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.

Links for Thought -- April 27, 2012

Pixar Story Rules (The Pixar Touch, h/t to Ritholtz) -- This is a great list of the "rules" that shape Pixar's stories.  No matter what our age, we all know (and I'm sure love) the great stories from Steve Job's computer animation studio.  While these rules are about how to structure a great animated film, they are deeper life lessons with broader implications.  Definitely worth a read.

Logical Fallacies Poster (Boing Boing) -- Ah remember the good 'ole days as a philosophy major in college memorizing the long list of all the fallacies.  Each day as I peruse the financial news, I'm pretty sure I encounter at least a handful.  Slippery slopes, strawmans and appeals to emotion are RAMPANT throughout today's 24-hour news cycle.  Which others do you see regularly?

Lonesome Dove (Free Exchange) -- The Economist's economics blog looks at Ben Bernanke's maneuvering and posturing through the financial crisis.  In particular, this post looks at how Bernanke has positioned himself between those like Paul Krugman saying the academic Bernanke would do more to fend off deflation, and the inflationistas who at every step of the way insist that hyperinflation is right around the corner.  This is a must read for those interested in macroeconomics.

Don't Cripple Innovation for the Sake of this Quarter's Numbers (Harvard Business Review) -- This article touches on a point I will get back to time and again.  Companies need to manage their business to maximize the long-term value, and not for meeting quarterly numbers.  Too often we see companies doing precisely the wrong thing.  Many of today's managerial challenges on this end are driven by increasingly fickle shareholders looking to make a quick buck on a trade, rather than building wealth through long-term investment.  The tide does seem to be shifting though.

Bullish Sentiment At Lowest Level Since Last September (Pragmatic Capitalism) -- I usually try to focus on pieces that are not pegged in time, but this I just found so damn interesting.  Right now as the market sits within spitting distance of multi-year highs, investor sentiment is much nearer levels consistent with a bottom.  This is a pretty consistent contrarian indicator, where the preponderance of market participants tend to be wrong.  It's also a great counterpoint to those talking heads who keep speaking of excessive bullishness.

People are Figuring Out Austerity is Stupid (Ritholtz) -- It's about freaking time! Austerity has never worked throughout history and it sure as hell won't work now.  Don't be fooled by all the appeals to emotion and slippery slopes (go check out those logical fallacies from above).  The austerity argument is stooped in moralism far more than sound economics, and in reality the morality is all wrong anyway.  There is a sound empirical explanation for why austerity not only doesn't work, but is also in fact counterproductive and a force which increases (not decreases) an aggregate debt burden.  It's all about thinking of things in terms of their relative levels (i.e. debt to GDP) instead of gross levels.

David Wright: Greatest Met Ever? (Fangraphs) -- Well just 3 years ago I think every Mets fan would've agreed Wright had a clear shot at being the greatest Met ever.  Today many would beg to differ.  Reality, as it often does, lies somewhere in the middle.  He had some all-time great Mets years, with a couple of injury riddled ones we'd rather forget.  Looks like things are getting back to normal though for D. Wright.  The most shocking surprise from the Fangraphs analysis is that Edgardo Alfonzo is way higher than I thought he'd be statistically speaking.  I was a HUGE fan back in the day.

Typically I leave off with a great nature shot, but today I will again diverge and end with the 3 best photos I took at today's flyby from the Enterprise Space Shuttle.  What a cool site that was flying first up the Hudson from downtown, and then back towards the city, past the Hudson cliffs and over the George Washington Bridge.  While the space shuttle is old and headed for retirement, I still couldn't help but laugh at the contrast with my recent post on New York City pre-concrete junge.  Just an awesome site to see! 

Links for Thought -- April 6, 2012

Disruptive Innovation: Can Health Care Learn from Other Industries? (HealthAffairs.org) -- This is a great conversation with Clayton Christensen on the impact that disruptive innovation can have on the health care industry.  Christensen gave us THE essential mental model for understanding innovation, and it's important to understand how this model will impact health care over the coming years.  One of my biggest critiques over the health care cost concern is that the entire conversation assumes the past growth rate will continue forward in perpetuity.  Meanwhile, right now there are rapid deflationary innovations sweeping through the industry that I think will not just mitigate, but realistically will drive down the cost of medical treatment over time.  In order to understand this, one needs to know the distinction between something that is merely an innovation, and something that is a DISRUPTIVE innovation.

