Bubble-icious Biotech

For me, one glance was all it took.

Looking at my colleague's computer from across the room, I could see that this pre-IPO company's lead oncology asset -- presumably the driving force behind this white-hot offering -- was likely a zero. There were as many patients with disease progression as there were responders to treatment, including one patient with a tumor that more than doubled in size while on drug. There was no clear dose response or obvious indication; the handful of responses observed occurred across almost all of the doses and tumor types tested. To me, these data looked more like a cluster of anecdotal case reports than an exciting new drug candidate.

Naturally, shares soared more than 50% on the first day of trading.

Fellow members of the biotech community, I've got news for you: we are in a bubble.

Investors have avoided the hard truth for a few months now, arguing that recent medical innovation -- and there have been major advances -- and sheer Wyle E. Coyote-esque momentum will carry us safely across this widening valuation chasm, once promise turns to profit. I've long sensed the fragility of this illusion, and this barely-visible waterfall plot laid the truth bare, at least for me.

I'm not the only person to have noticed the disconnect between valuation and reality: savvy buysiders, a few sellside analysts, and some members of the biotech media have all been asking the same question for a couple of months now. For much of the summer, Wall Street consensus remained almost defiantly optimistic. (It's not often that us biotech nerds get to lead the S&P 500 by a wide margin, so a little wishful thinking is to be expected.) Yet the clouds seem to be darkening, carrying hints that the rain of reality may soon drench this latest bout of irrational exuberance.

As the always-wise Howard Marks often notes in his memos, bubbles are the byproduct of excessive confidence and inadequate fear. Let's look at seven signs of overconfidence in the biotech market.

1. I can't keep up with the IPOs. There have been 38 IPOs in biotech through mid-October, far more than during any period in recent memory. Another 12 or so companies have filed an SEC Form S-1 (a pre-IPO requirement); if the market holds, most of those will likely be public by year-end. I confess I have no idea what some of these companies do, and haven't had the time to examine more than a handful of them in depth. To give you a sense for the magnitude of this avalanche, consider that there were only 35 biotech IPOs in the past two years combined. (Tip of the hat to David Thomas at BIO for compiling and sharing these data.) In fact, one well-regarded portfolio manager at a multi-billion dollar long-only investment firm recently admitted to participating in IPOs without having done a deep dive, presumably due to fear of missing out. This environment is great for the bankers, but suggests an unhealthy appetite for risk among those of us not profiting from hefty transaction fees.

2. Many freshly minted biotech IPOs won't have data for years. Historically, investor appetite for companies with little-to-no clinical data has been appropriately nonexistent, due to the low predictive value of very early-stage results. Yet the recent crop of IPOs contains at least five companies with only preclinical or Phase 1 data. (I haven't looked through all the S-1s.) From 2008 through 2011, not a single biotech company went public with only preclinical or Phase 1 data (there were two in 2012). Again, this suggests to me that the fear-confidence pendulum has swung too far from center.

3. IPOs are posting huge gains. Through mid-October, the average inception to date return for a biotech IPO this year is 55%, with an eye popping median gain of 40%. Believe it or not, at the beginning of the month the mean and median returns were 70% and 50%, respectively. Especially given the long time lag to proof-of-concept clinical data for many of these companies, that's a worrisome "red flag." Friendly reminder: although it hasn't seemed like it this year unless you're short, you can lose money in the stock market too.

4. The shorts have been getting killed. Everyone loves to hate the shorts, but like it or not, the skeptics are often right. Even if that longstanding truism of R&D efficiency -- that only 1 in 10 drugs entering the clinic makes it to market -- has improved, failure is still by far the most likely outcome. Yet multiple well-regarded short sellers told me over the summer that you couldn't be short in this market -- most biotech stocks seemed to go up relentlessly, regardless of fundamentals -- because you would get carted off without ever having the chance to be right. (Being "carted off" is a buyside colloquialism for losing shedloads of money, your job, or both.) That's not healthy.

