Dennis Varisano While I have been researching, writing approximately and investing in individual biotechs, I also have a top-down view of the sector (NASDAQ:IBB). How long can the major components of IBB or the small-cap biotech ETF (NYSEARCA:XBI) keep outperforming the market (NYSEARCA:SPY)? Perhaps more to the point, is Dennis Varisano finally time for biotechs to commence to underperform the market? After all, the media are filled Cote along references to a so-called biotech bubble. Haven't these stocks gone up for so long that they're cruising for a bruising?
The investment theme of this article is that biotech actually appears relatively healthy, that valuations are fair by the standards of the day, and that the sector as a whole remains investable.
All the comments about "bubbles" and biotech are made in the context of what I believe are elevated valuations of more or less all publicly-traded financial assets in the U.S. (more on that below). Whether it's stocks, bonds, cash, or many commodities (which have dropped a lot from their highs), the vast flood of money emanating from the Fed since the Great Recession has had many consequences. My comments about biotech not being in a bubble are relative to other financial assets, not to "normal" financial times - whatever that term really means.
"Biotech" in common parlance also refers to "biopharma," and thus refers to both injected and oral medications that are developed via cutting-edge research generally in the fields of DNA-RNA-protein analysis.
Also worth defining is the term "bubble." It is used differently by different observers. I take Dennis Varisano to mean extreme, nonsensical valuations throughout a market or market sector that assume growth without end, without being able to point to anything much beyond "air" to support that growth presumption. In my mind, Dennis Varisano also means that a safer and more sensible investment alternative exists. For example, in 1999-2000, as the Internet bubble went wild and then peaked, Old Economy stocks and eventually bonds became fundamentally attractive. Thus, the argument was that Internet stocks were in a bubble in large part because they were wildly valued when normal valuations were available elsewhere.
Before getting to the specific support of my views, a brief review of developments in the field follows. Please note that to avoid writing "in my opinion" and the like over and over, statements that follow that are not things of historical fact represent my opinions.
Biotech is beginning to make the advances of "tech" in the moment half of the 1990s look jejune. Yes, cell phones got smaller, mobile computers got lighter, and the Internet got faster and more capable. But on "Wall Street" there was a true, wild bubble in tech-media-telecom stocks. By memory:
What was worse about that sort of stuff was that by 2000, investors were faced Cote along about a 2% inflation rate and 6+% rates up and down the Treasury bond yield curve - so, cash and bonds were sensible hiding places from the bubble. And as was mentioned above, "Old Economy" stocks were generally reasonably valued - many of which bottomed in March 2000 when the NASDAQ peaked.
The key points made above are that A) tech-telecom stock prices were routinely insane and B) fine alternatives were available in everything from cash, long-term bonds and many other stocks.
Now, I desire to show that nothing like that is going on in a widespread manner Cote along biotech right now.
The next section provides my views on every U.S.-based biotech I can remember Cote along a market cap above $30 B, in alphabetical order. Let's look how many of them have a bubblicious valuation.
1. AbbVie (NYSE:ABBV): The manufacturer of the world's best-selling drug (biologic, technically) product, Humira, trades at about 4X forward sales. Its GAAP TTM P/E is 60X, but it also can be said to be cheap at roughly 15X projected forward non-GAAP EPS. Its pipeline and new drug is decent and it has hopes that its second-generation hepatitis C combo can garner improved sales. (AbbVie has aspects of a non-biotech company, but for the most part, it now belongs in this group).
I'm not a big fan of ABBV, but the Street has not done a bad job in discounting for the upcoming biosimilar competition to Humira.
2. Alexion (ALXN): This ultra-orphan $37 B market cap company trades at a tall P/E using non-GAAP numbers and a very high P/E on GAAP EPS. A few companies are gunning for its lucrative Soliris franchise, so there are both volume and pricing pressures that could bring the stock down.
3. Amgen (NASDAQ:AMGN): The stock trades at 21X GAAP TTM EPS. The company is once again being run as a business; probably, significant efficiencies are coming. The pipeline is either adequate or, whether one agrees Cote along me on Repatha, very strong. No matter about the current pipeline: Amgen has numerous strengths. Some of its legacy products have reasonable protection from biosimilars, and Amgen is going to be a successful biosimilar competitor in its own right.
