Biotech: Popping the Allegations of a Bubble

There’s a popular view going around these days that biotech is in a bubble. Jim Grant was the first that I know of who publicly expressed this view, and he rationalized his argument asserting the Fed’s zero interest rate policy was distorting markets without even a cursory mention of the specific developments which have transpired in the biotech sector over the recent past. Several smart market participants who I respect greatly have echoed this perspective. I want to use this post to dispel that notion.

I’m a humanities, not science guy. I also am a generalist, not a biotech investor. I have some exposure to the sector and don’t plan to increase or decrease that exposure any time soon. That being said, I will leave the science vague and hope someone more knowledgeable and with more skin in the game can expand on this argument. As recently as the late 1980s, the drug discovery process was entirely centered around literally sifting through dirt in order to find molecules that may hold some therapeutic power. The science was simply a matter of “leaving no stone unturned” in a quest to find anything that just might work. In the late 1980s, there was a pivotal moment where drug discovery evolved to a process of learning how diseases and ailments operated on a molecular level and then working backwards via inversion to find proteins which could positively change the active mechanism of the problem. If you are interested in this development and its business effect, I strongly recommend the book Billion Dollar Molecule by Barry Werth.

Today we are undergoing another profound change and the catalyst was the mapping of the human genome. Not long ago, Peter Thiel and Marc Andreessen debated whether there was real innovation happening in our economy today. Surprisingly not even Andreessen who took the “yes there is innovation” side of the debate even mentioned genomics and the impact it’s having on people’s lives around the world. The only real mention of biotech was Thiel’s complain about the FDA getting in the way too much, though if anything, this is not borne out by what has transpired these last few years. The problem for biotech is that its impact is very intangible compared to the Smartphones we all carry in our pockets everywhere. Genomics has greatly accelerated the process and efficiency of drug discovery. The results are evident, though people don’t see or feel it. In 2012 new drug approvals by the FDA hit a sixteen year high. Although 2013 did not see a new high in approvals, it did see the largest aggregate market opportunity for new approvals. I will oversimplify to make the point very clear: let’s say the average drug development timeframe was 10 years and has now accelerated to 5 years. Drug development inherently becomes worth more money if the time to earning first cash flows is cut in half.

This above provides some justification for why “this time is different.” Things can be different and still a bubble though, so to try and further dispel this notion I want to point out two anecdotal examples for why the bubble assertion is wrong. Again I want to qualify that overvalued and/or overextended does not mean something is a bubble. For starters, let me borrow Robert Shiller’s definition of a bubble: (as paraphrased by me from Shiller’s panel at the Economist’s Buttonwood Gathering) a bubble is a price-mediated feedback between prices and market participants, with excessive enthusiasm, media participants, and regret from those who are not involved. The “psycho-economic phenomenon” is a defining characteristic that becomes ingrained in a culture and is related to long-term expectations that cannot be pinned down quantitatively. Let me offer the following chart, and you tell me where there's a bubble:

Simply put, we see none of this. Biotech has barely reentered the market participant’s conscious despite the big players returning to top line growth for the first time in years following their patent cliff. There are few if any stories in mainstream media about biotech billionaires at all. If you want to see hype, look no further than social media companies. Do we see anything remotely resembling an awareness in the masses that biotech has been a strong sector? I get asked all the time by clients about Tesla, Bitcoin, Twitter, etc., and I’ve never once been asked about biotech. And yes I think Tesla, Bitcoin, and Twitter prices comfortably fit Shiller’s definition of a bubble.

So let me offer two anecdotes on price and valuation in biotech to provide some context to this discussion.

1) Regeneron: In 1991 is considered common knowledge that Regeneron was a bubble, was insanely priced and was unsustainable. Here’s what the pundits were saying at the time (and do read that link for it's quite telling how similar the complaints are today): “Regeneron is a real long shot for investors: With no potential products even slated for clinical trials, the company is a good 10 to 12 years from delivering a marketable product…. ‘These are companies that have no product, and no prospect of revenue for three years or more. It only makes sense for them to make money when investors are in a feeding frenzy.’”

