What Will Herald the End of the Biotech Boom?


"The truth is, I don't think there's a coming crash for the biotech sector—at least not in the near-term. But reasonable arguments can be made that we're in for a big reversal, and one of the keys to successful investing is to consider the other side of a trade."

We've had quite a run. Just pick your window into the biotech sector and the gains have been astronomical. As I write, sector ETF iShares Nasdaq Biotechnology (IBB) is up 214 percent since the beginning of 2012, while the blue-chip weighted NYSE Arca Biotechnology Index has done even better—up 238 percent. For the past two years, biotech has virtually been a can't-miss investment.

But as legendary investor John Bogle said, "Reversion to the mean is the iron rule of the financial markets." That alone is reason enough for savvy investors to eye the biotech sector with a little caution as we go into 2015. If what goes up must come down, we've got quite a way to fall.

The truth is, I don't think there's a coming crash for the biotech sector—at least not in the near-term. But reasonable arguments can be made that we're in for a big reversal, and one of the keys to successful investing is to consider the other side of a trade. Whether you're feeling bullish or bearish on the sector, here are some things to consider:

1. The peak of an IPO window often signals trouble ahead.

686 IPOs raising $32.6 billiion
Source: Stelios Papadopolous

It's reasonable to conclude from this chart that when the IPO market is absolutely dead—1985, 1989, 2003, 2009—it's a great time to buy. Just consider: 2003 marked the nadir before a bull market than ran until 2007; the current boom can be traced back to a bottom in 2009 that hasn't really paused since. It's a little harder to talk about biotech in the 1980s because the industry was so small then, but if you use Amgen for a proxy, 1989 marked the beginning of a run that saw the stock increase more than 10-fold in value over the following three years.

So if a dead IPO market is a buy signal, at least for the patient, what about a robust one? It's not quite as clear. The "genomics bubble" peak in 2000—which we've now far surpassed in terms of the number of IPOs in a single year—can clearly been seen in retrospect as a good time to get out. Likewise 1992, if we use bellwether companies like Amgen or Biogen Idec as a proxy. But the peak of IPO activity in 1996? It was followed by a great period in the market at large and a merely sideways period for biotech stocks, which picked up again as we moved closer to the end of the century. So take the zenith of an IPO window as a yellow flag, but nothing definitive.

2. Yeah, but are biotech IPOs really about to drop off sharply?
It's an easy prediction to say that we've hit the peak of the recent IPO boom—2014 is a tough act to follow—but that doesn't mean the window is closing. You could argue, on the one hand, that there just aren't that many more companies ready to go public, but "ready" is defined by the market. The usual death throes of an IPO window typical include a parade of progressively weaker companies making their debut. And it's notable that 41 percent of the 79 biopharma IPOs in 2014 were early-stage companies with programs no more advanced than phase 1—a big jump from 2012 and 2013.

Beyond that stat, however, the shoe doesn't really fit. We've seen many early stage companies that nevertheless are backed by some pretty impressive clinical data and have a good shot at an accelerated path to market—think Bluebird Bio (which actually went public in 2013), Kite Pharma, Sage Therapeutics, or (technically mid-stage) Zafgen. We've also seen a remarkable phenomenon in the likes of Juno Therapeutics, which was founded in late 2013, raised a huge sum of money, and went public at the end of last year...and plans to have 10 candidates in clinical trials by the end of this year. The number of companies ready to go public is, to some extent, a function of creativity, available capital, and demand for new issues. So it's hard to say that there simply aren't enough more waiting in the wings. And I'd argue that the quality of this window is better than, say, the class of 2000.

3. Does the investing public need this many IPOs?
Actually, yes. The truth is that we've gone through a long, long drought. From 1980-2000, an average of 311 firms went public every year across all industries, according to data from the University of Hong Kong and the University of Florida. In 2001-2011, that dropped to an average of 99. The drop off was even more pronounced for smaller, lower revenue companies (e.g. most new biotechs). The last couple years have been an encouraging rejoinder to the cries that regulations like Sarbanes-Oxley "broke" the IPO market.

Keep in mind, though, that one of the things driving the biotech sector right now is a strong generalist interest—just look at Jim Cramer making biotech a regular feature of his Mad Money program. These investors are more likely to get spooked at bad news or changing momentum and thus create more volatility.

If I had to guess, I'd say the period we're in now is a whole lot more like 1996 than it is 2000. We'll see an inevitable slowdown in both the number of biotech IPOs and sector stock market returns, but it should be a gentle landing that sets the stage for more positives ahead. Perhaps the biggest change is that you won't be able to win just by throwing darts—there are certainly some companies out there making amazing progress that will be rewarded in the year ahead, but they're likely to see those gains coming against a backdrop of greater volatility...and a fair crop of losers.

Karl Theil

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