Are Biotechs Overvalued?

U.S stocks are marginally lower on Monday morning, with the benchmark S&P 500 and the narrower Dow Jones Industrial Average (DJINDICES: ^DJI  ) down 0.38% and 0.48%, respectively, at 10:18 a.m. EDT. This week is relatively light in terms of economics data, but earnings season rolls on. Today's most anticipated results are those of streaming video and television service Netflix, which reports after the market close. There has been much debate concerning whether Netflix is overvalued, but the Federal Reserve expressed more concern about overvaluation in the social media and biotechnology sectors in its biannual monetary report last week. That warning appears to have taken its toll on the latter sector, with the Financial Times reporting on Sunday that investors have pulled $445 million from the iShares Nasdaq Biotechnology ETF (NASDAQ: IBB  ) so far this month, or roughly 9% of the fund's net assets. That means the fund has now suffered a net outflow year to date to the tune of $77 million, compared to a net inflow of $747 million in 2013.

There were two "offending" passages in the Fed's report. The following is the more broad characterization (my emphasis):

Equity valuations of smaller firms as well as social media and biotechnology firms appear to be stretched, with ratios of prices to forward earnings remaining high relative to historical norms.

The Fed believes the worst excesses are at the intersection of these two groups, where valuations appear "substantially stretched" versus plain "stretched" (my emphasis):

Nevertheless, valuation metrics in some sectors do appear substantially stretched -- particularly those for smaller firms in the social media and biotechnology industries, despite a notable downturn in equity prices for such firms early in the year.

That sounds reasonable enough, if you accept the initial premise that each group, separately, is already stretched. Not everyone does, however.

Last week, ISI Group biotechnology and pharmaceuticals analyst Mark Schoenebaum penned an open letter to Fed Chairwoman Janet Yellen, disputing the central bank's evidence:

You stated that biotechnology valuations are "stretched, with ratios of prices to forward earnings remaining high relative to historical norms." I just gathered biotech price to earnings ratios back to 1993 using Russell 1000 data, and my data show that the current ratio is roughly in-line with the historical median and is approximately 80% below the peak. Please tell me what I'm missing, Dr. Yellen.

Note, however, that Schoenebaum does not argue that biotechnology stocks are not overvalued, simply that the Fed's supporting statement that price-to-earnings multiples in the sector are high relative to historical norms is inaccurate. In an email to clients, he clarified his position:

I'm not arguing that biotech is "cheap." Rather, I'm arguing that there is little empiric evidence to support the conclusion that we are in a valuation "bubble."

By and large, as a value-driven skeptic, I would tend to side with the Fed in this debate. It's my understanding that the biotechnology sector has reliably destroyed tens of billions of dollars of shareholder value over decades -- the high-technology equivalent of airlines. However, I was surprised to find that the Nasdaq Biotechnology Index has produced a 13.5% annualized price return over the 10-year period ending June 30, which compares very favorably with the S&P 500's 5.6% return (dividends wouldn't come close to making up the difference). Furthermore, Schoenebaum's graph shows that the biotechnology sector sported a higher price-to-earnings multiple at the start of that period than it does now.

Nevertheless, while the sector as a whole may not be overvalued, individual biotechnology stocks -- particularly small caps -- are speculative. That doesn't rule them out of your portfolio per se, but no one should ignore that situation.

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