Fast-forward to today and an investor in Regeneron’s IPO is up ~1,789% in 23 years compared to ~390% for the S&P 500. This alone does not prove biotech is not a bubble but it highlights an important point that is fairly unique to this sector: even if you pay a high starting price, when you are right you will make multiples of your money. Simply put: bad investments in biotech will be worthless and successful investments will be worth multiples. The starting point matters little.

2) Incyte: This company is experiencing a wave of success, up a cool 207% over the past 52 weeks. Their first approved product, Jakafi earned $235.4 million in revenue in 2013 and is still growing today. In the pipeline, Incyte is working on one of the first treatments for pancreatic cancer which actually improves patient survivability. This first big spate of commercial success and big pipeline expansion would have a rational observer expecting this company to be way above record high levels, especially if we are in a bubble, right? Wrong.

In 1999 a shares of this stock were changing hands below today’s prices, though well above where INCY was upon earning its first real evenues. Back then there weren’t any signs of imminent success to be found. It’s definitely much easier to call something a bubble in hindsight, but the magnitude of the differences between then and now is striking. The fact that 1999 is still so fresh in many market participants’ memories is probably a powerful force in the proliferation of bubble assertions today.

Preclinical biotechs are valued based on odds of approval, the size of the market opportunity, the percent of the market the treatments can capture and discounted to today based on the time it will take to earn positive cash flow. It is unquestionably silly when biotechs surge in unison riding the wave of one company’s success. What happened in the wake of Intercept’s NASH primary endpoint success is not rational, and many companies did not deserve the pop they received. But that happens all the time in markets even when there is no bubble.

This is not a great time to pile into biotech, as some of these favorable developments discussed above have been reflected in prices. A bubble means run for shelter and seek cover, and that too is inappropriate right now. Something that is overextended is not necessarily also a bubble. It’s very possible, almost probable that biotech will go down 15% before going up from here. The fact of the matter is that biotech is the same as it ever was. The big boys are priced in-line with the market and have no premium attached to their multiple, and the small companies that investors get “right” will be worth multiples of what they are today, while the wrong ones will be worthless.

Thanks to my buddy who helped me pull this together so quickly today, you know who you are!

Disclosure: No position in any of the stocks mentioned, though a small portion of the portfolio is long specific biotech stocks.

Navigating the Global Economy - Buttonwood Gathering 2013

I had the privilege of attending The Economist’s Buttonwood Gathering 2013 replete with a stacked lineup of speakers and panelists. At a conference such as Buttonwood, one of the most interesting elements is the opportunity to exchange ideas with attendees who are generally pretty brilliant in their own right. I had numerous conversations with other Gatherers on topics ranging including Mexico’s pro-market reforms, Canada’s housing bubble, the European banking environment, and much more. Measuring consensus on such topics at Buttonwood provides a great glimpse into what the “Smart Money” is thinking. Sure enough, smart money seems abundantly optimistic in Mexico’s steps toward and capacity to successfully implement said reforms, Canada’s housing bubble is very real, and the European banking environment will have to pivot from an arena of nationalistic-driven excess to centralized decency.

These are simply some topics I conversed about with fellow gatherers. The panels themselves covered a wide range of topics, from the global economy, to the emerging market landscape and today’s optimistic venture capital environment for technology. While it’s impossible to completely cover each topic and the panelists’ thoughts in this post, I want to share some of the points that were more striking and relevant to me personally in the themes and topics that I focus on.

The two-day event kicked off with a conversation on the “global economic outlook” between José Manuel González-Páramo, Robert Rubin and Nemat Shafik, moderated by Zanny Minton Beddoes. All the panelists echoed the theme that Europe was improving and a decent coefficient of global growth was moving from emerging back to developed markets. Robert Rubin took a strikingly pessimistic tone towards the US growth outlook, given his belief that the conventional narrative of a fiscal drag was overstated and the real problem remains lack of demand and therefore anemic consumption. Shafik explained how there is increasing decoupling and dispersion amongst the various emerging markets and how each unique country thought of in its own unique way. Gonzalez-Paramo mused that Europe had the greatest potential to outperform estimates in the coming months should the relevant parties continue on the path towards a formalized banking union.

