Biotechnology stocks were among the market's top performers in 2014, but biotech stocks were also among the market's riskiest plays. For risk tolerant investors, biotech's pop-and-drop nature may be enticing, but should investors focus on big or small cap biotech stocks? We asked some of our top Motley Fool analysts for their opinion. Read on to learn which they think makes the most sense.
Todd Campbell: Whether or not to invest in big cap or small cap biotech stocks depends a great deal on an investor's willingness to accept risk and his or her time horizon.
Over the past decade, the market's top performing stocks have undeniably been small cap companies, and that allure may have many considering owning small cap biotech stocks, rather than big cap biotech stocks. But investors shouldn't forget that for every small cap biotech that has succeeded, many more have failed. Between 2003 and 2011, roughly 90% of all drugs entering clinical trials never made it to market.
Conversely, most big cap biotech stocks already have FDA-approved, revenue-generating drugs on the market that insulate them from inevitable stumbles in their product pipelines. Those approved products can mean billions of dollars in revenue and profit for investors, but big cap biotechs' more mature standing means that share price gains are likely to be smaller than for their small company peers.
That suggests that risk tolerant investors that won't need to tap their investments for a long time may want to sprinkle a couple promising small cap biotechs into their portfolio in hope of striking a big win, but risk-averse investors (especially those who are older) are better served sticking with tried-and-true big cap biotechs.
Cheryl Swanson: Remember the speed bump the biotech market hit early in 2014? From late February to mid-April, the Nasdaq Biotech Index dropped 20.8%, and virtually every stock in the sector suffered losses.
Large cap biotechs roared back and ended the year roughly tripling the gains of the broader market. But small and micro-cap biotechs were harder hit and didn't recoup as quickly. As recently as Q3 2014, small cap biotechs (between $200-$499 million) were off 13.6% for the quarter and down 6.4% year to date, according to BioCentury.
While there are multiple positive factors going for the biotech sector right now, the market breathes in and the market breathes out. After the huge gains we've seen, I've trimmed my basket of small cap biotech positions in favor of larger, more mature biotechs. I'm also focusing on biotechs whose drugs have the widest profit margins, since those are the companies who can afford to fight a price war.
The good news is that an aging population pretty much guarantees continued growth for the sector's products. So any retrenchment of biotechs -- if it comes -- I'll be viewing as a buying opportunity.
Brian Orelli: Big biotechs can't double overnight. Small biotechs can.
That's the sum total of my argument for buying small biotechs over big biotechs.
There's nothing wrong with owning Biogen Idec or Gilead Sciences or one of the other giant biotechs, but no matter how good their clinical trial data is, typically not much is going to raise the value of the company by more than a couple of billion or so. Given how large the companies are, that's only a gain of a few percentage points.
For smaller biotechs without a drug on the market, a $1 billion gain in value can be a double or more.
Of course, what you gain in potential increases you give up in stability. As Cheryl points out, smaller biotechs tend to be more susceptible to downturns in the overall stock market. A flight to safety is a flight from small biotechs. But I'd argue this risk is negated by equally unjustified increases in smaller biotechs as people look for higher returns. If you're invested in smaller biotechs over the course of many years, the two forces even out.
The bigger risk comes from the potential for failure. If a big biotech company's program fails, shares may only fall by a few percentage points. For smaller biotechs, it can mean a death sentence. The secret to investing in small biotechs is to find companies where the rewards justifies the risk -- easier said than done, but they're out there -- and/or to buy enough small biotechs so that the risk is pooled, although that reduces the overall upside.
Brian Orelli has no position in any stocks mentioned. Cheryl Swanson owns shares of Gilead Sciences. Todd Campbell owns shares of Gilead Sciences. The Motley Fool recommends Gilead Sciences. The Motley Fool owns shares of 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.