I'm going to go out on a limb and declare that we're in a biotech bubble. I have no idea if the bubble is in its early stages or if we're about to pop tomorrow. Bubbles aren't typically the same size or length, so it's hard to say when the run up we've seen over the last year will end.
The increased valuations are driven by generalist investors' increasing risk tolerance. Regression to "normal" valuations will happen when those investors move on. The bubble might pop if we have a big high-profile drug failure or two, or it might just deflate slowly as investors rotate out of the sector.
But the run is going to end.
Unfortunately, since we don't know when, jumping out of the sector right now might leave returns on the table. Instead investors should get prepared.
Investors love binary events because of their potential for quick big returns. When the investors leave the sector, the valuations of companies with imminent binary event should hold up.
For instance, if the biotech bubble popped tomorrow, I doubt Amarin (NASDAQ:AMRN) would decrease all that much. The biotech has an advisory committee meeting in a few weeks to determine if its triglyceride-lowering drug Vascepa should be used in patients with lower triglyceride levels. If the committee endorses the expanded use, sales should accelerate dramatically.
Ditto for MannKind (NASDAQ:MNKD). Investors are likely to hold on until the FDA makes a decision on its inhaled insulin drug, Afrezza, next year. If you like its chances of getting approved now, there doesn't seem to be much reason to sell. If it drops in value, the risk-reward benefit just skews in favor of reward.
Investors should be mindful of what might be behind the binary event. Both Amarin and MannKind will have drugs to sell if their binary events are positive, providing quarterly catalysts with hopefully increasing sales figures.
A company like Geron (NASDAQ:GERN), for instance, might be in trouble. Investors have bid up the biotech in anticipation of data from an investigator-sponsored clinical trial testing Geron's imetelstat in myelofibrosis.
If the trial is successful, Geron will likely initiate its own trial testing imetelstat in myelofibrosis, but that trial will take a while to run. Will investors stick around waiting for the results? I kind of doubt it.
When valuations are inflated, biotechs can afford to run on close to empty. Raising additional capital is as simple as calling an investment banker and selling more shares through a secondary offering.
When valuations are more realistic, raising capital becomes harder and investors will take impending dilution into account when they're valuing companies. Companies with cash to last through the next value inflection point should be fine.
There tends to be a progression as investors take more risk. It starts with large biotechs with products on the market and progresses to development-stage biotechs and then to start-ups going public.
As investors leave the sector, it seems logical that the reverse will hold true. First, the IPO market will dry up when investors begin shunning risk. Development-stage biotechs will be next, followed by large biotechs.
Investors worried about the bubble can mitigate some of the risk by investing in larger biotechs that won't be the first to fall. Much of Gilead Sciences' (NASDAQ: GILD) $100 billion market cap is supported by the sales it brings in, which won't go away if investors start panicking.
It helps that Gilead has the other two handled, too. Its most promising pipeline drug, sofosbuvir, for hepatitis C is under FDA review with an advisory committee meeting scheduled for the end of October. And its HIV franchise is a cash generating machine. Raising capital isn't necessary.
If you really want to be conservative, consider Amgen (NASDAQ:AMGN). In addition to a valuation based on current sales, you get a nice dividend to help prop up the valuation. The yield currently sits at 1.7%, which isn't all that much, but Amgen has raised it twice since establishing the dividend in 2011. Assuming Amgen continues the trend, the yield will go higher or shares will appreciate to keep the dividend yield the same. Either way, investors win.
Fool contributor Brian Orelli has no position in any stocks mentioned. The Motley Fool recommends 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.