Biotech Bonanza: 2019 Outlook

  • 2018 was a harder year than envisioned, even though second-half turbulence was somewhat anticipated
  • The biotechnology sector provided opportunities for attractive returns during 2018 although the late-year decline rapidly masked many of the successes
  • As of December 1, the Nasdaq Biotech Index was up +2%, S&P Biotech Index was down -4%, and the Prudent Biotech portfolio was up +54%, for the year-to-date
  • Biotech returns in 2019 will be tempered by broader market conditions and a renewed drive in the House for drug cost management
  • During 2019, biotech stocks will have an uphill battle but will still provide opportunities for attractive gains, though on a more selective basis

Biotech Pulse ~ Biotech Pulse - Biotech Stocks Outlook 2019

The stock market was on track for a solid double-digit return performance in 2018, until it entered the final quarter. The performance cart has been rattling ever since as the stock market's perception of risk has risen dramatically, leading to a sharp erosion of returns. While the broader stock market, represented by the S&P 500 (SPY) and the Nasdaq Composite, has lurched from one support level-to-another, declining 10% to 15%, the biotech sector slid rapidly right into the bear market territory. Both the Nasdaq Biotech (IBB) and the S&P Biotech (XBI) indexes have crossed the 20% decline-from-peak threshold, which indicates the onset of a bear market.

To a significant extent, the steeper decline in biotechs is the nature of the higher beta sector that it represents. Small comfort though even for seasoned investors accustomed to the high risk-reward potential of biotechs. The broader market correction this time is deeper than the one experienced earlier this year during the January-to-March period and will take patience to resolve, as discussed in Stock Reset Requires Patience. Nonetheless, the 27% decline in the S&P Biotech Index, with a greater proportion of small and midcap stocks, has been quite alarming.

Last year in our Editor's Choice 2018 outlook article Biotech Bonanza: Biotechs To Keep Shining In 2018, it was written:

We believe biotechs in 2018 will deliver double-digit returns of around 20%, with a +/- 5% variance. It is our anticipation that the first-half will be better than the second-half due to general market factors which will be discussed separately in our stock market outlook report. One has to keep in mind that the overall market has a higher probability of a normal correction going forward, and that will affect biotechs too. Be prepared for sharp volatility.

What was once a 15% to 20% gain year-to-date for biotechs in September has now eroded into losses for the year. The positive fundamentals for biotechs remain similar from last year although the broader tapestry has changed somewhat as we discuss below.

Regulatory Landscape To Remain Similar But Noisier

The healthcare (XLV) industry faces the risk of constantly evolving regulations. This is all the more pertinent for the biotech and pharmaceutical (biopharma) industry, where the threat of drug price regulation remains a persistent backdrop to industry fundamentals. The biotech industry depends on the pharmaceutical industry for its eventual high-valuation exit. So what's good for the pharma industry is often good for biotechs.

The relentless pressure of being made the whipping boy for drug price increases and bad industry publicity had pushed many biopharma companies to limit and even postpone such increases. Large companies like Pfizer (PFE), Merck (MRK), Bristol-Myers Squibb (BMY), Johnson and Johnson (JNJ), Novartis (NVS), Allergan (AGN), Amgen (AMGN) and Elly Lilly (LLY), amongst others, committed to not raising prices till year-end 2018. The industry's commitment towards exercising greater self-regulation was reflected in a slower pace of increases.

Most of the drug price increases typically occur in January and then mid-year in July. In an analysis by AP of drug price changes in the first 7 months of 2018, it was determined that there were 96 price increases for every price cut. But there were fewer and smaller hikes than in the past years, as shown in the chart below. ~

An analysis of 17 large biopharma companies by investment firm Leerink Partners found that the most price dependent companies during the period 2013 to 2017 were Amgen (AMGN), AstraZeneca (AZN), Glaxo SmithKline (GSK), and Pfizer (PFE), while the least price dependent biopharma were Alexion Pharmaceuticals (ALXN), Johnson and Johnson (JNJ), Novartis (NVS), and Regeneron Pharmaceuticals (REGN). Furthermore, the contribution of price increases to sales growth declined from 4% in 2017 to 2% in 2018.

Risk of Drug Price Regulation

The biggest risk for biopharma has always been a move towards legislating direct drug price negotiating power for the Centers for Medicare & Medicaid Services as a tactic to reduce drug prices. Such a move will have broader ramifications for how drug research and development is conducted, the introduction of new drugs, and industry profit. Consequently, it's something that the industry is heavily opposed to and the Congress is split on it.

Is it possible to arrive at any such legislation next year?

Yes. But, it will require the support of the White House in a grand bargain with the Democrats to arrive at such a deal. President Trump has shown a penchant towards pushing forward on controlling drug prices. But his earlier attempt, the American Patients First, was a more incremental approach and even industry-friendly. Democrats have favored bargaining power for Medicare, something which the President was in favor of during the election cycle. In his zeal to fulfill a campaign promise of reducing drug prices, President Trump may reach out for such a grand bargain. That will be a systemic change which will materially hurt the valuations of biopharma. But the possibility of such an event appears remote at this time. The President has not mentioned this idea since assuming office and many of his party members are against it. In addition, most likely the friction between the White House and the Democrats will only rise in 2019 due to the investigations of the Presidency that will be launched following a change of control of the House in 2019.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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