The discussion on Europe offered a natural segue into the second panel covering “Europe’s Burden” with José Manuel Campa, Bruce Richards and Nicolas Veron. Véron explained how the stress tests in Europe would be completely different this time around. Rather than pure stress tests, the exercise would be an intensive Asset Quality Review (AQR) done by the ECB instead of the European Banking Authority. Richards seconded this sentiment, and noted that the EBA tests were “laughed at.” Richards further explained how Europe’s banks have $42 trillion in assets compared to a GDP of $13 trillion, far larger than the US, which has $15 trillion in assets on a GDP just shy of $17 trillion. While Europe’s economy “has bottomed” it will take time for the banks to grow out of their size problem, with the US Savings and Loan Resolution Trust Corporation wind-down offering the best analog. Richards called Europe today “the largest asset disposition in the history of the world” and said the opportunity is in the very early stages, with assets like Spanish Non-Performing Loans available for 3 cents on the dollar.

Next, Roger Altman and Thomas Horton spoke about the changing corporate landscape in the US. Altman insisted that “uncertainty” in the business community stemmed predominantly from a shortfall in demand in the economy and not from Washington. The biggest trend Altman has been watching is the rise in activism amongst shareholders, and the willingness of institutional shareholders to embrace activist proposals. Meanwhile, Horton opined that US tax policy’s limitations on repatriation offered a significant hurdle to prudent balance sheet management in corporate America and that regulatory uncertainty has been a particularly large obstacle for him personally in helping American Airlines emerge from bankruptcy.

Day two started with an interesting discussion on monetary policy between Mohamed El-Erian and Vincent Reinhart. Both gentlemen generally agreed that central bank policy cannot create supply, but that it can move demand. In this context, the risk/reward balance of further quantitative easing has shifted decisively towards the direction of risk, with little reward. While the Fed has emphasized the importance of forward guidance, they completely underestimated the market’s interpretation as to when tapering would begin. El-Erian worries that in this environment, people are being “pushed, not pulled into trades.” Reinhart stressed that in the future Yellen Fed, there will place a greater focus on the dual mandate. Further, she will take it as her responsibility to provide guidance that is both broader in scope and deeper in explanation.

Next, Jim Millstein and Mary Schapiro talked about the financial regulatory environment. Millstein highlighted how in Too Big To Fail, there is no market discipline happening in either the equity or debt markets for banks. As such, there is no natural free market check on these institutions considering debt is subsidized with the TBTF guarantee and equity is too large for an activist to impose changes. Ultimately, Millstein sees finance heading towards a more utility-like role in the economy. Schapiro expressed some concern that while a stronger regulatory regime has been constructed, it has effectively been rendered toothless by a lack of funding, but that ultimately she was optimistic regulators will find a middle ground and bridge some of the gaps present between political goals and regulatory reality.

Japan was next up in the Gathering’s coverage of global economies. Koichi Hamada and Paul Sheard both shared their belief that Abenomics so far is working, particularly on the monetary policy side. Hamada noted that excess capacity to GDP declined from 3% to 1.5% and inflation actually started moving in the right direction for once. The problem, both agreed, is that little light has been shed and little progress made on supply side reforms that are ultimately necessary for Abenomics to truly work. Both believe that in time this will happen, but for now, Abe will have to combat an entrenched and powerful bureaucracy to get his way. Sheard made the point that no central bank in world history has tried to dislodge deflation expectations knowing it will inevitably have to re-anchor inflation to a 2-2.5% target. Japan has plenty of room to do more when compared to the Fed, as the US central bank increased its balance sheet by 250% during the course of the crisis, in contrast to Japan’s 54% increase. Both explained how while many worry about Japan’s “demographic” challenges,” Japan does have an opportunity in that women make up a smaller percentage of the workforce than in most developed countries and there is considerable room to improve.

