As
everyone knows from disinfectant commercials, germs lurking on the
kitchen counter can give you infections so virulent that you'll be sent
home from the hospital in a soup tureen. Fortunately, there are also
cures for those diseases, although the side effects may include
drowsiness, catatonia, dyspepsia, Cotard's Syndrome and uncontrollable
shrieking.
Our constant fear of diseases – stoked by ads for drugs
to combat illness – may be one reason behind the boom in biotechnology
stocks. More likely, however, is our fondness for a good story and a
red-hot stock. Biotech has been so hot the past two years that the
sector is starting to raise red flags. And, while it may have longer to
run, it's an area that the weak of heart and the short of cash should
avoid.
Despite a recent backup – more on that in a moment –
biotech funds are standouts in an otherwise mediocre quarter for mutual
fund investors. The average health and biotech fund has gained 5.4% this
year vs. 0.2% for the average stock fund. The difference is more
striking if you look at the funds' three-year records: They're up 100%
vs. 46% for the average stock fund.
Those big gains have raised
the question of whether biotech is in a bubble, which is in itself a
loaded question. By definition, bubbles are extraordinarily difficult to
detect before they pop. And high returns are not, by themselves, the
only hallmark of a bubble. CBS is up 1,902% since the stock market
bottom in 2009, but no one is claiming that media stocks are in a
bubble.
What makes bubbles so hard to spot? For one thing, there's
always a plausible story behind them. In the 1830s, canal stocks boomed
because it is indeed much easier to push something over water than over
rutted dirt roads. And in the 1990s, people invested in the dot-com
bubble because they believed that the Internet would be an enormous
gateway for commerce – which, in fact, it has evolved to be.
With
biotechnology, the plausible story is that medicine is making some
spectacular breakthroughs, and doing so after a fairly long dry spell.
The most notable is Gilead Sciences' hepatitis C drug Sovaldi, which
actually cures the disease rather than controls it. The disease makes
life a misery for 150 million to 200 million people around the world and
ultimately kills many of them.
"Biotechnology is a real, great
American story," says Rajiv Kaul, portfolio manager of Fidelity's Select
Biotechnology Portfolio (FBIOX). "It's very difficult to make medicine.
It takes hard work and the failure rates are high. But it's a really
exciting time."
Furthermore, the industry's rise has come after a
fairly long dry spell, when relatively few blockbuster drugs hit the
market, says Evan McCulloch, portfolio manager of Franklin Biotechnology
Discovery Fund. "Big pharma and biotech together had a significant
period of underperformance," McCulloch says. During that period, biotech
became extremely cheap relative to earnings.
Another problem in
the middle part of the last decade: The Food and Drug Administration
became more conservative after the failure of Vioxx, an
anti-inflammatory drug sold by Merck, was shown to increase the risk of
stroke and heart failure in patients. Currently, however, the FDA has
been more accommodative toward getting new drugs on the market, says
Kaul. "The FDA is doing the right things, and government has done good
things in terms of working with industry to get innovative therapies to
be priorities," he says.
The question then is whether investors
are getting too giddy about the prospects for biotech stocks. Gilead
(GILD), for example, sells for about 12.4 times its estimated 12 months'
earnings, which is fairly reasonable. On the other end of the spectrum
is Intercept Pharmaceuticals (ICPT), up 748% the past 12 months with no
earnings.
But the market for small-company biotech stocks has
always been giddy. One way to look at frothiness is the number of
initial public offerings in the biotech industry – 25 in the industry
this year alone vs. 45 last year. In a biotech bubble, you start seeing
IPOs of companies composed of two guys, a microscope, and a dream. "It's
not that bad yet," McCulloch says. "Companies raise money when they
can, not necessarily when they need it." And right now is an excellent
time for most companies to raise IPO money.
Nevertheless, biotech
is a sector that has had a good run, which means that investors are
likely to become skittish quickly. In the past few weeks, biotech stocks
have sold off, in part because of Rep. Henry Waxman's recent letter to
Gilead questioning the company's $84,000 price tag for Sovaldi. "It was a
shot across the bow," says McCulloch. "And what it means is that there
could be some revision to drug pricing in the long term."
Any laws
restricting drug pricing are highly unlikely in the Republican-held
House, however, and Gilead's champions note that the drug's price tag is
far less than for a liver transplant or for the years of care needed by
hepatitis C sufferers. But the letter may make companies wary of their
pricing – not necessarily a bad thing. "Companies want their prices as
high as they can make them without landing on front page of newspaper,"
McCulloch says.
Right now, it's hard to recommend biotech
investing for anyone but those who don't mind risk. While the best years
of biotech may be before us – and they probably are – you don't want to
pay too much for the future. For the brave, the top-performing health
and biotech companies are in the chart. Otherwise, consider a general
diversified fund. Health care is about 13% of the Standard and Poor's
500 stock index. You don't want your portfolio to come down with
unwanted side effects, such as itching, sneezing or hives.
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