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The "Secret" Of Successful Biotech Investing Revealed: All You Need To Know In One Chart

Back in March, just before the last parabolic phase of the biotech bubble, we showed something which at the time we thought was quite amazing: of the 150 companies that made up the Nasdaq Biotech Index, only 41 had any earnings. Of these 41 companies, just five companies (Gilead, Amgen, Shire, Biogen and Celgene) had earnings of at least $1 billion each, and the five combined accounted for 83% of all earnings in the entire sector. The combined Net Income of the profitable companies was $21 billion; this compared to a market cap for the NBI of $1.1 trillion, a 50x P/E ratio.

109 companies, or 73% of biotechs, had never made a dime in profit.

We were content with our "amazing" findings... until we ran into a recent note by Convergex' Nick Colas also looking at the biotech sector, which in addition to profitability looked at a very key second dimension, one which we had ignored: 2015 profits.

His finding is nothing short of stunning, and "explains" the "secret" behind biotechs' success.

* * *

While we present the full note in its entirety below, here is the TL/DR version:

What Colas did was first to pull the entire list of companies in the index – currently 144 in total – and ranked them by weighting in the index. The 80/20 rule applies to this group of companies – roughly 20% of the names (18.8% to be exact) made up 80% of the index. 

27 names made Colas' list, 15 are profitable in 2015 (and analysts expect 18 to produce profits in 2016). The balance are in the red through the next year at least. 

Looking at this universe of names, this is what he found:

  • On valuation: for the companies with profits in 2015 and 2016, earnings multiples are 22.3x this year and 19.0x next year. 
  • On growth expectations: analysts expect our sample to show an average of 21.4% revenue growth in 2016.  As with all the other data on this group, however, individual stock results vary a lot.  Wall Street expects as little as negative 1% sales growth for one large company, and as much as 170% for another name inside the top 10. 

And the amazing punchline: equities of companies with actual profits are down 6.8% on the year, while the stocks of loss-making companies are up an average of 46.3%. 

... or shown visually, the scatterplot of biotech earnings vs biotech YTD returns. This is also the chart exposing the "secret" behind biotech investing success: the more cash a biotech company burns, the higher the return it generates.

 

Thank you Federal Reserve for giving us this schizophrenic new normal.

* * *

Here is the full Nick Colas note:

Taking Biotechs to 11

There’s an old joke among equity salespeople on Wall Street that goes something like this:

Question: When do analysts put a “Strong Buy” recommendation on a stock? 

Answer: When it is a “Buy” recommendation that’s dropped 30% or more. 

Like most bittersweet humor, it is funny because it is all too often true. “Strong Buy” is what analysts say when their idea isn’t working but they still like the company management and/or strategy and/or valuation. Now, money managers know that buying a stock as it declines is only for the knowledgeably brave or carelessly foolhardy.  Sell side analysts don’t really see a problem with it…  If I liked it at $50 I better LOVE it at $35, right?

I got to wondering about the Biotech group – specifically the NASDAQ Biotechnology Index – and how analysts were responding to the price volatility in the sector.  To analyze that, we pulled the entire list of companies in the index – 144 in total – and ranked them by weighting in the index. The 80/20 rule applies to this group of companies – roughly 20% of the names (18.8% to be exact) make up 80% of the index.  Attached to this note you will find those name in list form, broken down by analyst recommendation (Strong Buy through Strong Sell) as well as revenue and earnings expectations and related valuation ratios. 

To start with the question at hand – have analysts stepped into the recent drop of 30% since mid-July?  The answer is “No”.  Two months ago, “Buys” and “Strong Buys” were 70% of all Wall Street recommendations on our sample companies.  Now, that number is 69%. Not much difference. The average name has 4.6 “Strong Buys”, up from 4.2 such recommendations 60 days ago, but the number of “Buys” has dropped from 6.2/company to 5.4/company.  

At some level, it is easy to understand the Street’s reluctance to amp up their profile on this group.  The overarching negative is clearly visible and seemingly growing by the day: political focus on drug pricing.  We are, after all, meandering our way into a presidential election year.  Consumers may appreciate the health benefits of new pharmaceuticals, but a few ill-timed and well publicized price increases are apparently too good a crisis to let go to waste.

The deeper issue in analyzing this group, and the one we’ll spend the rest of this note covering, is that it isn’t really a “Group” at all.  Yes, macro issues like drug pricing create the appearance of common fundamental drivers. But the reality is that this “group” trades on individual company fundamentals more than most industries. Consider the following points, with supporting data in the tables attached:

  • On equity price performance: The NASDAQ Biotechnology Index is up 1.5% year to date. Good news: that’s better than the S&P 500, which is still down on the year to the tune of 3.1%.  Bad news: in mid-July it was up just over 30%.
    The price performance for our 80/20 list of 27 names shows a lot of single-stock volatility.  On the plus side, two equities (Anacor and Ultragenyx) are +261% and +117% higher in 2015.  Conversely, three of the 27 are lower by 20% or greater: Mylan (25.1% lower), Jazz (20.0% lower) and Isis Pharma (31.2% lower).  All told, our 27 name sample has a standard deviation of year to date returns of 59%, quite broad for a collection of stocks in one “Sector”. 
  • On profitability: of the 27 names on our list, 15 are profitable in 2015 and analysts expect 18 to produce profits in 2016.  The balance - a third of the list – are in the red through the next year at least. 
  • On valuation: for the companies with profits in 2015 and 2016, earnings multiples are 22.3x this year and 19.0x next year. 
  • On growth expectations: analysts expect our sample to show an average of 21.4% revenue growth in 2016.  As with all the other data on this group, however, individual stock results vary a lot.  Wall Street expects as little as negative 1% sales growth for one large company, and as much as 170% for another name inside the top 10. 

The real kicker: equities of companies with actual profits are down 6.8% on the year, while the stocks of loss-making companies are up an average of 46.3%. 
 
In that last comment is the kernel of a problem that every investor faces when they look at this group.  The biotech sector produces a lot of winning stocks, and the group as a whole has performed extremely well for years. For active investors who may be down more than the 3.1% decline for the market in 2015, the group presents an important opportunity just now. If it can recover from the recent chatter on drug pricing, it could well dramatically outperform into December. And if either the group or the market as a whole continues to swoon, then biotechs will likely have another very noticeable leg down. 

The only other industry group with this “Make the call, right now!’ dynamic is Energy.  It, however, has been pummeled far longer than biotechs and value investors have an easier call there.  But the biotechs have a lot more beta on their side, for good or for bad.  Either way, this is one group every investor will need to consider regardless of their market call. 

To return to that old saw from the top of this note, the group isn’t a “Buy” or “Sell” here – it is either “Strong Buy” or “Strong Sell”.