During the last couple of years, it seemed that you could pick almost any biotech stock and end up making jaw-dropping gains. The Nasdaq Biotech Index (NASDAQ:IBB), for instance, has nearly tripled in value since 2010:
This parabolic rise has generated substantial buzz about the potential for a bubble forming among biotech stocks, in general. Unfortunately, most pundits have focused their attention on the entirely wrong group of biotechs, in my opinion, when asking this pivotal question -- namely, large-cap behemoths like Biogen (NASDAQ:BIIB), Celgene Corp. (NASDAQ:CELG) and Gilead Sciences (NASDAQ:GILD).
Their reasoning is based on little more than the fact that these three stocks have absolutely skyrocketed. The problem with such a cursory viewpoint is that it ignores the underlying reason these stocks have bolted higher. A deeper look at these three top biotechs shows that new drug approvals, and the ability to successfully expand the labels of existing products, has led to a meteoric rise in earnings, as well:
In Gilead's case, at least, we could make a rather compelling argument that its current share price hasn't even caught up with its increase in cash flows, revenues, or earnings. These are definitely not the right stocks to point toward as evidence of a bubble.
But that doesn't mean there wasn't a biotech bubble. Again, though, the majority of folks have missed out on another reality -- the bubble has already popped.
Small-cap biotechs with no revenues were the real bubble
I would argue that the success of major biotechs at bringing game-changing new drugs to the market caused investors to speculate on unproven technologies, driving their share prices through the roof. Prior to 2015, for example, shares of clinical-stage companies like Arrowhead Research (NASDAQ:ARWR), Inovio Pharmaceuticals (NASDAQ:INO), and Sarepta Therapeutics (NASDAQ:SRPT) were soaring all the way up until about March 2014:
And then a strange thing happened. Most of these developmental biotechs broke down, and simply haven't recovered:
Although the broader industry has continued to head higher, nearly unabated, small-cap biotechs have performed extremely poorly as a whole since March 2014, with 72% of these companies exhibiting negative returns on investment.
Here's where it gets interesting, though. If we limit our analysis to mid-cap biotechs, we can see that a stunning 93% of these companies have pushed higher during this same time frame.
But there is a good fundamental reason for this overarching pattern. These are the biotechs that tend to have newly approved products, or late-stage candidates closing in on a regulatory approval. Smaller companies, by contrast, generally possess little in the way of a revenue stream, and their clinical pipelines are often unproven.
Since the end of the first-quarter in 2014, the market has clearly rotated out of highly speculative small-cap biotechs for the most part, and instead, focused on companies with improving fundamentals.
Driving this point home, we've witnessed promising clinical-stage biopharmas like Dynavax Technologies (NASDAQ:DVAX) and Celladon Corp. (NASDAQ:CLDN) trade at mere fractions of their lead clinical candidates' revenue potential lately. At the height of the biotech boom back in 2013, these same stocks almost certainly would have been garnering eye-catching multiples of the estimated peak sales of their experimental products. So, in my view, the rising-tide phenomenon -- or a bubble if you want to call it that -- ended more than a year ago.
All told, the industry's growth trend is now being fueled organically by increases in revenue and earnings, not excessive enthusiasm by speculative investors.
George Budwell owns shares of Gilead Sciences. The Motley Fool recommends Celgene and 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.