It has been a tough four months for biotech investors since the indices hit all-time highs in early July. The sector then staged a substantial pullback that moved it into official bear market territory before the main biotech indices hit a bottom in late September. Since then a definite pattern has emerged as the sector has split; small developmental concerns continue to be pummeled by investors while the larger cap companies have regained ground.
The New Pecking Order
There has been a pecking order within the biotech sector that has emerged during the recent bout of volatility throughout the space. Large cap growth stocks that make up what I like to call “core” positions have a solid grip at the top of that pecking order. This is not unexpected as this happens pretty much every time sentiment turns negative on the sector. This almost always triggers a “flight to quality”. These “core” positions have real revenue and earnings growth, reasonable valuations, solid balance sheets and developing pipelines. They often pay nice dividend yields as well. Good examples of this sort of holding are Amgen (NASDAQ: AMGN) which just raised its dividend 27% last week. Other good large cap growth positions in the sector include Gilead Sciences (NASDAQ: GILD) and AbbVie (NASDAQ: ABBV)
This is why I have always emphasized that 50% to 75% of an investor’s overall biotech holdings should be in these types of core positions, depending on individual risk preferences. This is one of the key principles both within my own portfolio and that of the portfolio for Biotech Gems. This philosophy has been a key driver of performance in 2015. It has also allowed me to navigate this recent bout of volatility within biotech while minimizing risk.
Next up in the current hierarchy within the biotech space are small cap concerns that have commercialized products and actual revenue and earnings streams. A good example of this is a small biopharma called ANI Pharmaceuticals (NASDAQ: ANIP) whose recent bottom coincided almost perfectly with the overall bear market bottom for biotech that occurred near the end of September. The stock has slowly started grinding up since that time. Horizon Pharma (NASDAQ: HZNP) is another small cap biopharma in the same situation. Both are cheap given their growth prospects and appear to be doing better now that Valeant Pharmaceuticals (NYSE: VRX) much-publicized troubles appear to be lifting a bit.
Following this segment in biotech in the pecking order are small concerns that have no real recurring revenue growth yet but have catalysts that could change that in short order. A great example of this is Dynavax Technologies (NASDAQ: DVAX) which should announce Phase III trial results for its hepatitis B vaccine HEPLISAV – B early in the New Year. If successful as expected, this will trigger a NDA and hopefully FDA approval in quick succession. Based on analysts' and other comments, this vaccine should be able to garner half of the overall $600 million to $700 million annual market in this space. Approval would also make Dynavax a more likely takeout target in my opinion.
Another stock is this category is Synergy Pharmaceuticals (NASDAQ: SGYP). Its main drug candidate plecanatide just produced stellar Phase III trial results this summer and appears on its way to FDA approval. It has fewer side effects than its primary competitor in a growing space in the healthcare market. The drug should hit the shelves by early 2017.
At the bottom of the biotech pyramid are the small cap biotech companies that have intriguing but early or mid-stage pipelines. Nothing has changed on the likelihood of eventual success at getting these compounds through development, trials and approval for commercialized products. However, lacking any near-term catalysts the market has treated this segment of the biotech market like rented mules. There also might be some tax loss selling activity in this segment of the sector which can depress prices.
Outlook:
Despite the recent bear market in biotech the long-term drivers that have made the sector one of the best performing over the past five and ten years remain firmly in place. This includes aging demographics in developed countries, a growing amount of healthcare spending going to drugs and treatments and spending in the healthcare market growing much faster than the rate of inflation.
At some point sentiment will get better in some of the more speculative parts of the biotech sector. Ironically, when animal spirits do return to the biotech space and confidence returns the current pecking order I outlined above will be turned upside down as usually happens every time the market goes back to “risk on” mode. This is exactly why one should have their biotech portfolio configured in a way that emphasizes a heavy weight to large cap growth core positions along with myriad promising smaller cap firms across the spectrum of treatments, drugs, and diseases. This will allow you to navigate through the frequent bouts of volatility in this sector while benefiting when better times return.
I am building such a portfolio in my newsletter Biotech Gems for my subscribers to follow along with me as I bank lucrative returns in this sector. Right now there are 20 biotech stocks to choose from in the portfolio that cover many different diseases, drugs, and treatments just like I mentioned above.
Biotech is still my favorite sector in the market for booking outsized returns, and I don’t see that changing any time soon.
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