Important Read on Franchise Investing and Investing "Gurus" (CS Investing) -- Important read is definitely the best way to describe this post.  Here CS Investing gives us a look at what a competitive moat is and what the concept means.  Plus we get a great glimpse into how some of the most prominent investment gurus, including Warren Buffett, analyze moats when making their own investments.

Keynes: One Mean Money Manager (Wall Street Journal) -- Jason Zweig takes a look at the investment track record John Maynard Keynes and wow was it fantastic.  Despite Keynes being a macroeconomist, his successes in investment were primarily driven on the micro level, combined with an understanding of the behavioral element to investing.  This closely aligns with the value investing school of thought on markets, that alpha is possible with scrupulous fundamental analysis.  

Climate Change Isn't Liberal or Conservative: It's Reality (Boing Boing) -- In all seriousness, the title of this article should go without saying.  I first learned that climate change was real when the family swimming pool, which had frozen every summer as a child for me to play hockey on, just stopped freezing enough to skate on.  This started happening in the late 1990s, but now things have been taken to a whole new level.  I am increasingly frustrated and sickened by the "questions" raised over this very real issue.

Cutting A Star Out of the Picture (Wall Street Journal) -- Speaking of my childhood days playing hockey, this article is about the Islanders severing ties to Pat LaFontaine.  I grew up a rabid Isles fan, and even bigger Pat LaFontaine fan.  Pat is one of the all-time great Islanders and a model citizen.  Charles Wang once again demonstrates why he is a despicable person.  While we're on the topic of Pat LaFontaine, go check out his Companions in Courage website to learn about (and perhaps contribute to) some of his charitable initiatives.

Commodities Supercycle or Bursting Bubble? (Pragmatic Capitalism) -- This has been my question of the week, and led to today's post on our country's subsidy for commodity speculation.  It's an important question, because the answer has serious implications for the global economy.  Give this a read to help prepare for a conversation on this blog in the coming months as to whether the commodities bull is a monetary policy phenomenon or an emerging market growth story (or a little bit of both).  

I typically conclude this weekly links post with a nature picture, but for a second week in a row I will depart with a twist.  Here is Van Morrison with The Band performing Caravan at The Last Waltz, rock out for the long weekend, and happy holidays to all:

Links for Thought -- March 2, 2012

Apple: Thoughts on bias, value, excess cash and dividends (Musings on Markets) -- Two weeks ago, Aswath Damodaran brought us his valuation analysis of Facebook, this week he takes on Apple.  Aswath is a long-time Apple investor and a valuation guru.  He is generous enough to share not only his thoughts on Apple, but also his model.  Go check it out!

Mapping Solar Grid Parity (Energy Self-Reliant States) -- This is a really cool interactive map that shows when solar energy will hit grid parity around the United States.  Importantly this chart is taking a look at solar WITHOUT subsidies.  

The Silver Lining to Scarcity: It Drives Innovation (Harvard Business Review) -- Necessity combined with scarcity are powerful forces in the drive for innovation.  Too often innovation is not anticipatory, but rather reactionary to need.  Herein lies the "silver lining to scarcity."  This is a particularly relevant piece considering the questions about scarcity with regard to the future supply of crucial commodities like oil amidst surging emerging market demand.

Big Market Worries: Profit Margins (A Dash of Insight) -- Jeff Miller takes his stab at debunking one of the oft-stated mantras of today's market valuation: that margins are mean regressing and high, therefore they are due for contraction.  This is an important debate in establishing whether we are dealing with the real long-term compression of valuations, or whether this is simply a temporary uptick that will inevitably fade.  My belief--I side with Jeff.

Let Your Winners Run (A VC) -- Fred Wilson of Union Square Ventures tells us all to ride our winners.  When people see they are making money, it's very hard to take that itchy trigger finger off the sell button, especially in these days of high volatility.  Yet, to build outstanding performance over the long-run, it's important to recognize that the benefits of winners that keep growing are greatly increased by the effects of compound interest.  This is one of Kevin Douglas' strengths.