Biotech stock boom risks becoming bubble

November 4, 2013 9:55 am

Biotech stock boom risks becoming bubble

By Arash Massoudi and Michael Mackenzie in New York

In this year’s record-breaking bull run for US stocks, one industry in particular has been a standout performer. Biotechnology is on course for its best year since the dotcom boom. With stock market bargains fast diminishing, investors are betting that a number of “dream stocks” will deliver breakthrough medical treatments. But the question now is whether that prospect of future medical advances justifies a further run in shares – or whether the sector has simply become overheated.The Nasdaq biotechnology index has jumped 50 per cent so far this year, more than double the gains of the benchmark S&P 500 index.

Not since 1999’s stellar gain of 102 per cent have biotechs performed so well. This has paved the way for 35 new companies to list publicly in what has been the most active year for new listings in the sector since 2000, according to Dealogic.

Vadim Zlotnikov, chief market strategist at AllianceBernstein, says biotech companies represent a future growth opportunity for investors.

“We are seeing a massive outperformance by what I call ‘dream stocks’ or companies at the centre of disruptive technologies and deploying huge amounts of research and development funds. This appeals to investors given the perception about a paucity of growth opportunities in the world,” he says.

Among the biggest winners in biotechs this year are Acadia Pharmaceutical, up 377 per cent, Celldex Therapeutics, up 250 per cent, Aegerion Pharma, up 228 per cent, Clovis Oncology, up 219 per cent and Isis Pharma, up 220 per cent.

But such an impressive rally has also raised fear valuations could now be stretched. The current price/earnings ratio for the Bloomberg biotech index comprising 118 companies stands at 174 times, with a price-to-book ratio of 6.75, compared with 2.59 for the S&P 500.

Such hefty valuations show how heavily investors are depending on companies delivering on big promises.

Mr Zlotnikov warns that the sector is becoming expensive and, while valuation metrics point to the possible downside, they tell investors nothing about when a downturn for biotech stocks could happen. “Valuations are extreme in some cases and taking some money off the table is how we would look to play the sector at the moment,” he says.

Steve Silver, biotech analyst at S&P Capital IQ, believes the sector can expand further as the growth outlook for drug companies has changed dramatically in recent years.

“The extent to which these companies have gone up this year would suggest that a lot of positive news flow is priced in, but their valuations have not been stretched because the growth prospects have changed significantly with new drug approvals and acquisitions,” he says.

The bull case rests on the belief that the US Food and Drug Administration will continue to approve more drugs and treatments. The regulator, which has taken steps to hasten its approval process, certified 39 drugs last year – its most in a decade – and has approved 20 more so far this year.

That bodes well for investors hoping that the potential medical achievements of companies in the sector will make them attractive prey to large suitors. One such example came this summer when Amgen, one of the largest global biotech groups, saidit would acquire cancer drugmaker Onyx Pharmaceuticals for $10.4bn.

But there has been a shift in recent weeks by investors in favour of larger biotechs, which suggests fund managers recognise some companies look vulnerable to a correction.

Rachel McMinn, biotech analyst at Bank of America Merrill Lynch, believes investors are “going to come back to fundamentals”, favouring large-cap companies which are more likely to deliver on their growth targets.

By focusing on biotech with greater scale, investors also reduce the risk of a sudden backlash that the smaller companies in the sector can experience as they go through clinical trials.

Andrew Bogan, a private fund manager at Bogan Associates, says: “There are a lot of reasons, including the rash of IPOs that have been priced on promise rather than profits, to be cautious of where the biotech sector is trading right now.”

One incident, in particular, shows just how quickly those hopes can turn into losses. Ariad Pharmaceuticals last month plunged two-thirds in a single day after the FDA put a hold on patient enrolments for its cancer drug trials after a number of patients experienced increased side-effects including blood clots.