With all the signs of froth and uncertainty in the market, one sector stands above the rest.
Biotech stocks are poised for a 30% overall gain year to date, on pace to roughly triple the gains of the broader market.
This comes after just under 70% gains in 2013 and a massive bull run that makes the post-recovery gains of broad indices seem tame.
Just check out the five-year run of the iShares NASDAQ Biotechnology Index (NASDAQ: IBB) compared to the S&P 500 and Nasdaq Composite:
So is this a blatant sign of irrational exuberance at its worst, or a signal of growing strength with the legs to outperform in 2015 as well?
If only it were that simple. What we do know is that the market as a whole is uncertain which way the sector will go, no matter what, investors will have to go along with what it decides.
Let’s pull this issue apart and look at what 2015 will bring to biotechnology stocks.
Mixed Signals
Sticking with IBB as a proxy for the sector as a whole, two recent events shed some light on biotech at large.
First we had a meltdown and correction occur early in the year. March through mid-April the ETF slide saw a near 19% drop. The S&P 500 traded flat.
Then, during the October market sell-off, biotech basically kept pace with the decline in indices. Once the short-term pattern broke, biotech came roaring out of the gate with far larger gains.
Back in March and April, it was tepid job reports, fears of global economic slowdown led by China, and warnings on slowing corporate earnings.
Then in October… it was basically the same thing. Change the dates, quote a slightly different leading economic indicator, and you reverse the situation.
This touches on a truth in investing that is often overlooked. Anyone looking solely at a sector as a whole is making a mistake.
Without looking at individual companies and hard data (stock prices don’t count), you’re only gauging investor sentiment.
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, as 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 trends in biotech in 2015 even if it is unwarranted for exceptionally healthy and successful companies.
If the bullish mentality persists, a handful of temporary corrections that test the 50-day moving average are virtually guaranteed with the overall market-beating trend remaining in place.
As of today, returning to the 50-day moving average would represent a 6.55% drop, so a test of support or a couple day breach of it would represent a 5-10% paper loss that disappears within a couple weeks.
If the bears take the reins, we can expect biotech to go straight to the 200-day moving average, as it almost did in October. That would represent slightly more than a 14% drop today.
If that is breached and biotech as a whole goes beyond a 15% loss, a whole lot of money will start moving out of ETFs and individual stocks.
If you prefer to invest in biotech using only the major companies’ shares or ETFs in 2015, I strongly suggest keeping a trailing stop limit of no more than 15%.
Even if you’re not too big on biotech, any bottom that forms after a 15% decline represents a great buying opportunity.
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.
Two well-respected Morgan Stanley analysts (one is a former heart surgeon) did this and released a note to clients (emphasis added):
Major de-risking events leading to new mega blockbusters have transformed the Big 4 Biotechs (Amgen, Biogen, Celgene and Gilead). We expect total group revenues to double from $175B over the last 5 years to $335B over the next 5 years and total cash flows to triple from $31B to $95B.
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.
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, mean 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.
Coupled with the unquantifiable greed and its potential to turn into fear and free-falling share prices in the sector, and it opens up a clear path on how to play biotech in 2015.
Go Small Before They Go Big
The opportunity can be summed up as “following the big guys.”
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.
At the same time, individual investors tend to avoid them by making the same mistake mentioned earlier, lumping all the companies in a sector into the same category.
Meanwhile, for investors willing to do their research, there are a slew of reasonably priced companies with incredible potential that have flown under the radar.
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.
Or you could look for small companies working on innovative device designs.
For example, the U.S. Army just covered the entire cost of clinical studies for a small device that promises to revolutionize treatment of PTSD and traumatic brain injuries. It can also potentially help people with neurological damage or degenerative conditions.
All told, the company could help alleviate the symptoms of diseases and conditions affecting 140 million people, and which cost $950 billion per year.
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 revenue and cash flow in the sector that won’t dry up based on stock prices.
And in 2015, you’ll be hard pressed to find a better way to profit while coasting through the uncertainty that will face biotech as a whole.
