Just over two weeks ago more than 300 million Americans around the country were jubilantly ringing in the New Year and looking forward to presumed opportunities that might be headed their way. Here we are, 16 days later, and the U.S. stock market is off to its worst start in recorded history -- not exactly the "opportunity" most Americans were hoping for.
The Dow Jones Industrial Average, comprised of 30 dividend-paying multinational giants, was down 7.3% through Wednesday's close, and was closely flanked by a 7.5% decline in the S&P 500 and an even bigger 9.6% drop in the technology-heavy Nasdaq Composite. There haven't been many industries that have protected investors, but there are certainly industries that have been hammered far worse than others. Perhaps no industry has taken the start of the new year harder than biotechnology and drug developers in general.
Through the first eight trading days of the year (i.e., based on Wednesday's close), the SPDR S&P Biotech ETF (NYSEMKT:XBI), which is comprised of 105 holdings, was down 22%.
The craziest biotech stat you'll ever see
A 22% drop in eight days is already eye-popping enough, but there's an even crazier stat that'll really put the bloodbath the biotech industry has faced into context.
After running a stock screen of biotechnology and pharmaceutical companies with valuations in excess of $300 million as of Jan. 13, 2016 -- the reason I chose $300 million was to eliminate potentially wild price vacillations on low volume -- I came up with 165 companies. Out of those 165, just two were positive for the year. Among biotech companies, just two of 135 were positive for the year.
Allow me to repeat that. While the biggest healthcare conference of the year is ongoing (the J.P. Morgan Healthcare Conference) -- a conference, mind you, whose data releases and forward-looking guidance have historically been linked to advances in drug developers' valuations -- all but two of 165 publicly traded drug-developing companies have moved lower.
"What companies are up?" you wonder?
One is Dyax (UNKNOWN:DYAX.DL), a developer of rare disease drugs that Shire (NASDAQ:SHPG) agreed to purchase for $5.9 billion in November. The deal works out to $37.30 per share for Dyax shareholders, meaning the nominal gain in Dyax shares so far this year is nothing more than investors taking advantage of a small arbitrage opportunity rather than any clinical or company news driving Dyax shares higher.
The top-performing biotech stock through Wednesday's close? Recently spun-off Baxalta (UNKNOWN:BXLT.DL), which is up (wait for it...) just 3.3%. The reason for the jump in Baxalta shares? Look no further than Shire once again, which agreed to pay $32 billion for Baxalta. Shire had shown interest in the deal for some time now, but Baxalta's management team had been holding out for a higher cash component. It received exactly that this month when Shire agreed to pay $18 in cash per share and 0.1482 shares of its common stock in order to acquire Baxalta.
In short, not a single drug developer has moved higher year-to-date because of fundamental or clinical reasons. That's stunning.
Why biotech is getting throttled
You might be questioning why biotech stocks are getting throttled so badly in 2016. I suspect it boils down to three key points.
First, during times of volatility and uncertainty investors turn to defensive investments. A defensive investment can take on many forms, but it's typically going to be a profitable company that may pay a dividend. Within the biotech industry (inclusive of all publicly traded biotech stocks regardless of market value) around 90% of publicly traded companies are currently losing money. They are the antithesis of a defensive investment, and thus make the perfect stock to consider selling when short-term investors believe the tide is turning.
Secondly, there are tools investors tend to rely on when determining the value of a company. Metrics such as the P/E ratio, PEG ratio, and price-to-book value can help investors assess whether or not a business is a good value or not. These metrics are practically useless for most of the biotech industry. Quite a few biotech stocks are valued solely on the peak sales potential of their pipelines and how many patients they could eventually treat. It's an inexact science that often allows emotions to come into play, which in turn can lead to heightened volatility like we're witnessing now.
Lastly, biotech has also been one of the top performers since the last recession. Although it doesn't always hold true, industries that have outperformed tend to be some of the hardest hit when a shift in the market occurs.
How to survive the biotech carnage
Some investors would consider biotech's miserable start as all the more reason to avoid the industry. As for me, I see it as an opportunity to go digging around for solid long-term investments. The key to finding great biotech businesses is to take a three-tiered approach.
First, it's never a bad idea to consider investing in established companies. As noted above, clinical-stage companies may offer the quickest upside, but they also have little support in a falling market since they're unprofitable and burning through their cash on hand. If you instead purchase healthfully profitable companies you'll be far less likely to see your investment tumble 20%, 30%, or more as we've seen some biotech stocks fall year-to-date.
Secondly, consider investing in companies with huge pipelines. Again, this is likely going to cover the gamut of profitable companies since profitable companies have the cash flow to spend on research and development. However, businesses like Ionis Pharmaceuticals (previously known as Isis Pharmaceuticals) which aren't profitable but have a pipeline of around three-dozen clinical compounds could very well be worth considering.
Lastly, don't discount the idea of diversifying your biotech investment by buying an ETF, such as the aforementioned SPDR S&P Biotech ETF. A 22% loss is far from optimal to start the year, but with 105 different holdings investors would also be shielded from bad clinical results from one or two drug developers.
As I look back at this advice the one stock I'd encourage all interested biotech investors to consider is Celgene (NASDAQ:CELG).
Celgene is a very profitable drug developer that's expected to have four blockbuster drugs in 2016: Revlimid and Pomalyst for multiple myeloma, Abraxane for lung, breast, and pancreatic cancer, and Otezla for various inflammatory diseases. The majority of its growth is organic, demonstrating that volume growth and pricing power are on its side. It also boasts in excess of 30 ongoing collaborations, and it acquired a potential next-generation multiple sclerosis blockbuster known as ozanimod when it purchased Receptos last year for $7.2 billion. Adding the icing on top, Celgene's 2020 forecast implies more than a doubling in sales and EPS based on its estimated fiscal 2015 results.
In short, if you're a long-term investor then it's worth digging into the biotech industry with valuations having dipped so far so fast.
Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
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