It's been a rough 12 months for biotechnology stocks. Over a period when the broad market has risen by 12.9%, shares of the industry-tracking SPDR S&P Biotech ETF (XBI 0.66%) are down by more than 43%.
But what could have caused such a steep drop when the ETF holds stakes in such a wide array of biotechs? After all, it's hard to believe that so many of those companies could have experienced setbacks during the same period.
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Sentiment remains sour
In my view, the biggest risk facing biotech investors right now is that the market's sentiment is currently against high-risk companies in general as well as this sector specifically.
For clinical-stage companies with no drugs on the market yet, it makes sense that a broadly negative mood on Wall Street could have an outsize impact on share prices. With no significant sources of revenue, those biotechs are essentially story stocks -- their market value is determined less by financial performance brass tacks and more by perceptions about their potential.
Drug projects in the R&D phase can take years to reach approval and start yielding revenue -- if they do at all -- so the valuations of clinical-stage companies are based on investors' best guesses about what sales might be for each candidate drug in their pipeline, balanced against the chance that failures in clinical trials will render apparently promising compounds worthless.
When there's turbulence in the market -- as there is now -- investors often flock to the safety of companies with reliable cash flows that are likely to continue flowing in the future. That's pretty much the opposite profile of most biotech stocks.
Take Inovio Pharmaceuticals, for example. It doesn't have any drugs that are close to commercialization, nor does it have any recurring revenue sources. Though its shares once soared on the hopes that it would develop and market an effective coronavirus vaccine, the harsh realities of regulatory scrutiny and clinical trial delays punctured its inflated value, sending it tumbling by more than 78%.
In contrast, shares of stable-as-a-rock pharma giant Merck rose by nearly 5% even though those two companies' businesses are based on the same fundamental process -- developing new medicines.
But even profitable biotechs with blockbuster products on the market have been getting dragged down recently. Moderna's (MRNA 13.67%) share price has fallen by more than 63% in the last six months even though it raked in $11.83 billion in trailing 12-month revenue from sales of its coronavirus vaccine and grew its quarterly free cash flow (FCF) by 263.5% over the last three years.
In short, investing in the biotech sector while sentiment is so negative means that even doing your due diligence may not offer much help. When everything is dropping, there's nowhere to hide.
When will conditions change?
As frustrating as a bearish environment may be, if you're considering an investment in biotechs, it might not be a good idea to wait for things to start improving. Younger biotech companies that report favorable clinical trial results are still seeing their share prices surge upward -- same as always.
That means that if you wait on the sidelines, you'll miss out. At the same time, businesses with earnings might be available at bargain prices now, which will put you in a good position to profit once sentiment finally shifts. And it's likely that the prices of businesses that have been trading at more grounded valuations have been holding up a bit better than companies like Moderna and Inovio, which had highly inflated valuations last year.
All that said, it's unclear how much longer investors will need to tolerate falling share prices in the biotech sector broadly. Some relief might come once the questions of when and how fast the Federal Reserve will start hiking interest rates are answered definitively, but that policy shift has been punted so frequently that it's hard to assign a timeline.
Likewise, biotech shares will eventually get so inexpensive that they'll attract the market's bargain hunters. Until things settle down a bit, it's tough to estimate when that might happen either.
