3 Warning Signs the Biotech Rally May Be Over

The biotech sector has been creamed over the past couple of sessions. Have you been ignoring these three biotech bubble warning signs?

Mar 25, 2014 at 12:10PM

Yes, despite contrary belief, biotech stocks can actually go down just as they've been going up, and up, and up some more over the past couple of years.

Friday's tumble in the SPDR S&P Biotech ETF on the heels of congressional probing into the pricing practices of select drugs, including Gilead Sciences' Sovaldi, which amounts to a cost of $84,000 per year, set off a chain reaction that brought high-flying biotech stocks of all market caps to the deck. Over just the past four trading sessions, the SPDR S&P Biotech ETF has lost a whopping 9.3% of its value -- and this could be just the beginning.

Lab Eli Lilly

Source: Eli Lilly.

We've been given plenty of warning signs for months that a sizable correction could be in the offing in the biotech sector, but investors have largely ignored those warnings. Now it appears a biotech correction could be rearing its head. Here are what I believe to be three reasons the biotech rally may be over.

1. Post-IPO valuations make little sense.
We needn't look very far for a reason to scratch our heads if we more closely examine biotech IPOs over the past year.

In 2013, there were 38 total biotech IPOs with the group gaining an average of 43% for the year! Some have deserved their beefy gains, such as Five Prime Therapeutics, which just last week signed a collaborative deal with Bristol-Myers Squibb allowing the big pharma giant to access its exclusive immune-oncology platform in exchange for $20 million in upfront cash, $9.5 million in research funding, a $21 million common equity investment, and as much as $300 million in development milestone payments.

Many, though, made less sense. Take Prothena (NASDAQ:PRTA), which debuted in late Dec. 2012 and has proceeded to barrel from as low as $5.84 per share to more than $49 intraday last week. Prothena has delivered some exciting developments, including licensing its preclinical Parkinson's disease drug to Roche for $45 million. But, it ultimately has just one clinical phase study ongoing with systemic amyloidosis drug NEOD001, and even that's just in phase 1. Added up, that's two preclinical studies and one phase 1 study currently ongoing, yet Prothena ended last week with a valuation of $1 billion. To me, that makes very little sense!

2. Acquisition valuations are also reaching.
In addition to frothy-priced IPOs, big pharma has been reaching more and more to find growth opportunities both domestically and overseas. Knowing this all too well, small- and mid-cap biotechs are demanding hefty premiums from big pharma, and getting them!

There have been numerous reaches in the past year, but none stand out more than Perrigo's (NYSE:PRGO) purchase of Elan and Actavis' (NYSE:AGN) recent purchase of Forest Laboratories (NYSE:FRX).

On the surface, I completely get why Perrigo purchased Elan for $8.6 billion last year -- it wanted to incorporate in Ireland and take advantage of considerably lower corporate tax rates there, which would allow it to add to its profits. But, Perrigo paid an enormous premium for a shell of a company that had essentially sold its only marketable therapy for $3.25 billion in cash to Biogen Idec, and that didn't have much going on in its pipeline to begin with. The way I look at it, Perrigo gave up $2 to get $1 plus tax breaks in return.

Something similar can be said for Actavis, which agreed to acquire Forest Labs for a hefty $25 billion in a cash and stock deal. Based on Forest's current product portfolio, the deal might make a shred of sense, but given that the patent of its Alzheimer's disease drug Namenda, which accounted for close to half its total revenue in the latest quarter, is set to expire in 2015, the deal has all the makings of "cross your fingers and hope for the best."

M&A activity is bullish in that it signifies a business' willingness to take on risk, but I think that the risk being absorbed by acquiring companies is simply too large to ignore anymore.

Images

Source: Sara Hughes, Flickr.

3. Investors are counting their chickens before they've hatched.
Perhaps no company has been a better poster child for this than Intercept Pharmaceuticals (NASDAQ:ICPT). Shares of Intercept have leapt 437% since the year began, following the release of phase 2 data from its FLINT trial involving obeticholic acid (OCA), a therapy for nonalcoholic steatohepatitis (NASH), which is a liver disease that can result in cirrhosis or liver cancer, that was stopped early by an independent data monitoring committee for highly statistically significant efficacy. Because some six million people in the U.S. may have a severe form of this debilitating condition, the moat of opportunity for Intercept is huge. Adding to OCA's recent fame, its phase 3 POISE trial for the treatment of biliary cirrhosis of the liver also hit its primary endpoint last week.