5. Investors are chasing performance. The AMEX biotech index (BTK) -- an important indicator of the sector's performance, despite some structural flaws -- is up roughly 40% year-to-date. Notably, it's not just the BTK blue chips that have soared; the broadly based NASDAQ biotech index has posted a year-to-date gain of more than 50%. Here's the problem: if you're a long only, strictly biotech fund that's up an otherwise exceedingly respectable 25% this year, you're badly underperforming the indices. That dynamic can create anxiety for even veteran investors, which in turn leads to a semi-conscious willingness to turn a blind eye to risk. (This phenomenon was immortalized by ex-Citigroup CEO Chuck Prince's "if the music's playing, you have to get up and dance" comment, which immediately preceded the 2007-2008 financial crisis.) My conversations with other buysiders confirm that some usually sane investors are drinking the Kool-Aid with gusto and rationalizing "red flags" with alarming regularity.

6. Sellside notes are becoming increasingly farcical. There's a longstanding debate about whether biotech valuations should be based on an analysis of discounted cash flows (the more conservative method) or on price-to-earnings multiples (a more aggressive, but still valid, methodology). Usually, a company's true value lies somewhere in between these metrics. In the most bullish scenario, higher-than-expected cash flows enable a company to "grow into" its valuation. Unfortunately, the chasm between these measures now seems so insurmountable that even generating an attractive P/E based valuation can be tough. Rather than head home with the party in full swing, the sellside has turned to increasingly absurd, often comically tortured assumptions to generate attractive price targets. One sellside note -- a 31-page opus fantastical enough to make Gabriel García Márquez proud -- recently ascribed $1 billion in value to a drug candidate without any data in humans. Another analyst must've been channeling Harry Potter at the office; only magic could explain how $1 billion in projected sales disappears from a model formerly showing $2 billion in revenues without having any impact on the price target. Lastly, though you might think the analyst aggressively supporting a biotech with a long history of failure would be chastened when the company's latest lead asset implodes, you would be wrong. Recent notes barely acknowledge the stock's 40% plunge and simply shift focus to promoting the next-in-line drug candidate. It's still a buy! These most forehead slapping examples -- which I usually save for posterity and a good laugh -- also serve as a good reminder that buysiders aren't the real clients for investment banks. (If you can't guess the real client, here's a hint: IPOs and secondary offerings generate millions in fees for the banks.)

7. Healthcare conferences are mobbed. I'm awaiting the annual JP Morgan healthcare conference, a post-New Years' rite of passage that even in lean years is packed to capacity with investors, with more than a little trepidation. It seems like even the second-tier conferences I've attended this year have been overrun with people -- largely generalists -- I've never seen before. Another sign: the JP Morgan conference hotel booking process, which even in the best of times ends in sad resignation at the inevitability of usurious convention pricing, looks even worse this year. I may need to ask Tony Coles, the CEO of recently acquired Onyx Pharmaceuticals, if he's got room on his couch in San Francisco. (Tony: I'll call you!) It's becoming increasingly clear that the sheep are stampeding full speed into biotech.

It's always painful for some when the bubble bursts; in good times, people tend to forget the allegorical six-foot tall man who drowned in the river that's five feet deep, on average. However, for those judicious investors that avoid the overhyped and unreasonably priced during the boom, there's lots of opportunity when the music stops. (Never mind the prudent short seller who, having survived the run up, can finally capitalize on a return to sanity.)

Despite the many warning signs of over-exuberance, the underlying fundamentals of the biotech sector do show some encouraging signs. Medicine has made significant leaps forward since the implosion of the last biotech bubble in 1999-2000: biologics have dramatically improved the prognosis for many diseases, the cost of gene sequencing has plunged even as sequencing power has surged, and our collective understanding of biology -- although still woefully inadequate compared to the majesty of the human body -- is improving significantly. Moreover, there are promising new areas of interest, like precision medicine, that seem to be gaining momentum. That's the good news.

Yet even if medical advances drive valuations higher over the long-term -- a likely scenario over the next decade -- there will be hills and valleys along the way. It feels like we are cresting one of those hills right now, especially for small and mid-cap biotech. Although still susceptible to "black swan" risks, larger cap biotech companies have shown an increasing willingness in recent years to mobilize their vast balance sheets, rationalize expenses, and even consider dividends; these levers, along with deep R&D and commercial portfolios, will likely offer some insulation when sentiment deflates. Unfortunately, small and mid-cap biotechs have fewer financial engineering options and often rely largely on the promise of future profits, thus leaving them more vulnerable to a shift in sentiment.

The suggestion that "this time is different," at least for biotech equities, is likely wrong. Bubbles always burst, usually for unexpected reasons. Even though the biotech party is raging, my advice is simple: caveat emptor.