"Bubble" can be a provocative word in investing circles. Think of all that comes to mind when you hear it -- perhaps other words like over-hyped, overvalued, risky, etc. To quote from our own Motley Fool investing wiki, a bubble "occurs when people are happily paying more for stocks in a certain sector than they are worth given the fundamentals of the businesses." That happy buying keeps on going and going until it stops. Then the bubble bursts.
Many investors are definitely paying increasingly more for biotech stocks. I suspect that they're happily doing so. Major exchange-traded funds, or ETFs, that track biotech stocks are up over 30% so far this year -- easily beating the broader indexes, which have done quite well themselves. But is biotech actually in a bubble right now? If so, is that bubble about to burst? It depends.
Yes and no
Not all of these biotech run-ups have necessarily valued stocks more than the business fundamentals warrant. For example, shares of Celgene (NASDAQ:CELG) have soared by more than 70% in 2013. But if you look at the company's likelihood of continuing to grow earnings with sustained strength from Revlimid and great potential for other drugs like Abraxane and Pomalyst, Celgene's price doesn't seem too high even after an enormous run.
On the other hand, it isn't too difficult to find examples of biotech stocks that seem to have flown well past what their current fundamentals justify. There are some small companies with little to no revenue and no product likely to hit the market in the next couple of years that have skyrocketed to premium valuations.
For example, shares of Cytokinetics (NASDAQ:CYTK) have jumped more than 180% year-to-date. The small biotech currently claims a market cap of around $325 million. That's nearly 60 times the $5.7 million in revenue that Cytokinetics has made over the last 12 months -- and it's not likely to see significantly more revenue in the immediate future.
The biotech has no products in phase 3 development yet, although it is in collaboration with Amgen (NASDAQ:AMGN) on a heart muscle drug that is in two different phase 2b studies and has another neuromuscular drug in phase 2b. Amgen holds a $10 million stake in the company as part of the licensing deal.
There also are biotechs that have had a great ride in 2013 but could see more challenging days ahead. Astex Pharmaceuticals (NASDAQ:ASTX) stock has more than doubled so far this year. It has a market cap of around $550 million on nearly $80 million in sales over the last 12 months. However, Astex expects that sales for its lead product, Dacogen, will drop next year in the U.S. with the entrance of generic competition.
Stocks like Cytokinetics and Astex would likely fall heavily if the presumed biotech bubble burst. Of course, when bubbles burst they tend to take most of the stocks in the sector down.
The bubble that wasn't
Back to the original headline question, though: Is the biotech bubble about to burst? My view is that it won't -- because it's not really a bubble after all.
I looked at the top 10 holdings of the iShares Nasdaq Biotechnology ETF. These 10 stocks comprise more than 55% of the total assets held by the ETF. If we were seeing a bubble in biotech stocks, how many of these would you think would be at historically high price-to-earnings multiples? Maybe eight or nine of them? At least half?
The actual answer is that only two of the top 10 biotech stocks in the ETF are at their five-year highs for valuation -- Biogen Idec and Gilead Sciences (NASDAQ:GILD). I would argue that, like Celgene, neither of these stocks are too highly priced considering their earnings potential. Gilead, especially, looks strong in my view with its solid HIV franchise and big opportunities ahead stemming from its frontrunner status in commercializing an all-oral hepatitis C virus drug.
Sure, some biotech stocks are overvalued. I don't think the sector as a whole is, though. Biotech could become "bubblicious" at some point. For now, though, I suspect we'll see more stocks continue to pop than have their bubbles burst.
Fool contributor Keith Speights has no position in any stocks mentioned. The Motley Fool recommends Celgene and 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.