Biotech: Get in at the beginning of the next big bubble
By
MoneyWeek Editor
John Stepek Feb 05, 2010
Print this article
John Mauldin, the US investment adviser and pundit,
is hardly what you'd call bullish. Like us, Mauldin expects tough times ahead
for the global economy, involving a double-dip recession and huge problems
dealing with government debt.
But for all the potential bad news ahead, there is one
asset class he's very interested in. In fact, last month he announced that he's
started buying stocks in this sector and plans to keep adding to his holdings
"at least every quarter for several years".
So what's he buying? Some defensive combination of gold
majors, tobacconists and tinned goods manufacturers? Far from it. Mauldin is
investing in biotech, arguably one of the most speculative investment areas
this side of junior mining stocks. And he's buying now because he wants to be
well-invested in the sector by the time the bubble he expects to arrive one day
has inflated there. "I have lived through a number of bubbles. I have never
gotten to invest in one. This time, dear God, just once please let me be at the
beginning of a bubble."
What is biotechnology?
The word "biotechnology" encompasses several scientific
fields, including agriculture and some forms of alternative energy. But often
when people talk about biotech, they're referring to its medical uses. And the
medical biotech sector certainly has everything you need to create a bubble.
For one thing, few sectors have better fundamentals than the healthcare
industry. Everyone gets ill. Everybody wants to live for longer, and to be
healthier. And the fact is that only wealthy populations live long enough to
die in great numbers from the sorts of diseases and conditions, such as cancer,
that only biotech-based medicine holds the promise of cures for.
It's exciting too. It holds the same golden combination
of the promise of life-changing potential with a sort of science-fiction
wizardry, as the internet did. Who wouldn't want to invest in a firm with a
cure for lung cancer or a method of regrowing your heart walls? It's the chance
to do some good and to make a lot of money in the process.
Of course, a sexy story and sound long-term fundamentals
are one thing. Fulfilling that potential is another. Since the last big biotech
boom ended in 2000, alongside the popping of the tech bubble, the sector hasn't
realised its potential either in terms of investor returns, or for those hoping
for the raft of miracle cures promised at the millennium. And for the really
'blue-sky' treatments that Mauldin is interested in, such as stem-cell therapy,
we could be waiting a while before we see widespread commercial applications.
But even if you exclude the potential for bubble-blowing
in the sector, there are several good reasons to expect 2010 to be a good year
for biotech.
Big pharma's pipeline squeeze
Big pharma companies are running out of drugs – and out
of time. The main players face a 'patent cliff' in 2011, says Andy Smith,
manager of the Axa Framlington Biotech Fund. AstraZeneca, for example, could
see drugs that account for around 38% of sales coming off patent by 2012. When
that happens, generic rivals swoop in with their cheap copycat products and
sales fall hard. And the trouble is, most big pharma companies don't have the
new products to replace these old blockbusters. As Smith puts it, their research
pipelines are being "squeezed at both ends".
So where are they going to get their new drugs from?
Well, they won't be filling the gaps internally. Again looking at AstraZeneca,
at its latest results, the group plans to cut a further 8,000 jobs. About 3,500
of them will be in research and design. Anders Ekblom, executive vice-president
of drug development, said the group wants to create "healthy tension" between
in-house and external researchers. As Jeanne Whalen and Sten Stovall put it in
The Wall Street Journal, "this fits a trend in the industry: growing pressure
on internal research and development staff to justify their existence as
companies increasingly look to outside biotechnology firms and academic groups
for new experimental drugs to buy and develop."
The good news for big pharma is that it might be short of
ideas, but it's not short of cash. As James Burns, head of investment trusts at
Smith & Williams says, these firms "have very strong balance sheets and
huge cash positions with which to make acquisitions… and solve the problems
they are facing".
And the companies that are best placed to provide these
new products are biotechs. These firms have in some cases been working for up
to 30 years to create new treatments. Many are now at the stage where they can
provide the pharma sector with the new products it needs. The economic woes of
the past 18 months have seen consolidation between the big players in the
health sector rather than big spending on small biotechs. But with time against
them, the impetus to look at buying in products is greater than ever before.
