Over the past year or so, biotech stocks have taken one hell of a hit.
From a peak on July 17, 2015, the NASDAQ Biotechnology Sector Index fell over 37% to hit a level on June 24, 2016 that it first breached in the beginning of 2014:
We should keep that in perspective though.
Since the massive correction from the Great Recession ended in March 2009, the biotech index has absolutely crushed the rest of the market.
Here is how it looks compared to the NASDAQ Composite and S&P 500:
That’s right, it beat the NASDAQ Composite by 83.6% and the S&P 500 by 175.6%.
Even though the biotech remains down about 14% for the year, a bottom seems to be in the past, with about a 12% rise in the third quarter.
So how can we work this to our advantage, and what does 2017 have in store for the sector? Let’s dive in…
The Big Picture Caveat
First let’s get something out of the way here that absolutely needs to be mentioned.
A simple truth in investing that is often overlooked when it comes to individual sectors: At a certain point, it doesn’t matter how good the companies in a sector perform.
Biotech as a whole is facing the same uncertainty as the broader market, with the potential for even greater gains or losses than you’d see in more stable sectors.
Correlation across sectors remains very high, and investors process economic news in consistently chaotic and irrational ways. Disciplined investors aren’t at the helm.
With this in mind, we can expect overall investor sentiment to define overall trends in biotech in 2017 even if it is unwarranted for exceptionally healthy and successful companies.
If the bullish mentality persists we’ll see a broad bull market in biotech that lifts all adequately performing mid- and large-cap stocks.
If the bears take the reins, we can expect the NASDAQ Biotechnologies Index and biotech ETFs to go straight back down through the 200-day moving average they crossed above in late July 2016.
The problem with a bearish market is you don’t know how quickly it will evolve and how investors will behave. We know when it happens a whole lot of money will start moving out of the market, but it is extremely difficult to time.
Watch the Big Companies
After the caveat of fear and greed in the market and sector, here is how I prefer to look at the big biotech picture: I focus on the big four companies — Amgen, Biogen, Celgene, and Gilead — for forward indicators.
It isn’t that I find these stocks particularly appealing, although they all have their strengths. I like them because they provide insight into how the sector will act going forward.
These companies wield enormous power over the biotech sector through their ability to straight out buy any small biotech company they want.
Every company has its own expertise, development cycles, and potential returns. Biotech stocks simply cannot be evaluated like “normal” stocks.
Biotech companies with promising medical devices or pharmaceuticals in the pipeline can bleed money until their products come to market, which can take up to a decade. Once the product comes to the market, all of the pent up potential explodes, along with share prices.
Will all of the small companies focusing on a single product succeed? Of course not, but the ones that do will perform exceedingly well.
The extra revenue, and in particular the extra cash flow, means that the big four can go out and snap up the best small biotech companies with drugs and devices poised for FDA approval.
They can also throw more into their in-house R&D and pay small fortunes to small companies with critically important patents, whether they show promise, or present a barrier for similar projects.
Go Small Before They Go Big
2017 will pose a challenge for the big four. Drug price controversies, reverse merger penalties or outright bans, continuously ballooning medical costs, and a host of other problems are weighing on the big picture.
However, the constant need for new patent-protected drugs, treatments, and devices is insatiable.
The opportunity we’re looking at now can be summed up as “following the big guys.” While the big four see their upside limited by sector uncertainties, the companies they will pursue with lucrative business agreements or flat out acquisitions will not.
Plus, small biotech companies tend to be ignored by large institutional investors who don’t want to waste time on smaller positions, or simply cannot according to the rules of their company, ETF, or mutual fund.
That means they tend to trade with less correlation to the broader market, and purely on the potential of their research and development.
For investors willing to do their research, there are a slew of reasonably priced companies with incredible potential that have flown under the radar.
Two Examples
For pharmaceuticals, instead of going for all-or-nothing plays with just one or two drugs in development, you can follow Big Pharma‘s money right into companies that hold patents and control the supply of crucial ingredients for testing a massive new class of drugs being developed.
A notable example of these kinds of companies is Stellar Biotechnologies (NASDAQ: SBOT).
The company holds patents for sustainable production of keyhole limpet hemocyanin (KLH). In plain English, it is the only company that has figured out a non-lethal way to extract an incredibly valuable protein from shelled sea creatures that were rapidly disappearing from the Pacific Northwest.
This protein has irreplaceable qualities, and a very unique way of stimulating the human immune system.
A massive wave of new pharmaceuticals are being tested now. KLH can be used as an active pharmaceutical ingredient and combined with a disease-targeting agent to create immunotherapies targeting cancer, immune disorders, Alzheimer’s disease, and inflammatory diseases.
Stellar Biotechnologies has been in and out of the news, with share price surges that coincide with investor attention. However, it mostly operates behind the scenes from an investor perspective.
The same can’t be said for the companies that will need to rely on KLH to complete preclinical and clinical testing of their next big blockbuster drugs.
The odds are good that one of the big four will try to monopolize Stellar’s production with a very lucrative exclusive deal going forward.
With a $21 million market capitalization, any major announcement will send shares soaring again.
Or you could look to a mid-sized company like Inovio Pharmaceuticals, Inc. (NASDAQ: INO) as an example of a company with a strong portfolio of pharmaceuticals and devices moving through the approval pipeline.
Inovio could easily be a takeover target, as it is relatively small with $680 million market cap, yet is large enough to forge ahead and sell its products if and when they are fully approved.
Inovio has been developing DNA immunotherapies and vaccines focused on treating and preventing cancers, Hepatitis viruses B and C, HIV, the flu, Ebola, MERS, and Zika.
The company targets specific DNA sequences to produce immunity in healthy cells, or allow the immune system to target cancerous cells.
Coupled with the needle-less injection device Inovio has developed, called the Cellectra 5PSP Intramuscular Electoporation Delivery Device, it is sitting on one of the most promising packages of immunotherapy systems on the horizon.
These are the types of plays that dodge the irrational exuberance of the markets and uneducated masses of investors chasing past gains, and instead capitalize on what the big four, and biotech sector as a whole, need to drive future profits and growth.
And in 2017, you’ll be hard pressed to find a better way to profit yourself, while coasting through the uncertainty that will face the market as a whole.