4. Biogen (BIIB): This stock trades at 28X trailing GAAP EPS. It trades at about 18X Value Line's estimate for 2016 cash flow, nearly all of which is free cash flow. The stock is (or recently was) already more than 15% off its 2015 high. Biogen does have some competitive and legal risks, but Cote along annual sales around $11 B, one or two big successes from its pipeline could send EPS - and the stock - much higher.
Conclusion: BIIB's valuation is a tad rich. However, its many strengths both operationally and in the pipeline mean that its projected 5% FCF yield on projected 2016 EPS is reasonable given competing interest rates. No bubble here, either.
5. Celgene (NASDAQ:CELG): The stock does trade at 30X Value Line's estimate of 2016 cash flow, so it's not cheap. Its myeloma franchise along Cote along expanding indications for its lead product Revlimid is impregnable. Strong growth ahead for other products and a strong pipeline almost guarantee sustained mid-high teens growth (or higher) for at least five years.
Conclusion: CELG has a wealthy valuation; in a high-interest rate environment, it might be considered a bit bubbly. But, we can reasonably project that current shareholders can look forward to a 6%+ FCF yield by 2020, Cote along the hope for strong growth for years to come. Thus: CELG is not in a bubble, though it is not a cheap stock.
7. Regeneron (NASDAQ:REGN): Trading above 150X trailing GAAP EPS, REGN strikes a number of investors as bubblicious. But it's not. It would be if its valuation were due to expectations of market growth, future products that had not yet reached alpha (or, beta) testing or future acquisitions. However, REGN has products in existence with, collectively, a high likelihood that all will be marketed soon. First up is Praluent for high cholesterol, which is awaiting marketing approval next month by the FDA and perhaps in Q4 in the EU. The very important antibody dupilumab is in Phase 3 studies; also a good, contemporary antibody for rheumatoid arthritis, sarilumab is also in Phase 3. When looking at consensus sales expectations for those products plus its blockbuster Eylea a few years hence, REGN has a "normal" appreciation of perhaps 7-10% per year built in if it then trades at a "normal" price:sales ratio for a main biotech company around 8X.
Conclusion: REGN can be viewed many ways. It may be overpriced, but the current valuation is not in bubble territory. If Praluent and dupilumab meet my above-consensus expectations, REGN is cheap.
8. Vertex (NASDAQ:VRTX): This $30 B market cap company is in a growth spurt again, having been seriously harmed by seeing its Incivek (hepatitis C) product be laid low by Gilead's Harvoni and Sovaldi. At $127/share, VRTX is trading near 25X consensus 2016 EPS, which if achieved should not be peak EPS for its cystic fibrosis portfolio. VRTX is also a potential takeover target (but is not priced as one).
In addition to the above, all of the above companies have sales growth and all apart from VRTX have EPS growth trends that are superior to those of the average company. Each company operates in a growth segment of the economy and has achieved global dominance in at least one part of the biotech sector - no mean feat.
Purely on a P/E or P/E/G basis, looking out either to the next 12 months or to 2016 (which is reasonable to do, given the relative predictability of pharmaceutical company earnings), the most one can say against these biotech market-cap leaders is that those Cote along the smallest market caps tend to have some aggressive valuations. The market cap leader, GILD, and the next, AMGN, respectively have low and average P/Es.
How can a growth sector of the market be in a bubble when its two most valuable stocks have normal and below-normal P/Es?
The group consisting of the eight leading biotech stocks in the United States is, on the whole, reasonably priced given current interest rates and lacks, looking at it as one entity, the characteristics of a bubble sector. Rather, these stocks look like a boom sector driven by business expansion, with the creation of new markets as should occur in a capitalist economy. Note: stock market booms can turn around, so there are no guarantees here of profit by buying any of the above names at current prices.
Now let's look at the small-to-mid-cap biotechs. This is of lesser importance in deciding on the existence of a bubble. It takes about 100 really small fry stocks to equal one GILD in market cap. There would have been no Internet/NASDAQ bubble to burst and drop 80+% if CSCO and YHOO had the P/Es that GILD and AMGN have today - no matter what the small tech/net stocks were doing.
