2015: Another Good Year Unless “Something Happens”

Life Science stocks had another big year in 2014 up 48% tracking gains for the overall healthcare sector up 35%. Over 10 years the return is 300%! The move up was not a straight line as there were  two major corrections in April 2014 after the Q1 “bio-bubble” and again in October which tested investors’ mettle. We have developed a market model over the years that provides a rationale for the bull market in biotech stocks.  However as more investors become knowledgable of product breakthroughs with broader media coverage and as institutions throttle ever more money into the industry, we can get to an overbought situation with a severe correction. In the meantime bullish sentiment dominates.

We have identified  unique aspects of the life science market that supports its investment thesis. When the industry was at an earlier stage  there was a shortage of capital because of the high risks of clinical trial failure and a ten year time line for drug development. Today the sector is awash in capital for ETFs, IPOs, M&A and follow-on stock offerings. According to 2014 data from Renaissance Capital the US IPO Market set a 14 year record with 273 IPOs compared to 406 in Year 2000. In 2014 there 100 healthcare IPOs of which 69 were biotech IPOs or 25% of total. Healthcare returns averaged 31.7%. Eight of the Top Ten IPOs were biotech.

Companies in the industry are now well capitalized and new products provide revenue growth. What would change to make investors more cautious?  Will healthcare remain a strong sector or will there be pricing pressures?

Here are some of the key mantras of the bull market:

Stock Valuations Don’t Matter-In Billions$

It has become almost a cliche that financial metrics, in particular market capitalization, is not a reason to buy or sell a biotech stock. Biotech stocks without significant revenue are valued on the basis of technology, product pipeline and potential for acquisition by a larger company. Many exciting mid-cap emerging biopharmaceutical companies in the $2-6B capitalization range. These companies and many well financed smaller caps would be most vulnerable to a correction but they are currently in the “sweet spot” of the market.

Biotech Is Less Sensitive To Macro News

The healthcare sector has been a safe haven dependent more on domestic policies. Bad news around the globe like crude prices collapsing, concerns about China growth, ECB economic policy, wars in the Middle East and deflation in Japan have not hurt healthcare stocks. Should an overall  bear market develop due to weakness in the global economy, gains in biotech stocks may be slowed.

ETFs Are All You Need-Why Try to Pick Stocks?

Over the years we have compared the performance of life science ETFs to individual stocks and mutual funds and have concluded that investors can own an ETF and maybe one mutual fund and participate fully in market gains. Market returns have been strong and volatility has been low. Stock picking can achieve big gains but is much more difficult because it requires significant capital allocation and more frequent trading.

Momentum Players Rule

Biotech stocks are driven by institutions that have huge leverage over price movement because of  a small stock float, unique knowledge of technology and pending deals, and large positions. This can result in extraordinary gains and excessive valuations. Momentum investing and volatility is a key feature of a biotech bull market. Short stocks at your peril.

Don’t Fight The FED

Those of you that follow the market know how perceptions and comments from the FED affect the market. Throughout 2014 biotech stocks have been less volatile with “FEDspeak” but they do rally with the market if FED money policy is accommodative. The “zero” cost of money promotes deals and financings.

“Food Chain Effect” Drives Values

M&A and licensing continues at a lively pace and drives market liquidity because of the need for revenue growth and pipeline re-balancing. Technological breakthroughs and new treatments for cancer, HCV and autoimmune diseases encourage funding at all levels.

These are among the most important underpinnings of the bull market in biotech. On a fundamental level the big issue could be pricing as we saw in the last big sell-off in December with the Abbvie/Express Scripts deal hitting Gilead (GILD) stock hard. The market is driven by specialty institutions who have extensive experience in the market and its myriad players. Technicals do matter in biotech more so than in blue chip stocks because charts present every aspect of the trade, offering clues to future performance.

Retail investors should buy an ETF e.g. FBT and a highly ranked mutual fund e.g. FBIOX. Alternatively if you are a stock picker check out the Rayno Life Science  portfolio of large and mid cap stocks. Watch the XLV because healthcare has been a leading sector and any major changes here would effect biotech drug stocks. A 10% cash position should be reserved for new trades.

It could be a volatile year like 2014 but by December life science stocks will outperform the market.