Breaking Down Biotech's Bloodbath: Which Companies to Buy

Biotech stocks may have fallen sharply in the past few months, but that doesn't mean that every one of them should be avoided. On this Industry Focus episode, we uncork some of our best ideas for investors to buy.

A full transcript follows the video.

Michael Douglass: Unpacking the big opportunity in biotech's bloodbath... this is Industry Focus. Hi, Fools! Healthcare analyst Michael Douglass here today. Those of you who were expecting to hear Kristine, I am sorry. She is on vacation and I am filling in, so get ready for some vocalized pauses. But I'm joined by Todd Campbell, our regular contributor here on Industry Focus. Todd, great to have you.

Todd Campbell: Happy to be here. It's good to see you back in the seat, at least for this week.

Douglass: You're very kind. Hopefully, not our only encore performance of the original Industry Focus healthcare team, but we'll see how that goes.

Today, I wanted to talk a bit about biotech. Biotech has had a rough couple of months. The IBB is down 20%. Is that right, Todd?

Campbell: 21% since July.

Douglass: That's one of your major biotech indices. Those of us who follow healthcare very closely and invest heavily, our portfolios are suffering. Mine certainly is. I don't know about yours, Todd.

Campbell: I'm taking it on the chin as well. It's a long-term thesis so we're going to stay with it, right?

Douglass: Exactly. I think that's one of the big things. In today's episode, we're going to talk about why biotech has been down, then segue into what a long-term investor should do, and then talk about a couple stocks that are on our radar, particularly because they and the broader industry are on sale. Let's start with "Why?" IBB doesn't drop 21% in three months for nothing. What have been the main causes, Todd?

Campbell: There are a couple things [...] everybody has been talking about whether or not there's a bubble forming in biotechnology. There's no question that, in the wake of Obamacare and getting insurance and getting access to medicine -- in the wake of an aging population -- there's a lot more demand. At the same time, technology is advancing very rapidly. You're getting increasingly complex and potentially more effective drugs.

That's gotten people excited about the opportunities that are out there for healthcare, and as a result, a lot of these stocks doubled over the course of the last two years. This has been a very "hot place" for investors to be focusing their attention. However, as you mentioned, it's recently fallen off a cliff. Why? I think you can't really say that one particular thing is to blame. I think this is more the excuse that finally got people to say they had too much risk exposed in the industry and should rein it in.

A few weeks back, there was a very high-profile article in The New York Times highlighting how one company went out and bought this drug that's been around for 60 years and then increased the price by 4000% without doing anything to improve the drug. That was held up as saying, "What is going wrong? Something needs to change." That then led to Hillary Clinton coming out saying that she was going to do better at controlling and curbing costs. It's definitely been a news-heavy couple of months and a lot of that news heaviness has centered on the pricing of medicine.

Douglass: That, of course, makes investors nervous because at the end of the day, if these biotechs are going to make money, they're doing it because they take the risk, they have these drugs, a vast majority of phase 1 drugs fail, they take these drugs through these increasingly expensive trials and take on all that risk. There's often lots of failures, and then they command premium pricing for those that end up getting to market.

Maybe not all of them, but many of them. Suddenly, I think in a lot of people's minds it calls into question the business model. I think the key question is: Is this a bit overdone? First off, on a broader sector basis and then with the fact that any adjustments would affect different companies differently.

Campbell: Yeah. Larger-cap companies are going to fall less than smaller-cap companies. You've got companies that have drugs already on the market that are going to fall less than companies that are in clinical stages and are still researching those drugs. To your point earlier, anyone who has listened to you and I chat about this industry in the past, we've said over and over that 90% of drugs that go into human trials never make it to market.

Only 10% make it to market. Studies show that it can cost $1 billion or more to bring a drug all the way through clinical trials to commercialization. There's a lot of risk that's being taken on. For biotech investors and pharmaceutical investors and pharma investors, the ability to monetize that risk is what leads to earnings growth and rewards investors over the long run.

Douglass: Right. I'm not going to say that it's been a total drop because there are some companies that have actually increased in market value in the healthcare space, even throughout these last couple of months. With that said, it's been a general malaise. We were talking before the show about the number of larger caps that are falling 15% and 17% and 20% all clustered together in terms of how much they've fallen.

