By Michael Brush
There’s a world of hurt in biotech. It’s in a bear market.
The good news is the pullback offers an chance to get into exciting areas of biotech research like gene editing and oncology at better prices. Some of these names will see buyout pops since they’re now more attractive targets for big pharmaceutical firms.
It makes sense to turn bullish because, big picture, the decline is more about a sentiment shift than a change in fundamentals. Importantly, political risk is minimal even though the Democrats have regained power in Washington, D.C. (More on that in a moment.)
First, about that world of hurt. The SPDR S&P Biotech exchange-traded fund /zigman2/quotes/205950134/composite XBI +0.27% plunged 20% from the early February highs through the end of last week (a bear market). That’s way worse than the 1.6% decline for the S&P 500, the 7.3% decline for the tech heavy Invesco QQQ Trust Series ETF /zigman2/quotes/208575548/composite QQQ -0.84% . The biotech rout is deeper than the declines in all but one of the 50 worst performing S&P 500 industry groups over the same time frame (auto makers, down 25%).
The damage is huge in popular gene editing stocks that individual investors chased in part because of all the buzz around ARK Invest and its ARK Innovation /zigman2/quotes/204808965/composite ARKK -1.60% and ARK Genomic Revolution /zigman2/quotes/206454610/composite ARKG -1.23% ETFs. Those gene-editing stocks were recently down 45% to 60%. The iShares Nasdaq Biotechnology ETF /zigman2/quotes/206189322/composite IBB -0.29% has fared better with “only” a decline of 12.8%.
To sort out what’s going on here and what might be buyable, I recently checked in with Jefferies biotech analyst Michael Yee. He’s worth listening to because he’s not afraid to turn cautious on the group when need be – like during the latter part of the spectacular November-February run. (Sell-side analysts are often just cheerleaders.) He’s also ranked among the top three biotech analysts in recent Institutional Investor polls.
Here are the key points.
1. The biotech decline is not about a ‘long-duration asset’ curse
According to this popular meme, valuations of companies with very distant earnings are getting hammered since interest rates are up. That increase the discount rate in valuation models.
But this isn’t the culprit, says Yee. “I strongly believe the pullback is rotation from hypergrowth disruptive to recovery and cyclical areas of the market.”
Investors want those names now that the vaccine rollout is here, and it’s clear the economy is going to take off this year. Biotech is a source of funds. So, it’s more about a sentiment shift than a change in biotech fundamentals.
The “long duration” meme never really make sense, points out Leuthold Group strategist Jim Paulsen. Biotech performed quite well from August through the end of the year, even though the yield on 10-year bonds /zigman2/quotes/211347051/realtime BX:TMUBMUSD10Y 0.00% doubled. A look back over the last 10 years shows that biotech stocks are not correlated to changes in interest rates, agrees Yee.
Part of the problem for biotech is that generalist portfolio managers and individual investors rushed in during late 2020. Generalists didn’t own enough biotech and this was making them underperform their Russell 2000 benchmarks, says Yee. Retail investors were drawn in by the “Ark effect,” as ARK Invest’s Catherine Wood took on the role of innovation investor guru.
Whenever generalists and retail move in to a specialized sector, it can be trouble because many of them don’t really understand what they own. So, they sell just as quick when the tide turns.
2. There may be significant M&A now
So far this year, two biotech names from my stock letter (link in bio below) jumped sharply on takeover news: Five Prime Therapeutics and Pandion Therapeutics. I expect more of this, with biotech stock prices down so much. Many big pharma companies have pipeline holes to fill. The key is to look for companies with therapies in late-stage development, or recently approved products.
Yee’s short list of possible takeover targets includes: Horizon Therapeutics /zigman2/quotes/206690250/composite HZNP -0.0086% , Ultragenyx Pharmaceutical /zigman2/quotes/204970392/composite RARE -0.23% , Arrowhead Pharmaceuticals /zigman2/quotes/204828235/composite ARWR -1.29% , Kodiak Sciences /zigman2/quotes/207655028/composite KOD +2.34% , Allakos /zigman2/quotes/203639566/composite ALLK +4.38% , ALX Oncology /zigman2/quotes/219511930/composite ALXO +0.41% , Intellia Therapeutics /zigman2/quotes/207821052/composite NTLA -2.00% , Pacira Biosciences /zigman2/quotes/202929053/composite PCRX -0.96% , Olema Oncology /zigman2/quotes/222642382/composite OLMA -2.53% and Protagonist Therapeutics /zigman2/quotes/205674595/composite PTGX -0.29% .