Obama's healthcare reforms
This isn't the only reason to expect more mergers and
acquisitions activity in the sector. The healthcare sector in general was
overshadowed by one thing in 2009: the threat of serious reform to the US healthcare
system. When first proposed, says Smith, it looked like the new rules could
cost around $1trn across the entire sector. A year later, and for better or for
worse (we're not going to delve into that particular can of worms here), those
reforms have been seriously damaged by Obama's 'shock' loss of Massachusetts to the
Republicans. As Smith puts it, "reform is not dead, but it's on life support.
Whatever's going to be taken out of the sector, it will be less than $1trn."
In any case, healthcare reform was always more of an
issue for big pharma than for the biotech industry. But that hasn't stopped it
from hanging over share prices. Uncertainty has a habit of paralysing activity.
If big pharma is scared of higher costs or new regulations dictating the types
of drugs it can make, that's one reason not to go on an acquisition spree. It
also makes it harder to work out what value to put on a company, says Smith.
With this uncertainty lifting, the path should be clearer for increased
activity in the sector.
New life at the FDA
Another boost for the healthcare sector in general this
year could be a recruitment drive at the US health regulator, the Food and
Drug Administration (FDA). Of all the world's health regulators, the FDA is the
most important – it holds all the key hoops that any new drug or treatment has
to jump through. But as well as becoming more demanding In recent years (not
necessarily a bad thing), the FDA has also "historically been chronically understaffed",
says Burns, which has slowed up the approval process.
But with the appointment of a new FDA commissioner,
Margaret Hamburg, this could change. For one thing, she is expected to be more
keen to drive through new drugs. It will also be easier for her politically,
because she's been picked by the Democrats. Moreover, the FDA is also likely to
get a big budget increase for next year.
As the Los Angeles Times puts it, the agency is "a
screaming exception to the Obama administration's freeze on discretionary
spending in the 2011 budget. Overall, the FDA budget could grow by as much as
23% to just over $4bn from the current $3.3bn". The budget has already grown by
78% since 2008. "The increased spending would allow the FDA to add 1,200 jobs,
expanding its workforce by 10%." Part of the reason for the big hike is
precisely so the FDA can keep up. "Today, the FDA is relying on 20th-century
regulatory science to evaluate 21st-century medical products," warns the
regulator.
Biotech is historically cheap
As Burns says, "the major, profitable biotech companies
are now trading at historically low valuations, and are as cheap as they have
been since 1991". The p/e of the sector recently fell below that of the S&P
500 as a whole for the first time ever, reports The Wall Street Journal.
Moreover, most big investors are ignoring the sector. "Virtually all generalist
investors are underweight the sector, so any change in sentiment could have a
dramatic impact."
Of course, just because a sector is cheap doesn't mean it
can't get cheaper. However, as noted above, valuations in the biotech sector
are underpinned by the potential for mergers and acquisitions. After all, if
stocks are cheap it's all the more reason for desperate big pharmas to try to
pick them up at inexpensive levels before investors get interested in the
sector again. That in turn could be a catalyst for the stocks to be rated
higher by investors.
So what should you be buying now? We take a look at the
stocks and funds that are set to profit from both big pharmas' pipeline
problems and from growing interest in the biotech sector below.
The best bets in biotech
So what stocks should you buy to profit from big pharma's
woes? The problem with trying to predict which stocks are mergers and
acquisitions targets is that you're as likely to get it wrong as you are to get
it right. So you are better not to buy stocks simply on the basis that they may
be taken over at some point. In terms of getting broad exposure to rising
investor interest in the biotech sector, you'd be better off buying an
investment trust, or even an exchange-traded fund, in the sector. James Burns
of Smith & Williams likes the Biotech Growth Trust (LSE: BIOG). Biotech
Growth trades at a discount to its net asset value of 8%. Given the board has a
target of trying to ensure the discount doesn't widen beyond 6%, as Burns says,
now "would seem an attractive entry level for new investors". The portfolio is
currently split between 40% in major biotech stocks and 60% in smaller ones.
