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May 22, 2022, 8:10 a.m. EDT

Biotech is in ‘a Category 5 storm, the same as energy in 2020’ — why contrarians say the sector is a buy

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By Michael Brush

If you want to know how much investors hate the biotech sector right now, consider this simple statistic: More than 25% of small biotech companies have stock-market capitalizations that are smaller than how much they have in cash.

“The market is saying a quarter of these companies are literally worth nothing,” says Jefferies biotech analyst Michael Yee, who recently published this insight.

That’s remarkable. That 25% is the highest in 15 years — higher than even during the agonizingly long bear market of the 2008 financial crisis.

Back then, 18% traded below cash. From 2010 to 2020, the number bounced between 3% and 11%, according to Yee and his team. He’s referring to small- and medium-cap (smidcap) companies, those with a market cap of less than $5 billion. These are the ones that tend to have no earnings and have early-stage therapies in testing.

“This is the worst drawdown we have seen in our careers,” says biotech analyst Charmaine Chan with the Cambiar Opportunity Fund /zigman2/quotes/209711246/realtime CAMOX +2.91% . “No one has seen anything worse unless they have done this for over 20 years.”

For contrarians, this kind of extreme signal suggest only one thing. The sector is a buy. While it’s tough to find any biotech experts who are bullish on the group (even Yee is cautious), I’m not the only one looking at this as a contrarian opportunity.

Category 5 storm in biotech

The macro analyst Larry McDonald at The Bear Traps report has a similar view. To spot contrarian buy signals, McDonald tracks a collection of capitulation markers he developed during the 2008 crisis. They tell him when a sector is so despised that it is worth buying, in the contrarian sense. It’s a “blood in the streets” indicator, to borrow from the old Wall Street adage that says we should buy stocks when there’s blood in the streets. His capitulation gauge tracks several technical signals, among other things.

“The capitulation model for biotech is a Category 5 storm, the same as energy in 2020,” says McDonald. “The risk-reward is fantastic, at least for a countertrend bounce.”

Look at how the SPDR S&P Oil & Gas Exploration & Production exchange-traded fund /zigman2/quotes/203527521/composite XOP +1.20% is up over 170% from its 2020 midpoint.

McDonald suggests the SPDR S&P Biotech /zigman2/quotes/205950134/composite XBI +1.09% and iShares Biotechnology /zigman2/quotes/206189322/composite IBB +1.72% ETFs. I suggest six individual stocks below with help from Yee and Chan. McDonald thinks the XBI could go up 20% to $83 in a shorter-term countertrend rally, and possibly rise 30% to $90 or more a year from now. Those targets are the 50- and 100-day moving averages.

Biotech experts disagree

People who know the space better than myself and McDonald aren’t on board. Yee, who has been cautious since last summer ahead of the big decline, thinks biotech will remain challenged for the year. “It will take a lot of time to heal these wounds,” he says.

There’s nothing broken about the underlying science being developed in biotech, or the prospects for innovation, he says. It’s just that stocks can stay cheap for longer than you expect. “Why would someone wake up tomorrow and say ‘I need to buy all the smidcap biotech stocks down 50%?’ It’s always tough to be the first one in the swamp.”

“I think it a little bit too early to be bullish,” agrees Cambiar’s Chan. “You need catalysts to change the narrative.”

Look for progress on these fronts.

1. More biotech mergers and acquisitions

“M&A would change the narrative, but it’s not happening,” says Chan.

There is a good case for it, though. “Big pharma has so much cash they could basically buy the whole smidcap universe,” notes Yee. Their cumulative cash balance has now risen to more than $300 billion.

“The CFOs of big pharma are looking at this carnage, and they are just licking their chops,” says McDonald. “You are probably going to see substantially more transactions down here.”

/zigman2/quotes/209711246/realtime
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$ 24.79
+0.70 +2.91%
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June 24, 2022
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/zigman2/quotes/203527521/composite
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$ 121.99
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Volume: 13.06M
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/zigman2/quotes/205950134/composite
US : U.S.: NYSE Arca
$ 77.06
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Volume: 18.56M
June 24, 2022 4:00p
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US : U.S.: Nasdaq
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