Biotech Gets a Reality Check
Biotech stocks are up big for the fifth year in a row, IPOs are hot and short sellers are in retreat. Investors, beware.
If the biotech sector is in a bubble, it has yet to pop. After a brief selloff in April, the Nasdaq Biotechnology Index has regained its mojo; it is up nearly 20% so far this year. If it keeps this up, it is on its way to beating the broader stock market for a fifth consecutive year.
Meanwhile, demand for new issues is as strong as ever: Shares in Axovant Sciences soared 99% on Thursday after the company raised $315 million in its initial public offering, the largest one on record for a biotech company. Axovant bought its drug candidate to treat Alzheimer’s disease from GlaxoSmithKline in December for just $5 million up front. Axovant is now valued at more than $2 billion.
Biotech’s great lure is its potential for breakthroughs. There have been encouraging signs on this front. Scientific innovation in recent years has led to a cure for hepatitis C along with meaningful advances in fighting cancer, diabetes and a host of rare diseases. Meanwhile, the Food and Drug Administration has created new regulatory pathways to bring drugs to market, creating a friendly environment for clinical-stage firms. The FDA approved 41 new drugs for commercial use last year, the highest on record. Another 12 have received the green light so far this year.
But biotech’s great lure is also the root of its great danger for investors. Of the index’s 146 constituents, 94 have trailing 12-month revenue of less than $100 million, according to FactSet. In aggregate, their revenue is $2.2 billion—equal to just 1.5% of their combined market capitalization of $146 billion. Gilead Sciences, the most valuable biotech company in the world, boasts a market cap of $175 billion, against $24.9 billion in sales—a relatively tame revenue multiple, at least for this sector, of seven times.
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On their own, nosebleed valuations don’t mean a crash is imminent—as any investor who tried to bet against technology stocks in the 1990s would tell you. And today’s biotech short sellers have retreated. It now takes 6.7 days of average trading volume to cover a short position within an exchange-traded fund replicating the index, well below the five-year average of nine days.
But too much capital is chasing relatively few high-quality assets. Besides the manic multiples, another sign of this is that asset manager T. Rowe Price closed its Health Sciences Fund to new investors on June 1, in order to “maintain the integrity” of the fund’s investment strategy. The fund makes up the vast majority of T. Rowe Price’s health sciences strategy, which had $14.8 billion of total assets at the end of April and saw inflows of $1.1 billion in the first four months of the year. “If flows were to continue at the current pace,” portfolio manager Taymor Tamaddon said in a news release, “it could eventually strain our ability to invest efficiently and result in a less effective investment strategy.”
In plain English, that was a person whose livelihood rests on persuading people to give him money to invest telling biotech investors to just cool it already.