Current Estimate 3.46 5.56 16.69 21.34
7 Days Ago 3.46 5.57 16.70 21.35
30 Days Ago 0.56 0.90 2.67 3.41
60 Days Ago 0.59 0.96 2.79 3.72
90 Days Ago 0.59 0.97 2.80 3.72
Biotech: The Forgotten Bubble
With valuations at nose-bleed levels and IPOs proliferating, the sector could be headed for a fall. Keep your eye on the group’s momentum.
Updated July 18, 2015 1:10 a.m. ET
It often feels as if there are more bubbles in financial markets than in a room full of tykes with bubble wands.
There are the popped bubbles, the soon-to-be-bubbles, and even a “bubble that’s not going to burst,” as one wag recently described the art market. Then there’s the forgotten bubble.
That would be the bubble in biotech stocks. Almost exactly a year ago, Fed chief Janet Yellen observed that the sector’s valuations “appeared substantially stretched.” Her aside spurred biotech analysts to defend the stocks; bears predicted an imminent decline, and everyone else wondered whether Yellen really meant the “B” word.
And then the panic faded, although the biotech rally didn’t. The iShares Nasdaq Biotechnology exchange-traded fund (ticker: IBB) has gained 57% since July 15, 2014. The conditions that prompted concerns about biotech have only gotten more extreme. This time, there really might be a bubble.
Start with valuation. The iShares ETF now trades at 58 times forward earnings, versus 43 times a year ago, which wasn’t exactly cheap. The Standard & Poor’s 500 stock index trades at 16.7 times. In other words, biotech constitutes no more than 3% of the S&P, and yet accounted for 15% of the rise in the benchmark’s stock market value in the past year. “The impact biotech has had has been enormous,” says Mike O’Rourke, chief market strategist at JonesTrading.
Bulls contend that biotechs’ lofty prices have been earned, thanks to their cutting-edge research, the Food and Drug Administration’s willingness to approve new drugs, and the resulting rapid earnings growth. Acquisitions have been occurring on a regular basis: Just last week, Celgene (CELG) announced that it would purchase Receptos (RCPT) for $7.2 billion. That adds to the premium, as well.
Yet there comes a time when just rewards tip over into excess, and biotech might be approaching that moment. For evidence, look no further than this year’s 109 initial public offerings. Nearly 30% have been by biotech outfits, easily topping 12% in 2000. At the same time, more companies have been going public at an earlier stage of development. Aeglea BioTherapeutics, for instance, is seeking to raise $86 million, even though its primary drug hasn’t started early-stage trials. “There has been an explosion of low-quality IPOs,” says Ralph Coutant, a portfolio manager at Matarin Capital. “It feels quite bubbly.”
The problem with financial bubbles is that, unlike the soap bubbles produced by my 4-year-old son, it is almost impossible to predict when they will pop. There is little sign yet that biotech stocks are headed for a fall, and those who heeded Yellen’s warning have given up big gains. But Coutant is becoming cautious. He’s avoiding the most speculative stocks, and is instead focusing on companies that have actual products in the market and look relatively inexpensive. Among them: United Therapeutics (UTHR), which the Street expects to earn $182 million next year and trades at 17.2 times forward earnings.
But sticking with quality isn’t enough—which is why he’s paying close attention to price momentum; once performance starts to slip, it’s time to go. “When the tide goes out and the focus turns to the fundamentals, we will see who is swimming naked,” he says, paraphrasing Warren Buffett.
PAST DOESN’T PREDICT THE FUTURE, but studying it might be the best way to determine which companies will be announcing big share buybacks.
That’s the conclusion of Barclays strategist Jonathan Glionna. His quest is important because companies that announce buybacks outperform the market by more than two percentage points during the 90 days following an announcement, with almost half of the gain coming immediately after it’s made. And, when it comes to this game, to win it, you have to be in it.
Glionna found that half of the companies that had bought back shares in 2012 and 2013, but hadn’t as of the middle of 2014, would go on to announce a repurchase later in that year, compared with 20% of all S&P 500 companies. In the past five years, buying serial share repurchasers would have returned a half-percentage point or more than the S&P, on average, in the second half of a calendar year.
Limiting the list to companies that can actually afford to buy back shares—Glionna screened out those with a ratio of less than 5% of free cash flow minus dividends to market capitalization—improved performance in four of the past five years. This year’s list includes Citigroup (C), Edwards Lifesciences (EW), and UnitedHealth Group (UNH).
That was the reason for the weakness in past few weeks.