August 24, 2014
We learn from our mistakes, at least I hope we do. Below is a chart comparing four of the biggest "bubbles" in US market history:
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| Courtesy of Macrotrends.com |
I'm going to refrain from using the term "bubble" and instead use "irrationally exuberated price discovery". Often times in these moments, it drives rational agents to act not so rationally. Looking at the chart above, we see an almost identical explosive rise in prices followed by an equally rapid decline regardless of the asset class. There are myriad factors (known and unknown) that contribute to the exuberance but I'd like to focus on one particular case: excessive speculation.
Below is a chart of bitcoin:
We cannot deny the fact that no one really knew what bitcoin was worth last year. In a span of less than a week, we saw highs just north of $1100 and a near 50% collapse. At the time, the digital currency was, in my opinion, nearly useless. It really couldn't be used as actual currency since it wasn't really adopted. There was a single cafe in Palo Alto that accepted bitcoin but a $3 dollar cup of coffee may have actually cost you $10 the next week due to price volatility. I suppose it was good for money laundering.
So now we arrive at the biotechnology sector. Here is a quote from Yellen herself earlier in July:
Nevertheless, valuation metrics in some sectors do appear substantially stretched—particularly those for smaller firms in the [...] biotechnology industries, despite a notable downturn in equity prices for such firms early in the year.
Let's take a closer look at valuations in the small cap biotechnology sector vs the S&P500:
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| Price of small-cap biotech vs. S&P500. Source: Ameritrade TD |
Year-to-date, Ameritrade's small cap biotech index has risen almost 20% above the S&P500. Is there a problem with this?
To answer this question, let's take a look at what the S&P500 is actually indexing.
The S&P500 is a stock market index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ - Wikipedia
So the S&P500 essentially tracks the prices of generally well established, dividend-paying components of American markets such as Boeing, Berkshire-Hathaway, Coca-Cola, etc. Let's look at some components in the small-cap biotechnology sector:
The above list is the first page of Ameritrade's listing in the sector, arranged with descending market cap. Immediately, you notice that of the 22 companies on this page, only 8 actually have a listed P/E ratio, indicating that only 8 of the largest companies (by market cap) in this sector generate positive revenue to even have a price/earnings ratio listed. Additionally, only two companies in this entire index pay a dividend (PDLI ~ 6% and AMGN ~2%).
So why is this sector popping? Investors sure aren't receiving any meaningful dividends from these components. Instead, they are speculating on the future worth of these companies, which can pay a handsome reward if $PBYI (Puma Biotech.) serves as an example:
However, Puma is an outlier, no doubt. Not all of these companies will explode 5-fold in price overnight. In fact, a lot of these companies will fail to pass any of their products to public markets and will be acquired/liquidated at a net loss to investors.
$TKMR, Tekmira, developing a potential Ebola vaccine that barely skidded its way into clinical trials due to urgency saw speculative buying, and a lot of buyers in the stock got burned.
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| Notice the similarity in price action to bitcoin? |
Tekmira made a public offering earlier this year at $28. That price, for a company that has yet to generate positive cash flow. It closed today at $17.74. Tekmira is typical of what a lot of the small-cap biotechnology sector currently looks like. No positive cash-flow and sky-high P/E's and valuations. Now let's look at the NASDAQ's Biotech. Index Fund ($IBB):
See a pattern emerging? The average P/E of components in this ETF is approximately 40, whereas the average P/E of all stocks publicly traded in the US is about 19. Here is NASDAQ's page on this ETF that lists some statistics and components of the fund.
If history serves as an example, I see a lot of similarities between today's biotechnology sector and the NASDAQ of the early 2000's. Investors were shooting valuations of any company with a .com domain name sky-high regardless of whether they had any sound fundamentals or even a sensible business model for that matter.
Having gone through the .com bubble, investors are of course more cautious in exhibiting such exuberance in the year 2014. However, in my opinion, I think that history may be repeating itself. Having worked in the pharmaceutical industry, I've seen many "promising" drugs fail late stage pre-clinical trials from some of the best publicly traded pharmaceutical companies. Furthermore, it's not even unusual to see drugs fail late-stage clinical trials.
In a previous post, I talked about how Wall Street "prices-in" shares in pharmaceutical companies with the assumption that their drugs will successfully pass clinical trials. If this weren't true, we would never see drastic price crashes upon announcements of clinical trial failures.
Having said that, no one can be 100% certain of what any asset is really worth. It may be the case that the biotechnology sector is fairly valued, but it also could be not. As we head into the Fall, keep in mind that 5 years of economic stimulus is coming to an end and that the risk of increased interest rates becomes more and more palpable with every passing minute.
Good luck this week.
#biotechnology, #ebola, $TKMR, $PBYI, $AMGN, $IBB
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