Given that, I think the key question that should be asked is: With this broad, sectorwide sell-off, what great business models have been thrown out along with less optimal ones? Which babies have been thrown out with the bath water? What's an attractive large-cap company for beginning investors in healthcare that's on your radar because it's been beaten down so much?

Campbell: I know one that you're going to talk about.

Douglass: It couldn't be Gilead Sciences (GILD -0.56%), could it?

Campbell: It may just be Gilead Sciences. You and I have talked a lot about this company ever since they came out with what was a revolutionary hepatitis C drug at the end of 2013. It's an impressive company generating a tremendous amount of cash and a lot of earnings. Quite frankly, I have a hard time believing that buying at these prices isn't going to be a smart move long term for investors.

Douglass: Gilead is trading at -- going with adjusted earnings as opposed to the GAAP EPS -- with adjusted earnings Gilead is trading at 8 times next year's estimated earnings. We don't really see that valuation much in healthcare. With the broader market valued in the teens, it's hard to imagine that a company that's had such tremendous growth and has such strong hepatitis C and HIV market share, and they're the Goliath in both of those spaces -- they're selling at such a discount.

Campbell: People have been betting against Gilead as far as their market share in hepatitis C for a while now, thinking that AbbVie is going to come in and steal away market share. Merck is going to come in and steal market share. Bristol-Myers is going to come in and steal market share. However, that hasn't materialized. Instead, any competition resulting in lower price has actually been a good thing because more patients are now being treated, resulting in greater top-line sales growth.

With Gilead just coming out late last month reporting that their scanned genotype next-generation hepatitis C drug had cure rates of 99%, it's hard to believe that this isn't going to be an industry leader, at least within this market. When you're looking at paying 8.5 times forward earnings, it's almost like you're getting the dominant position in HIV treatment for free.

Douglass: That's a good way to put it. Let's get off my particular hobby horse. What's another large-scale company? For a retail investor, the sort of person who might not be interested in getting really in the weeds, but wants something with broad exposure and has been down in the double digits?

Campbell: There are two companies that jump out at me that are intriguing. I own Celgene (CELG) -- which is one of them. Celgene is down 15% since July, it's a Goliath in multiple myeloma treatment, it's got a new autoimmune disease drug that's growing very quickly, it's got a lot of different irons in the fire that continue to kick out new drugs. One of the things people need to remember is the payer pushback -- granted, no one wants to pay more for cancer drugs than they were 10 years ago. But these drugs are very effective.

It's kind of like what we saw with hepatitis C. If you can create more effective drugs that reduce other costs later down the road like hospitalization or relapses in cancer cases, then you can get premium pricing and insurers will be willing to pay for it. I wouldn't steer away from Celgene solely because it's involved in cancer. The other large company that I think is intriguing is Pfizer (PFE -1.05%).

Pfizer took it on the chin when it lost patent protection of Lipitor a few years ago, but the sales have now stabilized and their purchase earlier this year of Hospira, which is a leader in biosimilars, could be transformative. If you're concerned about drug pricing, then ramp up the pace of approval for biosimilars. If that ends up happening, then Pfizer stands to benefit.

Douglass: For those who are less familiar, biosimilars are essentially generic forms of biologic drugs. You've got two types of drugs: small molecules and biologics. Biologics are more difficult to duplicate. In fact, you can't precisely duplicate them, which is why they're called biosimilars and not...

Campbell: Bio exacts.

Douglass: Bio exacts. There it is. We'll just call it that. Thank you. The path to approval for biosimilars has really just begun to be established here in the United States. Unlike typical small-molecule generic drugs that you can buy like acetaminophen for Tylenol anywhere, it's been very difficult for people to get their hands on biosimilars. This is an opportunity to lower that drug cost.

I could see an administration which is perhaps unable to make some of the big changes that a lot of campaigns are talking about right now, like Medicare negotiating directly for drug prices, some of these other big public policy moves. Instead they would direct the FDA to establish a clearer path forward for biosimilars with something like that.

