Over the course of this long bull market, biotech stocks have been very, very good for their owners. Perhaps too good. Investors have shown such rabid enthusiasm for biotechs—especially small, unproven companies that have yet to bring a drug to market—that some observers are using another b word to describe the high-flying sector: bubble.
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Bubble or not, biotech investors have been having a blast. Over the past five years, iShares Nasdaq Biotechnology ETF (symbol IBB), an exchange-traded fund that tracks 150 Nasdaq-listed biotech stocks, earned an annualized 31.2%, more than double the return of Standard & Poor’s 500-stock index. In 2012, 2013 and 2014, the ETF earned 32%, 66% and 34%, respectively. It tacked on another 13% in the first nine weeks of 2015.
Short-term returns—and valuations—of individual stocks are stunning. Juno Therapeutics (JUNO), which is developing cancer drugs, went public in December at $24 per share. It rocketed to $62 and now trades at $53, giving the company, which has no sales, a market value of $4.8 billion. (Share prices and returns are as of March 6.)
There are legitimate reasons for the fervor. Industry insiders say the pace of innovation has never been greater, and the Food and Drug Administration is approving more drugs more quickly than ever.
Finding success stories remains a challenge, however. Share prices of companies that win approval for their drugs or show enough promise to be acquired by one of the industry’s big players can double or triple in a flash. Companies, especially young ones, whose drugs flame out during testing often run out of money and leave their shareholders with massive losses. “To invest in individual names in this field, you need nerves of steel and confidence that you understand the science,” says Morningstar analyst Robert Goldsborough.
Investors willing to embrace the risk of smaller biotech companies should look to the iShares biotech ETF, which is weighted by market value. We think it’s a better choice than SPDR S&P Biotech ETF (XBI), which gives equal weighting to its 87 holdings and thus offers greater exposure to the smallest, youngest and most speculative companies. The iShares fund has delivered roughly the same return as the SPDR ETF over the past five years, but it did so with about 25% less volatility.
We should note that in a sector in which so many stocks seem wildly overpriced, one in particular looks extraordinarily cheap. Gilead Sciences (GILD, $102) is the largest biotech company, with a market value of $150 billion and expected revenues this year of $28.1 billion. The stock has stalled since October, and it now sells for 11 times analysts’ average 2015 earnings estimate of $9.53 per share, which represents an 18% increase from last year’s profit. By contrast, the price-earnings ratio of the S&P 500 is 17.
Gilead’s core business is treatments for HIV, but the firm has been branching out, via acquisition, into other fields. Its newest drugs, Harvoni and Sovaldi, have already given Gilead a “dominant” share of the market for treating hepatitis C, says analyst Jeffrey Loo, of S&P Capital IQ. But competition is heating up, which may explain why the stock is so cheap. Gilead told investors in February that it will offer bigger discounts than expected on Sovaldi and Harvoni this year.
Still, Gilead’s shares appear to be way too cheap to ignore. Analysts Phil Nadeau and Marc Frahm, of Cowen & Co., have a 12-month price target of $125. Loo is even more bullish, with a one-year target of $143.