Please ensure Javascript is enabled for purposes of website accessibility

5 Years of Biotech Outperformance

I have no idea if the biotech sector is near a bottom, but based on history, it would seem that we’re within 10% or so of that mark. The greatest risk seems to be that the binary outcome possibilities for developmental-stage biotech stocks (either fail or succeed) don’t mesh with investors’ risk appetite right now.

In March 2002, my wife made a prescient financial decision. She began buying shares of Fidelity’s biotechnology fund in her IRA.

Several years later, after we’d tied the knot and I was reviewing our retirement accounts, I asked her how she came to decide on that specific sector. After all, the rest of her portfolio was allocated to relatively mainstream areas: dividend growth, high yield bonds, small cap stocks and large cap growth & income. So why biotech stocks?

Her answer was typical of one who makes quick decisions (usually the right ones) and never looks back; “It seemed like a good idea at the time.”

That’s all the detail I could squeeze out of her, which left me feeling hugely unsatisfied! Out of the long list of potential funds that Fidelity offers, what on earth inspired something as specific as biotech? Why was this the only sector fund (actually, it’s a sub-sector of healthcare)? And if she was looking for sector exposure, why not choose something more mainstream—and lower risk?

Perhaps it was because she was a biology major in college. Or maybe she became impatient and never made it past B on the sector list. I’ll never know more than that it just “seemed like a good idea.” There was absolutely zero research—that much I can guarantee (for the record, as an analyst who spends days researching individual stocks, I love that there wasn’t). Perhaps it was just good intuition.

Perfect Timing on Biotech stocks

As luck (skill?) would have it, her timing was exemplary. The biotech sector was in a downward slide. From the 2001 peak to the 2002 trough, the sector fell by roughly 50%. It was a great time for long-term investors to be averaging in. Over the next decade, biotech would experience its fair share of ups and downs, outperforming the broad market in five years, and underperforming in the other five. By the end of 2011, biotech had more than doubled from its 2002 low—a decent return, but nothing crazy. Again, it was a good time to be buying, especially since the real fun was just about to begin.

5 Years of Biotech Outperformance

In 2011, biotech crushed the market to rise 22% (the S&P 500 returned 0%).

It rose another 38% in 2012, a year in which the S&P 500 was up 13%.

In 2013, biotech rallied an absolutely insane 74%, versus a 30% gain in the broad market. Surely this was the top!

Not quite. Biotech had two more years to go. It soared 33% in 2014 (versus 11% for the S&P 500), and tacked on another 12% in 2015 (the S&P was down 1%).

By the end of 2015, the biotech sector was up 750% from the 2002 low (over the same time frame, the S&P 500 returned 122%). The move was typical biotech—far from a straight line, with a number of violent corrections exceeding 18%.

The historic push—biotech was (and still is) the first sector to outperform for five consecutive years, from 2011 through 2015—attracted a lot of attention from both bulls and bears. On the long side, historically cheap valuations, fat pipelines, legitimate “miracle” drugs and an FDA “Breakthrough Therapy” program—which expedites the approval process for treating diseases for which there are currently few or no treatment options—all contributed to the rise. No shortage of great story stocks—easily understandable by those who haven’t spent years in a lab—also helped to spread the word that some biotech exposure was a wise move.

But by 2014, if not earlier, the bears could easily claim valuations on all but the biggest and the best biotech stocks Celgene (CELG), Biogen (BIIB), Gilead (GILD), etc.) were stretched.

Or they could just point toward the massive gains over the previous years. Or that less than 10% of drugs are approved by the FDA. Or toward seemingly unethical drug prices—a price tag of $84K for a 12-week course of treatment with Gilead’s hepatitis-C cure seems outrageous on the surface (perhaps less so when factoring in the cost of not curing—and the cost of drug development).

Perhaps most important, common sense suggested that the biotech rally must be getting long in the tooth. And that was what led us to put a hold on new biotech purchases in my wife’s IRA at the beginning of 2014. We didn’t sell any, but the cash we’d been allocating to biotech just went into a money market fund, to be invested in the same biotech fund when things seemed less frothy. The decision wasn’t overly scientific; it just seemed like a good idea at the time.