Another safer bet than individual biotech stocks is to
look for the 'picks-and-shovels' companies that will help biotechs and big
pharma firms to get products past the FDA (the US regulator)
and thus replenish their pipelines more rapidly. Pharmaceutical Product
Development (NASDAQ: PPDI) is a good example. The company is a clinical
research organisation. It specialises in helping drug companies – from giants
like Pfizer to small biotechs – to get over the various hurdles involved in
bringing a product to market, including the various phases of clinical studies
undertaken and the regulatory approval process.
The stock trades on a forward p/e of 18, and has a
dividend yield of 2.6%. It's not a huge yield, but as Matt Koppenheffer points
out on Motley Fool, it has room to grow. "To date, the company's payout ratio
has been kept relatively low, at 35%, which provides security and gives the
company extra room to raise the dividend in the future. Meanwhile, the
company's balance sheet is a thing of beauty, with nearly $600m in cash and no
debt."
Within the sector, Forest Labs (NYSE: FRX) is "a great
core holding with lots of upside", reckons Jon Stephenson, research analyst for
Summer Street Research. Forest is a big pharma
group. But unlike most of its peers, Forest is
already focused on using external researchers to do the hard work of drug
discovery for it, says Jay Palmer in Barron's. "Forest doesn't employ thousands
of in-house research scientists... instead [it] lets smaller biotech and
medical-research firms come up with the drug and do the initial testing; it
then swoops in with an offer to buy, or more often license, the promising
ones."
Like most big drug groups, the group has problems with
patent expiry. Its best-selling drug, anti-depressant Lexapro, loses protection
in 2012. However, it also has a decent pipeline, says Palmer. Seven drugs are
in Phase III (late-stage) clinical trials, including a powerful antibiotic and
treatments for schizophrenia and diabetes. And as Palmer puts it, "the stock is
strikingly cheap". It's on a p/e of 8.7, a big discount to the rest of the
sector, and it also has an extensive cash war chest with which to buy or
license more new drugs. Stephenson has a price target of $43 a share on the
stock. Then there's the market for 'biosimilars'. These are basically the
equivalent of 'generic' drugs for biopharmaceuticals – in other words, they are
copycat treatments that can be made once existing ones fall out of patent. But
there are some key differences. For one thing, biosimilars are harder and more
costly to manufacture, simply because biopharmaceuticals themselves are more
complicated drugs. But more importantly, says Joseph Kreuger on
SeekingAlpha.com, is that they "fall under new patent protection, effectively extending
the exclusivity of the old drug it is replacing".
In other words, when companies are facing patent expiries
on biopharmaceuticals, one good option would be to manufacture a biosimilar
drug to allow them to maintain their hold on the market. One stock to buy to
take advantage of this, suggests Kreuger, is PROLOR Biotech (OTC: PBTH). The
company uses its patented technology to create longer-lasting and more
effective versions of existing biopharmaceuticals. Given that its technology
could potentially be used to extend the life of products with a current market
value of around $5bn, Kreuger reckons the stock is a very obvious takeover
target. Be aware that the company is traded over-the-counter in America,
so you'll need a broker who can trade these stocks – TD Waterhouse is one that
does.
• This article was originally published in MoneyWeek magazine issue number 472 on 05 February 2010, and was available exclusively to magazine subscribers. To read more articles like this, ensure you don't miss a thing, and get instant access to all our premium content, subscribe to MoneyWeek magazine now and get your first three issues free.
Published in
Investments
| More
articles
by
John Stepek
Related articles
-
By Paul Hill, Feb 10, 2012
-
By Paul Hill, Feb 10, 2012
-
By Paul Hill, Feb 10, 2012
-
By Phil Oakley, Feb 10, 2012
FREE - MoneyWeek's daily investment email
Our free daily email, Money Morning, is an informative and enjoyable analysis of what's going on in the markets. Written by our Editor, John Stepek, and guest contributors.
Sign up FREE to Money Morning here.