On Wall Street, last year’s winning sectors are often this year’s losers. That maxim could be tested in 2013 by biotechnology stocks, which last year gained a whopping 41.7%, as measured by the NYSE Arca Biotech Index. Other biotech-focused indexes gained from the low-30% to low-40% range.
But according to some people who follow the industry, the factors that drove those stellar gains remain in place. And barring a directional shift in the market, further upside could be in the offing.
Credit for the strong gains in 2012 goes to a reinvigorated Food & Drug Administration. “The agency received a higher level of funding in 2012, so it was able to approve more drugs,” says Steve Silver, a biotech industry equity analyst for S&P. In fact, 30 new drugs were approved in 2012, up from 21 in 2011. The agency had been accused of a slow-moving and mercurial approach to drug approval in prior years, but investors now look to the FDA to maintain a more robust—and predictable—slate for drug approvals.
But not all drug makers are being lifted by the rising tide. “Big pharmaceutical companies continue to lose patent protection for key drugs and must keep acquiring smaller biotech firms to replace lost revenue streams,” Silver says.
And the fact that biotech firms tend to target more novel approaches to disease than their Big Pharma peers is another key factor in their recent strong performance, according to Ryan Issakainen, who oversees the First Trust NYSE Arca Biotechnology Index ETF (FBT). “These biotechs make more complex drugs and should be less exposed to patent issues,” he says.
The fund’s underlying index focuses on the cutting edge of biotech development. For example, two of the top ten holdings focus on DNA sequencing firms Sequenom (SQNM) and Illumina (ILNM). The index “steers clear of the younger and riskier speculative biotechs” says Issakainen, adding that the portfolio is re-balanced every quarter (so that each holding is roughly 5% of the portfolio) to prevent it from becoming hostage to overvaluation of any one particular name.
Morningstar gives the fund four stars, noting that this ETF “is a great, low-cost way to gain diverse exposure to the biotech sector in one trade.” The 14% annualized return over the past five years comes with a fairly high degree of volatility, which is why Morningstar slaps a high-risk rating on the ETF. The 0.6% expense ratio is among the higher-end expense loads in this peer group.
FBT was up 6% this year as of Friday’s market close.
Large-cap biotechs fared especially well in 2012 after several years of underperformance relative to smaller biotech stocks and traditional drug companies. The gains “appear correlated with improved visibility into pipelines and long term growth potential,” Merrill Lynch’s Rachel McMinn noted in a report.
Merrill’s McMinn said that “oncology has been and we expect will continue to be a keen area of licensing/M&A interest to the pharmaceutical industry.”
Van Eck entered the fray in December, 2011 with an approach it believes differentiates itself in this increasingly crowded ETF niche. “We wanted to focus on the industry leaders, and also sought to price it with a low expense ratio (of just 0.35%)” says Brandon Rakszawski, product manager at Market Vector ETFs.
The Market Vectors Biotech ETF (BBH) owns the industry’s blue chips and eschews any companies that have yet to build a broad-based drug portfolio. The recent top five holdings—Amgen (AGMN), Gilead Sciences (GILD), Biogen Idec (BIIB), Celgene (CELG), and Regeneron Pharma (RGEN)—have a collective market value exceeding $200 billion. The fund got off to a roaring start by rising more than 47% in its first year of existence, plus another 6% so far in 2013.
The iShares Nasdaq Biotechnology (IBB) is the most popular ETF in the sector, with more than $2 billion in assets under management and more than 500,000 shares traded daily. The ETF takes a highly diversified approach, holding more than 100 stocks from the Nasdaq biotech index. Each holding has a market value of at least $200 million. Roughly one-fifth of the portfolio is dedicated to early-stage developing biotechs, which helps to capture upside when the sector’s off-the-radar upstarts strike gold with either an FDA approval or a buyout.
Still, nearly three-fourths of the fund is earmarked towards mid-sized and large biotechs, which helped this portfolio in 2008 when the market was tumbling. The ETF slipped just 12% that year, and has risen at a double-digit clip in subsequent years, leading to an 11% annualized gain over the past five years. The 0.48% expense ratio is in the middle of the pack. Like with the first two funds, IBB was up 6% this year as of Friday.
Merrill Lynch’s McMinn notes that smaller biotech firms failed to participate in the broader industry rally in 2012, and they now sport lower valuations as a group. She’s a bit cautious on further gains for the industry’s big players, and spots a rotation coming. “As we look to 2013, we see some pressures on multiples in more expensive growth stocks and potential for multiple expansion in cheaper stocks with improved pipeline visibility,” she wrote in her report.