A Stock Market Bubble in Biotech Stocks?

Source: Flickr user Urbanicsgroup.

Ask nearly any investor and they'll tell you practically the same story: the stock market is akin to an unstoppable locomotive at present. It took 15 years, but the Nasdaq Composite recently took out new all-time highs, while the Dow Jones Industrial Average and S&P 500 have regularly ticked off new record closing highs.

Since the market bottom in the most recent recession, the broad-based S&P 500, arguably the most representative index of the three, has seen its value rise by more than 200%. But within the same timeframe the SPDR S&P Biotech ETF (XBI -1.12%), a basket fund that includes 100 different biotech stocks with an estimated EPS growth rate over the next three to five years of nearly 22%, has shot higher by just shy of 400%, inclusive of dividends. 

It's not uncommon for investors to be more willing to take risks during a bull market as growth stocks rotate into favor and defensive issues rotate out of favor. However, investors also have to question whether or not biotech stocks, which have significantly outperformed the overall stock market indexes, are entering bubble territory.

So I pose the following question: Is there a stock market bubble in biotech stocks? I'd opine that the answer is both "yes" and "no."

Bargains are few and far between
Ask the Oracle of Omaha, Warren Buffett, about the stock market in general and he'll tell you that there isn't a stock market bubble, but that there are few bargains to choose from. Though Buffett is describing the market as a whole, not just biotech stocks, I tend to partially agree with him with regard to biotech stocks. I do believe bargains are few and far between, but that there are still attractively priced biotech stocks within the sector if you really dig deep.

Source: Gilead Sciences.

For example, I'm still partial to both Gilead Sciences (GILD -0.56%) and Celgene (CELG), which despite strong runs higher are still valued at a PEG ratio below one, implying the potential for more upside.

Gilead Sciences' primary growth drivers are its hepatitis C duo of Sovaldi and Harvoni. There were some concerns heading into Gilead's first-quarter report that its recent multi-year agreements with pharmacy-benefit managers and insurers would harm its gross margin. However, Gilead was able to smash Wall Street's expectations on the heels of $3.58 billion in sales from Harvoni, which is on pace for more than $14 billion in annual sales. HIV/AIDS drug Stribild was no slouch either, with sales rising 66% year-over-year.

Source: Celgene.

Likewise, Celgene's Q1 results also crushed Wall Street estimates entirely thanks to organic growth. Blood cancer drug Revlimid logged a 17% increase in sales to $1.34 billion, while sales of cancer drug Abraxane rose 21% and anti-inflammatory Otezla generated $60 million as its post-launch ramp-up continued. Celgene also reaffirmed its previously-issued guidance of $9 billion to $9.5 billion in sales and $4.60-$4.75 in adjusted EPS for the full-year. Between expectations of label expansion for Revlimid, Abraxane, and Otezla, and the company's more than two dozen ongoing collaborations, Celgene looks poised to grow organically for years to come.

At 10 and 17 times forward earnings, respectively, both still appear to be biotech bargains.

This could be a bubble
However, there is one area of biotech that I do believe is in bubble territory: predominantly clinical-stage biotech stocks, or stocks without established pipelines and revenue streams.

Biotech is a unique sector in that standard fundamental ratios are generally useless. Sure, P/Es and PEG ratios work for Celgene and Gilead Sciences, but it's completely fruitless for the close to 90% of the sector which is still losing money.

Instead, investors tend to value clinical-stage or early development biotech stocks based on the results of their clinical trials and the potential size of their patient pools. It's an inexact science that can certainly lead to some inexact pricing.

Take GW Pharmaceuticals (GWPH) as a perfect example. GW Pharmaceuticals is a developer of cannabinoid-based therapies from the cannabis plant. Its pipeline consists of six clinical compounds, including Sativex, which is approved in select overseas markets for spasticity associated with multiple sclerosis. Sativex hasn't sold particularly well overseas, and could struggle to hit $100 million in peak annual sales based on its initial sales trajectory.

Source: GW Pharmaceuticals.

The remainder of GW's pipeline is built around its potential to use marijuana for medical good. GW Pharmaceuticals has been riding support for legal marijuana, and were marijuana to be legalized on a federal level, at least for medical purposes, it would remove some of the research hurdles currently in place for GW Pharmaceuticals.

However, a $2.2 billion valuation for a company whose lead clinical compound, Epidiolex -- which is being studied to treat two rare forms of childhood-onset epilepsy -- may bring in roughly $300 million in an increasingly competitive space makes GW Pharmaceuticals' valuation extremely frothy. It doesn't help either that the company will likely lose money throughout the remainder of the decade.

This is a stock where emotions have gotten the better of investors, and there are more absurdly valued clinical-stage biotech stocks where this came from.

Time to answer the question
Let's now return back to our original question: Is there a stock market bubble in biotech stocks?

If you're invested in what are essentially blue-chip biotech stocks, then no, there probably isn't a bubble, since deeper product and pipeline biotech stocks have the cash flow and support of investors. On the other hand, multi-billion dollar valuations for clinical phase biotech stocks with no approved products could be construed as a bubble.

I'd suggest biotech investors continue to stick to the game plan that works for them as long as they have a long-term investment horizon, but I'd also certainly say that investors would be smart to stick with tried-and-true biotech names like Gilead and Celgene rather than chase the supposed next big thing in clinical-stage development.