Can Biotech Dominate for a 4th Year in a Row?

Biotech has been on one heck of a terror. According to Credit Suisse, the industry has been the top industry for the past three years, trouncing the S&P 500.

For the biotech industry to dominate for a fourth year in a row, one or more of the following things need to happen.

Flight to risk
One of the reasons the biotechnology sector has done so well recently is investors have been willing to take on more risk. As buyers outpace sellers, the value investors are willing to pay for pipelines increases.

The typical cycle starts with large-cap biotechs with multiple drugs on the market. As investors seek more risk, they invest in companies with a single drug and then move on to development-stage companies. Finally the most-risky investments are new companies going public.

A few years ago, private biotechs couldn't find enough buyers to support initial public offerings. Now IPOs are so oversubscribed that companies such as Dicerna Pharmaceuticals (DRNA) tripled after its IPO this week. Dicerna Pharmaceuticals has a nice drug-discovery unit, but its pipeline is extremely early stage. It's going to be years before investors see any revenue from Dicerna's drugs.

Now, there's nothing more risky in the public biotech sector for investors to move into. The only way for valuations to increase further is for more generalist investors to move into the sector.

Biotechs get snatched up
Another reason biotech valuations remain high is that pharmas and large biotech companies keep snatching them up for premiums. While investing in the hopes of a takeout is generally a pretty poor investment thesis, it's certainly on investors' minds and adds something to the valuation of many biotechs.

Just the rumor of a buyout is enough to send a stock soaring. Ariad Pharmaceuticals (NASDAQ: ARIA) spiked 20% in one day last week when the London Mail newspaper said Eli Lilly, GlaxoSmithKline and Shire are all potentially interested in buying the company.

It doesn't really matter whether Ariad Pharmaceuticals gets bought. The industry can handle rumors that don't turn out to be true.

What's important is that some biotechs get purchased this year, giving everyone else hope that the companies they own might get bought too.

Good old-fashioned earnings
The Nasdaq Biotechnology Index is made up of 116 stocks, but the top six make up around 40% of the index.

The value of those large biotechs -- Regeneron Pharmaceuticals (REGN -2.02%) and Amgen (AMGN 0.34%) have the largest weight as of the last update -- is driven less by their pipeline than by sales of existing drugs and the earnings they create. Even if investors pull back on their risk tolerance, the value of Regeneron, Amgen, and the rest of the larger biotechs won't change all that much as long as their earnings are growing at a reasonable rate.

Be careful out there
I'm not going to call the top, because predicting the end to euphoria is always difficult. But we've been through this before, and when the bubble pops, it isn't going to pretty. Selling begets selling.

For that reason, I think investors are much better off owning a basket of well-selected biotechs that they can sell when the potential reward doesn't justify the risk rather than owning the broader index through an ETF. Owning fewer stocks may be more risky because one failed trial will take a larger chunk out of the biotech portion of your portfolio, but the flexibility makes up for it.