changes in reimbursement policy.
Biotech is also hampered by a lack of good research. Take the spectrum of hard tech research and place it on a bell curve of quality. Do the same for biotech and a comparison of the two curves will show the biotech curve is leaning to the left. There is a higher percentage of garbage research in biotech. This makes it very difficult for investors to weed out the disasters from the successes, something particularly crucial when every stock is subject to overnight risk.
I could go on here, but I think you get the point I'm trying to make. There are few good reasons for biotechnology to trade in concert with hard tech. This difference is widening each day as the technology sector becomes more mature.
I chose this week to present this concept for two specific reasons:
First, I wanted to meet (in person at MIM1 and via e-mail) more of my fellow Minyans. The people I normally write for, my Biotech Monthly Subscribers, are people who are already very familiar with biotech investing. Before I rattled off 1500+ words on the subject, I wanted to make certain it would not be same-old, same-old for you.
Second, and far more important, is I think the concept of delinking biotech and hard tech is dawning on Wall Street. In a Buzz item a couple weeks back, Todd drew a comparison to 2000 that made my ears pick up. I've read a couple of things in the last few weeks where people have been dancing around issues on the same track as what I have written above. There is a chance this trickle of sentiment change turns into a flood, and I want my fellow Minyans to be ahead of the flock if the delinking occurs.
I can't stress enough this is not a call for blind investment in biotech. It's damn risky and in different ways than most investors are used to. It's hard to find good, company-specific research to help guide you, which means you'll likely need to develop in-house expertise on the matter at some point.
That being said, there are significant rewards if you can pick the right companies to be in your diversified portfolio. There are sound reasons why the sector should be divergent from many of the troubles you have read about in these pages. If this divergence occurs, it is an excellent reason to give the sector a closer look.
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