The Nasdaq Biotechnology Index gained by 36% so far this year. There are six biotech companies in the S&P 500, and the average gain for the group is 40% -- even with this year's massive earnings disappointment from Amgen .
Gains like these would be understandable if there had been a significant medical advancement or a major drug release in the last few months. But since this has not been the case, some degree of caution is warranted.
The biotech industry certainly has a reputation for being one of Wall Street's riskiest investments. But it is clear that markets are waiting in anticipation of the next medical breakthrough. Broad interest in 10 of the sector's U.S. IPOs has generated early investments of nearly $750 million.
The focus of these companies centers on a wide range of areas, developing drugs for illnesses like hepatitis C and multiple sclerosis. The real reason behind this interest, however, might have more to do with the strong bullish sentiment supporting stocks as a whole than with the prospects for individual companies.
In fact, support for most of the clinical-stage biotechs hinges on the fate of a single drug, which adds to investment risk and begs the question of whether or not all this year's surge in interest is warranted.
Broader Sentiment in Stocks Supports Biotech
Widespread enthusiasm in stock markets this year has encouraged investors to take a chance on small biotech companies as they move forward in the hope of creating the next headline-grabbing medical miracle. Smaller biotech companies generally lack stable cash flow, and this means they tend to have a hard time working up interest from credit investors.
But these companies are now pursuing IPOs at the fastest rate in a decade, making up nearly 15% of all U.S. IPOs so far this year. Industry data shows that roughly one in 10 biotech companies are able to successfully launch and distribute one of its products, making investments in the sector a difficult practice. But when the right biotech companies are chosen, early investors can see substantial returns later on.
When we compare this year's performance in the Nasdaq Biotech Index (up 36%) to that of the S&P (up 18%), the possibilities for strong returns start to become clear. This year's performance in the Nasdaq Biotech Index surpassed the previous dotcom-era record, and doubled this year's bull rally in the S&P 500.
New Biotech Names to Watch
This renewed interest in biotech companies has grown from a broad rise in risk-seeking behavior and central bank stimulus on a global level. This type of environment is highly supportive for biotechs looking to come into the market at strong valuations.
In many cases, these companies are still in the earliest stages of the drug development process (with some companies yet to complete even one clinical trial). It is now clear that the bar for progress has been lowered for biotechs looking to enter the market.
At this stage, most of the interest from institutional investors and hedge funds has centered on small-cap specialist companies with a clearly defined medical niche.
Some examples of names to watch can be seen with Enanta Pharmaceuticals and Tetraphase Pharmaceuticals , which completed IPOs in March.
Enanta made a name for itself with its development of hepatitis C drugs, collaborating with AbbVie and Novartis in the process. The company reported second quarter revenue of $1.2 million, well below the $36.6 million seen during the same period last year. These declines resulted from the company's upfront payment of $34 million from Novartis in early 2012.
Tetraphase was a larger disappointment in the first quarterly earnings report after its IPO. The company is focusing its efforts on Eravacycline, which is a pill meant to treat multi-drug resistant infections (such as those seen in the urinary tract).
Tetraphase reported first quarter net losses of $2.8 million (30 cents per share). While this was an improvement on the net loss of $4.7 million (52 cents per share) seen during the first quarter of 2012, these figures were lower than the 27-cent loss per share that was expected by analysts.
To be sure, we are still in the very early phases of development in both companies but with the widespread enthusiasm that marked recent biotech IPOs, the early signs suggest initial valuations were on the high side and that continued weakness is likely into the latter parts of the year.
At the time of publication the author held no positions in any of the stocks mentioned.
This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.