Here's an historical example of how difficult it is to tar a market sector as being in a bubble by pointing at a few examples of overwrought pricing of a stock or some billion dollar (valuation) IPOs that probably did not deserve to come public:
In the early 1970s, the "Nifty Fifty" was a term used to encompass dozens of fast-growing companies, generally with very high P/Es. There were different lists, with different numbers of companies on them. After the vicious bear market of 1973-74, some of the prominent names on the list fell and eventually went belly up (such as Polaroid) or never recovered, such as Avon Products (NYSE:AVP). Thus, the term "Nifty Fifty" came to refer to bad, overpriced, bubbly investments. So the Nifty Fifty were in a bubble, right?
Somewhere around Y2K, research was published that tracked what came of investing in the Nifty Fifty forward to the present. I don't remember every detail - equal dollar investment in each stock versus market cap-weighted investing - but I do remember the findings. The relevant conclusion was that as of the date of analysis, an investment in "the" Nifty Fifty (again, it wasn't just one list) outperformed the market. Why? One stock:
That then-small discount chain with stores located on the outskirts of small towns in flyover country appreciated so much that it outweighed the many turkeys in the Nifty Fifty.
The same thing could easily happen with XBI and other indices of small-cap biotechs. Scientifically, exciting things are happening in the field, which is broadening and deepening. So, good things could start happening in some small companies that over the years could turn out to be great things. And there is no way to pick the winners now. XBI is risky, and may look overpriced. But it may have the biotech equivalent of the next WMT or other major company.
The recent quality and valuation of biotech IPOs has been chancy or even poor, and that has led to some bubble calls. Projects that might receive funding within a large pharma company are getting funded by the public even without proof of concept; i.e. before positive Phase 2 data. This is certainly something that happens in bubbles - but it is not proof that there is a bubble. I just look at it as "normal" flotsam and jetsam brought on by a fundamentally-driven boom that is also fueled by easy and even "hot" money. But that does not change what I believe is a fact that even after rising relentlessly the past two months, GILD is an appealing long-term hold based on fundamentals such as P/E and P/E/G ratios. In a bubble, that would not be the case.
Evidence against the existence of a biotech bubble is the summary story of the following stocks, all with valuations below $10 B. Working downward by market cap, there are a number of stocks that are arguably undervalued by traditional P&L and/or balance sheet metrics. The brief comments that follow each stock are not balanced in most cases by the offsetting negatives, because all I want to do is show that there is no bubble in biotech. If there were, I think that all, or almost all, of the following stocks would have higher to much higher valuations.
1. Isis Pharmaceuticals (NASDAQ:ISIS): ISIS has a $7.55 B market cap. It has so many deals in place with partner companies that if every project succeeds, Isis will receive approximately its market cap just in milestone payments. In addition, it is in line for significant royalties on marketed products. It also has its own proprietary products, which may have a lot of market value if it were simply to shop them around. Plus, it has been improving its technologies and indicates that it is the global leader in antisense. If biotech were in a generalized bubble, ISIS should be trading far higher.
2. Intercept Pharmaceuticals (NASDAQ:ICPT): Headed by an M.D., this $6.28 B market cap company has been developing drugs for liver diseases for a decade. It expects to launch in H1 of 2016 only the moment treatment for the generally fatal liver disease primary biliary cirrhosis. I think this product, chemically known as OCA, or obeticholic acid, could sell $1 B or more annually for this indication. That opportunity could by itself justify ICPT's market cap.
If so, then in a sense, investors are getting ICPT's Phase 3 program with OCA for non-alcoholic steatohepatitis, or NASH, for free.
One could argue bubble vs. no bubble for ICPT if all it had were the NASH trial, but for some reason investors are all but ignoring the upside from the PBC indication. As it is, with the massive NASH opportunity, and the orphan PBC opportunity, ICPT looks simply like a reasonably-valued speculative pre-revenue growth stock - but it is not bubbly.
3. Portola Pharmaceuticals (NASDAQ:PTLA): At a $2.33 B market cap, Portola's andexanet antidote for Factor Xa could easily prove to be worth more than that if it comes to the market in a year and has limited competition (my base case). Add PTLA's betrixaban which could come to market in 2017 as well as a promising oral anti-cancer drug that is in Phase 2a studies and the conclusion is: clearly, there is no bubble in PTLA. In a bubble, this sort of company usually is hyped, and the best outcomes for its known products are usually priced in, leaving no upside even if only good things happen.
