The Biotech Surge: Bubble or Opportunity?

You might think investors are becoming more risk averse, considering the choppiness year-to-date in the stock market. The S&P 500 has dropped 10% from its 52-week high and is now barely up for the year. Beloved tech leaders like Facebook (NYSE: FB) and Apple (NSDQ: AAPL) have fallen 33% and 23% respectively from their highs.

Based on this action it makes sense that investors might tighten the notch on their risk meter. But based on the bullish action lately in biotech — which is easily the riskiest segment of the stock market — that supposition is far from reality.

On Monday, the day after President Trump and China agreed to postpone an escalation in the trade war, the market opened strong. Trump agreed to delay and possibly abandon plans for a 25% tariff that was on the docket for January 1. In return, China agreed to eliminate a 40% retaliatory tariff imposed on U.S. auto exports. The pair agreed to attempt a resolution regarding other prickly trade issues, including technology patents.

But many of the groups one might expect to move on the news showed a muted response. General Motors (NYSE: GM) and Ford (NYSE: F) both rose only a few percentage points. Agriculture-related stocks, which should see a rebound in business due to the resurrection of soybean exports, showed more impressive jumps. Caterpillar (NYSE: CAT) and Deere (NYSE: DE) rose mid-single digit percents.

But the big winners were the biotechs, as this chart shows:

The Good News from San Diego

It seems the biotech heavy-hitters had no interest in following news from the G-20 summit where these trade deals were hashed out. The place to be was San Diego at the 60th annual meeting of the American Society of Hematology (ASH for those in the industry).

Many of the biotechs presenting data there enjoyed gigantic moves.

Tesaro (NSDQ: TSRO) rose 58% due to an acquisition by Glaxo SmithKline (NYSE: GSK). The larger pharma company offered $5 billion in cash. Tesaro’s ovarian cancer drug Zejula is already on the market. Glaxo is betting its sales will grow dramatically if doctors choose the drug as first-line therapy for ovarian cancer.

Global Blood Therapeutics (NSDQ: GBT) rose 55% on news that the U.S. Food and Drug Administration (FDA) granted the clinical stage biotech a quicker approval route for Voxelotor, its sickle cell disease drug. The drug is currently in Phase III, a later phase of testing, but would typically see a much longer timeline to potential approval if not for this special notice.

Many other biotechs skyrocketed on Monday. In fact, of the top 20 fastest-rising stocks on the Nasdaq that day, 11 were biotechs.

Biotechs are considered one of the riskier stock groups due to the binary nature of the drug approval process. Many small to mid-size biotechs do not generate any revenue. Discovering and trialing new drugs is an ultra-expensive proposition.

For this reason, many biotechs go public to raise the money to fund that exploration. While the science and data unveiled in the prospectuses of these nascent companies can sound quite impressive, it is all but impossible to know if a drug will perform as expected in a human trial.

This constant need for financing and chance of drug failure is why it’s inadvisable to own just one or two hand-picked biotechs. You need the diversity of many biotechs to soften the huge stock price decline delivered with a failed drug trial.

Most larger biotech and pharma companies like to wait until a drug is further along in development before hitting the buy button. These companies, which typically generate significant amounts of cash from selling already approved blockbuster drugs, are always on the hunt for new drugs to add to their portfolios.

Investors don’t seem to mind the risk. More than half of the initial public offerings (IPOs) priced since the market started to swoon in October are biotechs. More than two-thirds of them generate zero revenue. That’s right — zero. Just about all are losing money with no prospect of substantial profits for several years.

It’s possible this retreat to risk is a sign that the bubble of optimism inflating the market hasn’t deflated. Or it’s possible that investors are continuing their race from one industry group to the next in search of future leaders. Either way, there’s fodder for bullish and bearish plays in the biotech group.

My colleague Jim Pearce knows how to pinpoint bullish plays, regardless of the direction of the market.

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