Robert Shiller and Lewis Alexander then held an interesting discussion about bubbles. Shiller started with a definition of a bubble: they are a price-mediated feedback between prices and market participants, with excessive enthusiasm, media participants, and regret from those who are not involved. The “psycho-economic phenomenon” is a defining characteristic that becomes ingrained in a culture and is related to long-term expectations that cannot be pinned down quantitatively. Alexander offered a distinction between those bubbles that are a systemic risk verse those that are not. Bubbles carry systemic risk only when they have a credit component. Thus, in the absence of a credit component, the risks of a bubble are not all that severe for society at large. The housing bubble was one such systemic risk event, though both emphasized this was clearly not the fault of the Federal Reserve Bank (as many skeptics proclaim). Home prices began their rise in 1997 and continued to rise even during periods within which the Fed was raising interest rates. Shiller explained that there simply was no correlation at all between the path of rates and home prices, and that the efficient market hypothesis was the real culprit for inducing a sense of complacency in market observers that all prices are rational. Further, right now, people are calling for bubbles everywhere and they can’t all be the Feds fault, as is evidenced by what Shiller said is “most likely” a bubble in Brazilian real estate. Though Alexander cautioned that the problem with monetary policy is how it is a “blunt tool” and influences all or nothing with regard to price, so some distortions can happen. These distortions are mainly in interest rate risk, not credit risk right now and he does not see accompanying systemic risk as a result.

The two Bagehot Lectures were given by Agustín Carstens and Alan Greenspan. Carstens discussed the role of emerging market central banks in a crisis environment. Central banks should continue to focus on keeping inflation under control, and could use some macroprudential policies to offer a countercyclical buffer, though such policy should be used “like tequilia--only in moderation.” EM central banks also should play a supervisory role to regulate the flows of currencies and help mitigate volatility, but monetary policy can’t do all this on its own. Many EMs need serious structural reforms and it’s unfortunate that these needs are only recognized on the down side of the cycle, not the up. This is equally true in other areas. For example, Mexico opened a permanent line of credit with the IMF when times were good, while now countries who would benefit from such a line don’t want to do so for fear of appearing to “need” it and in the process, looking vulnerable. Alan Greenspan then took to the stage. He explained how there is a significant bifurcation in our economy whereby capital investment of a less than 20 year duration is doing quite well and of greater than 20 years is in a deep slump. Greenspan believes this is the result of uncertainty in long-term planning and blames tax policy as the culprit. Right now in the US we are seeing one of the greatest spreads ever in term structure between 5 and 30 year Treasuries and this is a reflection of the gap between the short and long-term economies.

In the ensuing panel on fiscal priorities with Roger Ferguson, Laura D’Andrea Tyson and Carmen Reinhart, D’Andrea Tyson quickly launched into her rebuttal of Greenspan’s argument. She explained how the fiscal stimulus relative to GDP was rather small, and the premature austerity undertaken by the government since emerging from crisis has made the recovery slower than it needs to be. There is considerable excess capacity in our economy, and this is a far bigger culprit in weak long-term investing than anything else and this uncertainty is over demand, not politics. Carmen Reinhart agreed with most of these points and added that private sector deleveraging continues to be a headwind to growth. She also noted that the US has done particularly well relative to others around the globe, but worries about how the US will unwind it’s large fiscal deficit when all is said and done. Ferguson elaborated on how big the private sector short-fall was during the crisis and how much more the government could have stimulated the economy instead of leaving monetary policy as the “last man standing” to help. He complained that “politicians are acting Ricardian in a Keynesian world” and hurting, rather than helping our cause. He and D’Andrea Tyson remarked on how the negative real interest rates on Treasuries offer a serious opportunity for the government to borrow and invest in much-needed infrastructure projects, but unfortunately everyone in a position to do something is focused on discretionary spending as a problem when it’s really entitlements. If only discourse were more rational.

While this is hardly an exhaustive summary of the Buttonwood Gathering, these were some of the more relevant discussions on topics that I am concerned with. I took fairly extensive notes during the two days, and if anyone would like some more insight on any of the specific panels discussed here (or those that I didn’t mention), please feel free to leave a comment below or email me and I will be sure to answer.