However, investors are placing a lot of faith in OCA -- a $7.2 billion market valuation, to be exact -- despite ongoing questions about the long-term safety of the drug, which independent researchers are currently reviewing. What I find even more mindboggling is that we don't even have the full data set from the FLINT trial yet! It isn't even scheduled to be released by Intercept until July. So while investors ponder OCA's blockbuster status, we're not even sure how effective and safe the therapy actually is.

These biotech bubble warning signs have been evident for months; now it just remains to be seen if this dip over the past couple of days turns into a full-blown correction, or if we again shake off these warning signs and head higher.

Biotech stocks have soared over the past year, but there's a good chance many will struggle to keep up with this top stock in 2014
There's a huge difference between a good stock and a stock that can make you rich. The Motley Fool's chief investment officer has selected his No. 1 stock for 2014, and it's one of those stocks that could make you rich. You can find out which stock it is in the special free report "The Motley Fool's Top Stock for 2014." Just click here to access the report and find out the name of this under-the-radar company.

Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.

The Motley Fool recommends Gilead Sciences. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

1 Key Step to Get Rich

Our mission at The Motley Fool is to help the world invest better. Whether that’s helping people overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we can help.

Feb 1, 2016 at 4:54PM

To be perfectly clear, this is not a get-rich action that my Foolish colleagues and I came up with. But we wouldn't argue with the approach.

A 2015 Business Insider article titled, "11 websites to bookmark if you want to get rich" rated The Motley Fool as the #1 place online to get smarter about investing.

"The Motley Fool aims to build a strong investment community, which it does by providing a variety of resources: the website, books, a newspaper column, a radio [show], and [newsletters]," wrote (the clearly insightful and talented) money reporter Kathleen Elkins. "This site has something for every type of investor, from basic lessons for beginners to investing commentary on mutual funds, stock sectors, and value for the more advanced."

Our mission at The Motley Fool is to help the world invest better, so it's nice to receive that kind of recognition. It lets us know we're doing our job.

Whether that's helping the entirely uninitiated overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we want to provide our readers with a boost to the next step on their journey to financial independence.

Articles and beyond

As Business Insider wrote, there are a number of resources available from the Fool for investors of all levels and styles.

In addition to the dozens of free articles we publish every day on our website, I want to highlight two must-see spots in your tour of fool.com.

For the beginning investor

Investing can seem like a Big Deal to those who have yet to buy their first stock. Many investment professionals try to infuse the conversation with jargon in order to deter individual investors from tackling it on their own (and to justify their often sky-high fees).

But the individual investor can beat the market. The real secret to investing is that it doesn't take tons of money, endless hours, or super-secret formulas that only experts possess.

That's why we created a best-selling guide that walks investors-to-be through everything they need to know to get started. And because we're so dedicated to our mission, we've made that available for free.

If you're just starting out (or want to help out someone who is), go to www.fool.com/beginners, drop in your email address, and you'll be able to instantly access the quick-read guide ... for free.

For the listener

Whether it's on the stationary exercise bike or during my daily commute, I spend a lot of time going nowhere. But I've found a way to make that time benefit me.

The Motley Fool offers five podcasts that I refer to as "binge-worthy financial information."

Motley Fool Money features a team of our analysts discussing the week's top business and investing stories, interviews, and an inside look at the stocks on our radar. It's also featured on several dozen radio stations across the country.

The hosts of Motley Fool Answers challenge the conventional wisdom on life's biggest financial issues to reveal what you really need to know to make smart money moves.

David Gardner, co-founder of The Motley Fool, is among the most respected and trusted sources on investing. And he's the host of Rule Breaker Investing, in which he shares his insights into today's most innovative and disruptive companies ... and how to profit from them.

Market Foolery is our daily look at stocks in the news, as well as the top business and investing stories.

And Industry Focus offers a deeper dive into a specific industry and the stories making headlines. Healthcare, technology, energy, consumer goods, and other industries take turns in the spotlight.

They're all informative, entertaining, and eminently listenable ... and I don't say that simply because the hosts all sit within a Nerf-gun shot of my desk. Rule Breaker Investing and Answers contain timeless advice, so you might want to go back to the beginning with those. The other three take their cues from the market, so you'll want to listen to the most recent first. All are available at www.fool.com/podcasts.

But wait, there's more

The book and the podcasts – both free ... both awesome – also come with an ongoing benefit. If you download the book, or if you enter your email address in the magical box at the podcasts page, you'll get ongoing market coverage sent straight to your inbox.

Investor Insights is valuable and enjoyable coverage of everything from macroeconomic events to investing strategies to our analyst's travels around the world to find the next big thing. Also free.

Get the book. Listen to a podcast. Sign up for Investor Insights. I'm not saying that any of those things will make you rich ... but Business Insider seems to think so.


Compare Brokers