Biotech: Bubble or No Bubble?

Investors’ enthusiasm for biotech has pushed valuations and stock prices to all-time highs. Some are calling “bubble” – but is it?

In the current low interest rate environment, some of the most attractive returns are seen in U.S. health care equities. Investors’ enthusiasm for biotechnology in particular has pushed valuation and stock prices at all time highs. Pessimists argue that these are signs of an imminent bubble. An expected monetary policy change and soaring biotech stock prices reminiscent of the early 2000s fuel their fear. Optimists, however, argue that this time is different. They contend high valuations and stock prices are justified by the companies’ healthy financials and a burst of development and innovation in the sector. 

The biotech sector has been in a three-year boom period, and the strong performance does not show signs of slowing down. The Nasdaq Biotech Index is up around 240% since 2012. During the first quarter of 2015, the sector climbed 12% as measured by iShares Nasdaq Biotechnology ETF (NYSE: IBB), while the S&P 500 returned only around 1%. No wonder many expressed concerns of an upcoming biotech bubble. Their fear is explained by an expected increase in interest rates before the end of the year. But there are strong reasons to believe the biotech boom may continue.

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First, the surge in biotech stock prices is backed by the companies healthy financials and earning potential. This earnings season, the overall health care sector is expected to report the highest earnings growth rate of over 10%. That will be led by biotechnology, with a 35% projected growth. Actavis (NYSE: ACT), a favorite of the billionaires, is predicted to be one of the largest contributors.

Strong earnings may continue as companies make advances in the development of treatments for cancer, hepatitis C and genetic disorder. The burst in innovation and new drugs is helped by a less conservative FDA and cheaper technologies. Companies can now develop new products cheaper than in the recent past and commercialize them faster. Last year, the FDA approved 41 drugs, the most in over a decade. In fact, the FDA and European Medicines Agency approval rate is up 10-20% from historical norms.

Once a new drug is approved and resealed commercially, the revenues of the drug maker spike. A new drug brings in around $1 billion in earnings. Last week, the FDA approved Amgen’s heart failure medication Corlanor. Almost six million people in the U.S. suffer from this condition. Amgen is expected to sell the drug for around $4,500 per year. According to BTIG analyst Hartaj Singh and reported by Business Insider, current biotech valuations are a refection of the companies increased sales and earning potential.

If we compare the price-to-earnings rations (P/E) of biotech stocks today with P/E rations of technology stock before the tech bubble, we clearly see that 2015 is different than the early 2000s. First, in 2000, the Nasdaq – where many technology and biotech stocks are represented – was trading at P/E as high as 175. Today, the Nasdaq P/E ratio is around 32. Secondly, biotech companies such as Amgen (NYSE: AMGN) have P/E rations in the 20s. In the early 2000s, many of the technology companies were trading at P/E rations well above 100.

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The higher valuations and the enthusiasm around the sector are also a result of more M&A activity. Year to date, the overall health care sector has announced over $100 billion in M&As. The biggest deal was the merger between AbbVie (NYSE: ABBV) and Pharmacyclics. Abbvie acquired Pharmacyclics for $21 billion to gain access to Pharmacyclics’ Imbruvica blood cancer treatment – one of the top-selling cancer drugs worldwide. The Imbruvica sales are expected to reach $1 billion this year in the U.S. alone, and $5.8 billion worldwide by 2020. Additionally, the aging U.S. population and the increasing prices for cancer treatment will also benefit drug manufacturers going forward. While higher drug prices are controversial, more cash on hand will allow companies to invest in R&D and acquisitions.

Historically, after a period of boom and monetary policy moves, a correction in stock prices is expected. So, it is normal for investors to be concerned with the state of biotech equities. However, the health care sector shows more promise than ever before. The companies’ healthy earnings, more drug approvals, and innovations make a strong case against a biotech bubble. Before the Fed increases interest rates there may still be upside for biotech investors. But predicting monetary policy moves may be just as hard as predicting a bubble burst.

Actavis and Amgen are part of the iBillionaire Index, and the health care sector represents 16% of the index.

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