Pfizer would definitely be a big beneficiary of that, along with Amgen (AMGN -0.59%), which has been really ramping up its biosimilar program for similar reasons to Pfizer. Pfizer lost Lipitor a few years back -- most of its sales, anyway -- and Amgen has got a number of drugs that are likely to go off patent protection in the next few years or have recently. So biosimilars are a smart way for them to go ahead and seize market share elsewhere.

Campbell: I've written on the subject and we've talked about it before. I think this is something that investors need to pay attention to. It's not just the big-cap stocks that might be interesting to investors here. There are clinical-stage companies that have late-stage programs underway that may be intriguing for people who are looking to take on more risk, too.

Douglass: Sure. I'd say a good example is Celldex (CLDX 2.67%), which has a late-stage drug called Rintega. It's in phase 3 trials right now for glioblastoma multiforme, which is a form of brain cancer. It targets folks who are a subset of that patient population, which is about one-third, who express the EGFRv3 mutation. Celldex is an interesting company because it's down around two-thirds off its high earlier this year and that's in part because Rintega isn't on track to potentially come to market as quickly as I think a lot of investors were hoping.

Not that Celldex has ever guided for it to come sooner to market than the expected time, which is probably based on a few different factors, probably sometime in 2017; but it's interesting because you look at S&P Capital IQ estimates from analysts to what the company's revenue will be in 2020 and it's currently trading at 1 times its 2020 revenue. That would essentially be what Rintega would bring in along with a couple of other things here and there. That's effectively discounting a lot of their earlier stage pipeline.

Early-stage drugs are hard to value and I don't really tend to assign a lot of value to them, but they're a nice bonus. When you've got a drug like varlilumab, which is the cancer drug they're testing in a number of different indications, in combination with a number of other folks' cancer drugs -- most notably Bristol-Myers' nivolumab, also known as Opdivo -- which is one of the Goliaths in the immunotherapy space, which [are] drugs helping your immune system target cancer -- that's been working in clinical trials. Suddenly you've got a company where your opportunity feels a bit asymmetric compared to the risk.

Campbell: I want to add something. Obviously, we have no idea where these stocks are going, we have no idea whether or not the trials will confirm positive results in previous trials, or if the FDA will approve them. We don't know. You're looking at a stock that's lost two-thirds of its value. For the average investor, you shouldn't put all your eggs in one basket. You should have a lot of different healthcare stocks as part of a greater diversified portfolio.

You'll own some drugmakers, you'll own some biotechs, you'll own some hospitals, you'll own an insurer, you'll own a pharmacy company; but if you're young enough and you've got a long-term time horizon, you can put a little bit in something like this and you might end up with a big winner.

Douglass: Maybe you end up with a big loser, too. The hope here is that you're keeping it to a small enough percentage of your biotech portfolio and your overall portfolio that if it loses it's not a big deal. This is not a Pfizer. This is not a Gilead, or a Celgene. That makes sense as larger positions if you like them because of their broader diversity and deeper pipelines.

Campbell: Absolutely. If you have 1% or 2% of your portfolio in a name like this, it's not going to kill you if something goes wrong. Right sizing these kinds of positions and portfolios is very important for investors. I think there is the potential that a lot of people got out of their wheelhouses in the last couple years is a perfect opportunity to look at your holdings again and make sure that the things you bought were bought for the right reasons.

Douglass: What will happen to healthcare today, tomorrow, or next week? We have no idea, but long term, the demographic trends are unmistakably good for healthcare. I think it's an exciting sector for investors over the long-term mind-set. Todd, as always, thanks for your contribution and your commentary here. It's been such a pleasure to talk with you about this.

Folks, as always, if you ever have any questions, or a stock on your radar, or you've got a question on a stock that we've mentioned, or anything at all, send us an email. That's [email protected]. Again, that's [email protected]. Thanks much. Check back to Fool.com for all of your investing needs, and Fool on!

As always, folks on this show and The Motley Fool may have positions in companies that we mentioned. I can tell you for sure that Todd and I both own Gilead and Celgene. It's important to never buy a stock based on what you hear. Do your own research. It is the right thing to do, it's the Foolish way, and it's a great tool for long-term investors. Always do your own due diligence. Thanks!