Is It Time to Buy Biotech Stocks?

Source: Thinkstock

Source: Thinkstock

One of the worst performing sectors in March was biotechnology. The iShares Nasdaq Biotechnology ETF (NASDAQ:IBB) was down over 13 percent in just the past month, whereas the S&P 500 was essentially flat and the Nasdaq Composite was down about 3.5 percent. Why is biotechnology underperforming, and should you step in and take advantage of these lower prices?

Biotechnology shares have been significantly outperforming, and it is time for a correction. Over the past year, despite a dismal March, the iShares Nasdaq Biotechnology ETF is up 43 percent versus the S&P 500 and Nasdaq Composite, which are up 18 percent and 27 percent, respectively. Some of the largest biotechnology companies have had new products hitting the market that have been boosting sales, and as a result, many of these companies’ stocks spiked in 2013 as investors began to price in rapid growth. For instance, Biogen Idec (NASDAQ:BIIB) has seen its sales and income spike in the past year, so that its EPS is up over 50 percent; so is the stock over the past year, and over the past five years shares are up over 450 percent. Nevertheless, now shares trade at 37 times earnings, and this seems like a stretched valuation.

Similarly, large-cap biotech company Celgene (NASDAQ:CELG) saw its shares spike from $112 in June to over $170 towards the beginning of the year. Acceleration in the company’s revenue growth from 14 percent (2012 versus 2011) to 18 percent (2013 versus 2012) generated incredible enthusiasm for the company’s shares, which at the beginning of the year traded at 50 times earnings. Now the shares have started to come back down to Earth, but at $139 each they still trade at 40-times trailing earnings. I suspect that there is further downside in Celgene shares as well.

There are other examples as well of companies whose stocks flew too high and are now coming back down to Earth as investors become more cautious. I suspect that this will continue considering the extremely high valuations that many of these stocks trade at. According to the iShares Nasdaq Biotechnology ETF website, the fund trades at 44-times earnings and over 11 times book value in the aggregate. This is too high for virtually any investment and therefore the correction might continue.

Nevertheless, biotechnology is still an exciting field and there is a lot of money to be made. One approach is to purchase shares of the largest component of the iShares Nasdaq Biotechnology ETF – Amgen (NASDAQ:AMGN). Amgen is not growing quite as rapidly as companies such as Celgene or Bioden Idec, but it was able to grow its sales by about 12 percent year-over-year in the fourth-quarter, and it trades at just 18 times trailing earnings, or just 15 times 2014 earnings estimates. Thus, the stock trades at a discount not just to the iShares Nasdaq Biotech ETF but to the S&P 500 as well. Furthermore, the company has an aggressive stock repurchase program in place, and it pays a 2 percent dividend. This seems small, but it has been growing and it still beats the dividend yield of the S&P 500.

Investors looking for a more sophisticated strategy might consider buying shares in Amgen and buying put options on the iShares Nasdaq Biotech ETF in anticipation of the spread between Amgen’s valuation and the rest of the industry’s valuation converging.

Those investors who want to buy the ETF in the hopes of a recovery propelled by continued strong growth in the industry will find support at around $200/share (the fund currently trades at roughly $230/share.) While I still think that this is a lofty price from a valuation perspective, I am mindful of the fact that biotechnology companies are rapidly and consistently growing their profits. While the shares might pull back and consolidate for a few months, it will ultimately be in strong demand considering that growth stocks are a rarity in this weak economic environment. Therefore, I wouldn’t be surprised to see the uptrend resume some time later this year.

Disclosure: Ben Kramer-Miller has no positions in the stocks mentioned in this article.

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