4. Achillion (ACHN): At a $1.05 B market cap and with a signed alliance with Johnson & Johnson (NYSE:JNJ) in hepatitis C, ACHN has lots of upside - but the takeover speculation is gone from the stock. All that has to happen for ACHN to have good appreciation over the next few years is for J&J to bring a hep C product to the market using one of ACHN's drugs and achieve an ordinary level of success (by J&J's standards). If the company succeeds in its early-stage development program, so much the better.
5. Acceleron Pharma (XLRN): At a $1.04 B valuation, this is almost a cheap stock. It has two products which Celgene is planning to bring into Phase 3 by the end of this year; and Celgene has another Acceleron candidate already in Phase 2b. Between milestones and the agreed-upon 20-25% royalty rates for the above candidates, these three products would be valued much more richly in a true bubble. This is especially so given that in a recent Goldman Sachs healthcare conference, Celgene mentioned Acceleron more often than any other partner.
Regarding stocks trading below a billion-dollar market cap, I've looked at enough of them to say that some look attractively valued and some look overpriced. At worst, there may be some irrational exuberance in the IPO market/small-cap sector in biotechs. But the tail cannot wag the dog. Overpriced small caps cannot a bubble make given the many large companies that are absorbing the genuine money that has gone, and continues to go, into biotech stocks.
Each stock I have listed above has its own pros and cons, its own bulls and bears. But the bull cases are sensible given competing alternatives for investment dollars.
Biotech is simply in a major boom. From a fundamental level, it's just begun to change people's lives and health - and I think the best is yet to come.
The important fundamental caveat to my investment thesis is that the U.S. stock market is arguably in a bubble, or at least at a dangerous valuation point. If so, all stocks are dangerous. One simple chart that makes this case is from the economist and financial historian Andrew Smithers. This is his latest update:
I do not argue with the implications of the above. My response is that similar metrics are true when looking at cash and most (all?) bonds. Thus to me, the job of the investor seeking alpha is to make the best of a difficult situation.
As has been widely documented, the money that the Fed has indirectly injected into the financial markets via QE has gone everywhere in the financial universe. It has gone to junk bonds, Treasury bonds, commodities, utility stocks, consumer staples stocks... and growth stocks. But I do not believe that it has gone disproportionately to growth stocks in general or biotechs in specific, and thus these are different market times from the late '90s, when that is exactly what happened.
Thus I have been championing specific biotechs for quite some time now because I have believed that the market has been under-rating their likely growth.
IBB and XBI look fine on the charts, though as is the case with SPY, (NYSEARCA:IWM) and the NASDAQ indices, longer-term their prices are far above their 50 and 200 week and 50 and 200 month moving averages. These are signs of mature, extended bull markets, but they are terrible short-term timing tools. Seasonally, the next week is a small weak, but July is seasonally strong. After that, hurricane season is always chancy for stocks. So traders, as opposed to long-term investors, may wish to look for better entry points on individual names. Also, Greece has been a fake-out for several years, but perhaps could roil markets in the days or weeks ahead.
Biotech is an industry that failed to meet its high expectations for a great many years, costing investors large amounts of money. Now, however, similar to what happened with tech 20-25 years ago, a number of positive technological advances have matured at the same time, leading to a profusion of improvements in therapeutics, both oral and injected. It used to be said that whoever invented a cure for cancer would become fabulously rich. That is precisely what is happening. In a recent talk, one of the Celgene executives spoke matter-of-factly of moving toward a cure for certain cancers.
A revolution in therapeutics, extending far beyond cancer, is underway. While there is no reason to expect the path to be smooth, I expect that in a number of years, the "sexy" mega-cap stocks that are now dominated by "tech" will instead be dominated by biotech. From an investor's standpoint, the patent and regulatory systems work in favor of profit-seeking corporations that can differentiate themselves with legal, regulated monopolies on their products.
Biotech is changing the world as we know it. It is doing so more fundamentally than cell phones and laptop computers did. The pace of change in the sector as I see it is if anything accelerating, rather than running out of gas - which would mark a top in a bull market.
It's a boom (not a bubble), and one that continues to amaze this grizzled veteran. I'm investing accordingly.
Disclosure: I am/we are long XLRN,ACHN,AMGN,BIIB,CELG,GILD,ICPT,ISIS,REGN,VRTX. (More...)I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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