As it turns out, the rally was extended. Even though biotech stocks were up 12% in 2015, the top was in by the middle of the year, and the sector was in free fall when 2016 arrived. It’s now off roughly 38% from the peak. Unlike most other sectors, biotech has yet to see a reversal this year. It’s still trending flat to down.

So what does common sense suggest investors do now? It depends on your time horizon. For true long-term exposure, we added a little to the Fidelity biotech fund in October 2015, after the sector fell by 25% (it has since fallen another 13%). We’ll buy a little more this month, following the same strategy that worked so well starting in 2002 (dollar cost averaging, especially on the dips). We have also been very selectively buying biotech stocks (outside of an IRA) based on company-specific factors.

I have no idea if the biotech sector is near a bottom, but based on history, it would seem that we’re within 10% or so of that mark. The greatest risk seems to be that the binary outcome possibilities for developmental-stage biotech stocks (either fail or succeed) don’t mesh with investors’ risk appetite right now. We don’t know exactly what will happen with drug pricing and reimbursements. And the sheer carnage in the biotech sector is enough to give pause, especially on the small cap end of the spectrum.

On the bright side, the FDA and other regulatory bodies around the globe appear ready to continue programs to accelerate development for treatments of unmet medical needs, especially oncology. Valuations are back down, IPOs have dried up, investor sentiment toward all biotech stocks (large-cap and small-cap) is bearish, and political posturing over drug pricing and reimbursements is casting a pall over the entire group. The sector is down almost 40% from the peak! When things seem this dire, it’s usually a good time to start paying attention, and maybe even dipping a toe.

This Biotech Rallied 35% in the Last Month

There is one particular area of biotech that I’m fairly bullish on, however, and I think investors should pay attention too.

These are the life sciences companies developing diagnostic equipment and related consumables (similar to a desktop printer and a consumable ink cartridge). These companies aren’t reliant on the approval of a single drug. Rather, they sell equipment to researchers and labs, and they generate repeat business from the consumables. The business model is much lower risk than a drug development company. And in contrast to the rising cost of drugs, the cost of diagnostic equipment is coming down. That means it’s increasingly available to smaller labs and individual researchers, which significantly increases the market size.

When the Human Genome Project (HGN) was completed in 2003, the scientific community finally had a blueprint for a human being. The promise of sequencing technology that could potentially predict disease triggers and inform treatment options was no longer a pie in the sky dream. Whereas the first human genome took 13 years to sequence and cost $3 billion, the cost has come down to roughly $1,000 today. And there are countertop diagnostic systems that can analyze genes in minutes.

Today, gene sequencing is a very competitive market. Large caps Illumina (ILMN) and Thermo Fisher Scientific (TMO) are both relative heavyweights. And small-cap stocks, including Affymetix (AFFX), are drawing the attention of acquirers.

My favorite small cap in the space grew fourth-quarter revenue by over 40%, has recently introduced lower-cost diagnostic tools, and has collaborations with many of the best large-cap biotech stocks to develop and commercialize diagnostic tests. These tests are the very definition of personalized medicine, and help determine the efficacy of certain drugs on individual patients. And, unlike most biotech stocks, this one is up 35% over the last month!

This stock is currently recommended as a Buy in Cabot Small-Cap Confidential. Membership is currently closed, but you can put your name on the wait list and we’ll let you know when the spots open up.

Your guide to small-cap investing,

Tyler Laundon
Chief Analyst, Cabot Small-Cap Confidential 2.0

Tyler Laundon is chief analyst of the limited-subscription advisory, Cabot Small-Cap Confidential and grand slam advisory Cabot Early Opportunities. He has spent his entire career managing, consulting and analyzing start-up and small-cap companies. His hands-on experience has taught Tyler that the development of a superior business model is the biggest factor in determining a company’s long-term success. Accordingly, his research focuses on assessing the viability of management’s growth strategies, trends in addressable markets and achievement of major developmental milestones.