Managing Editor’s Note: A year ago, Janet Yellen warned that biotech stock valuations were “substantially stretched.”
Since then, biotech stocks have surged 42%.
In today’s essay, Marc Lichtenfeld, editor of Lightning Trend Trader, explains why Janet Yellen’s bubble theory is dead wrong.
He also reveals the two big trends set to keep the biotech sector booming over the next decade and beyond…
If you’ve been paying any attention at all to the stock market, you know that the biotech sector has been on fire.
The Amex Biotechnology Index is up 19% year-to-date (versus a 3% gain for the S&P 500).
Over the past two years, the index has more than doubled – up 106%. At the same time, the S&P 500 has climbed 29%.
The huge move in biotech has caused many skeptics – including Fed chief Janet Yellen – to declare that the sector is in a bubble. And the recent acquisition of Synageva BioPharma by Alexion Pharmaceuticals for a 140% premium did little to persuade the bears that they are wrong.
But they are wrong.
Big Pharma on the Prowl for New Drugs
It’s no secret that the giant pharma companies are scrambling to replace drugs that are losing their patents and facing generic competition. Hundreds of billions of dollars in revenue are at stake.
For example, AstraZeneca just reported lower first-quarter profits after the patent for its acid reflux medicine Nexium expired. Sales of the drug fell 31%. The company’s cholesterol fighter Crestor will lose patent protection next year. Combined, these two drugs make up a third of AstraZeneca’s revenue.
The story is the same across nearly every large pharmaceutical company. As a result, big pharma is constantly on the prowl for new drugs to replace lost revenue.
That means smaller companies stand to benefit as the drug giants go shopping, either for individual drugs or for entire companies. Their ultimate goal is to obtain a pipeline of multiple drug prospects – or a certain technology that is used to create drugs.
The way a partnership for an individual drug works is like this:
Biotech Company “A” has a drug that just finished Phase 1 trials with promising data. Big Pharma Company “B” pays the biotech company $20 million in cash for the rights to develop and market the drug.
The larger company now takes on the expense (and risk) of clinical trials. Along the way, the biotech company is entitled to $100 million in milestone payments. These might occur after successful Phase 2 trials… at the beginning and end of Phase 3 trials… and if/when the drug is granted final approval.
Additionally, the smaller company will get a royalty payment on sales of the drug once it’s on the market.
Obviously, the numbers vary depending on each company’s characteristics.
Purchase Prices Are Soaring
As drug companies become more desperate, they are willing to pay higher amounts for drugs.
In January, for example, Amgen said it would pay Kite Pharma $60 million for access to its cancer drug that had yet to be tested in humans. Kite is eligible for another $525 million in milestone payments as the drug progresses through development.
Sometimes one drug isn’t enough to satisfy the insatiable appetites of large pharmaceutical companies. They want all the drugs. So they buy the entire company and gain access to its pipeline. This often includes, just as importantly, patented technology.
In March, Cellular Dynamics agreed to be acquired by Fujifilm Holdings for $16.50 per share. The stock closed at $7.94 in the trading session prior to the announcement. Cellular Dynamics had $16.7 million in sales in 2014. Its technology will allow Fujifilm to produce fully functioning human cells.
Also in March, Teva Pharmaceuticals agreed to a $3.5 billion buyout of Auspex Pharmaceuticals to obtain its drug for Huntington’s disease. Teva also gained access to its pipeline of drugs for Parkinson’s disease and idiopathic pulmonary fibrosis. The $101-per-share price represents a 42% premium to where the stock closed just before the announcement.
Everybody’s Getting in on the Action
Biotech stocks have always enjoyed much larger acquisition premiums than the rest of the market. With demand so high for new drugs and technology, I expect that to continue for the foreseeable future.
It’s never a good idea to buy a stock simply because you think the company will get acquired. But as long as huge premiums are being paid for biotech stocks, big money will likely continue to pour into the sector.
Even some large investors who don’t normally invest in biotech are getting in on the action. John Paulson of Paulson & Co., who made billions betting against the U.S. subprime mortgage market in 2007, recently bought over 2% of Synergy Pharmaceuticals.
Synergy is known to biotech aficionados, but is not front of mind to most big money managers.
The Silver Tsunami
America’s population is getting older. All of those baby boomers are becoming grandparents, retiring, and entering their golden years.
Roughly 10,000 boomers turn 65 every day. In 15 years, there will be 75 million Americans over the age of 65, including the youngest of the baby boomers. (That’s up from 44.7 million in 2013.)
And as people get older they tend to get sicker and require more health care.
According to the Agency for Healthcare Research and Quality, 82% of Medicare beneficiaries have at least one chronic condition. The Congressional Budget Office projects that spending on health care will go from 4% of America’s GDP in 2007 to 7% in 2025. By 2050, that number should rise to 12%.
As Americans spend more on health care, an increasing percentage of those expenses will be on biotech drugs. Biologics already make up 24% of total drug sales, accounting for $221 billion in annual spending.
Furthermore, biologics are attractive to big pharma companies because they often carry a higher price point. Cancer-treating biologics often cost tens of thousands of dollars for a course of treatment.
And drugs for rare diseases can cost six figures a year… with many patients dependent on therapy for the rest of their lives.
For example, Soliris, which is made by Alexion Pharmaceuticals, is the most expensive drug in the world. It treats a rare and sometimes fatal form of anemia. It costs around $440,000 per year.
These kinds of drugs will have an increasing role over the coming years. Tons of research is being conducted in immunotherapy and other new ways of fighting a wide variety of conditions, such as cancer and diabetes.
And with all of the upcoming patent expirations… there will be tremendous interest in the sector from large pharmaceutical companies looking to add to their research capabilities, pipelines, and product offerings.
Why the Uptrend Will Continue
To top it all off, the fundamentals for this sector look great. And so do the technicals.
You can see from the chart above that the Amex Biotechnology Index has been in a strong uptrend since 2012. It’s actually been rising since 2009, but the index has followed this uptrend line perfectly for the past three years.
There’s a saying in technical analysis that a trend in motion stays in motion. In other words, these types of trends tend to stay in effect until they break down meaningfully.
As shown above, we could even experience a 10% correction in the index and still be in the long-term uptrend.
In fact, if we did see the index pull back 10%, I’d be buying with both hands.
This is about as strong and perfect of a trend as you’ll see on a chart. And it suggests we should see higher prices for the foreseeable future.
The angle of the trend is not too steep, which means it’s sustainable. Sometimes when a stock or index rises too fast, even if it tracks along a trend line, it can’t maintain that momentum for very long. But this trend line is the kind that you’d find in a technical analysis textbook.
It’s reassuring when the technicals and fundamentals point in the same direction.
Biotech is a sector you have to be in over the coming decade. It has its risks. And it can be volatile.
But over the years, it should generate extraordinary returns as new medicines come on the market and larger companies gobble up smaller ones.
P.S. Marc sees countless opportunities in the white-hot biotech sector right now. But there’s also no shortage of stinkers. To help you determine which is which… and understand the catalysts pushing certain stocks higher… he’s produced a free video. You’ll want to check it out ASAP as it’s set to be removed from the Web soon. Click here to watch.