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.”