The End of the Small Cap Biotech Bubble
Biotechnology and Pharmaceutical (“Biopharma”) stocks have skyrocketed since January 1, 2013, most notably in the small cap growth universe. Their outperformance against the broad index of small cap growth (SCG) stocks has been dramatic, totaling 173% vs. 62% for the Russell 2000 Growth Index.
We believe that Biopharma is currently in an investment bubble, with inflated valuations which have become disconnected from fundamentals. As a result, Redwood’s SCG strategy has been and continues to be significantly underweight Biopharma stocks. We do not believe that the trend of the past 29 months can persist and we anticipate that our portfolios will benefit significantly from weakness in biopharma stocks.
Signs of a Bubble
Our conviction in our Biopharma underweight in the Redwood Small Cap Growth strategy driven by three unsustainable phenomena. These issues have been present in prior bubbles and have historically preceded poor stock performance. They include a spike in IPO activity, a deterioration in the quality of new issues, and excessive valuations.
Too Much Supply. There has been a spike in capital raised through IPOs and secondary offerings. Since 2013, Biopharma companies have raised $32B of equity capital in 365 IPOs and secondary offerings. This is almost equal to the amount of capital raised during the previous decade.
Figure 1: Biopharma Capital Raised 2001 - 2015
Biotech stocks now represent almost 11% of the Russell 2000 Growth Index, which is an all-time high and more than two standard deviations above the 20 year average (Figure 2). After the two previous peaks in 2001 and 2009, the Biotech stocks in the Russell 2000 Growth Index underperformed the overall benchmark over the ensuing 24 months by 3,400bps and 880bps, respectively.
Figure 2: Weight of Biotechnology Stocks in the Russell 2000 Growth Index
Low Quality. The end of an investment cycle is typically preceded by an acceleration in lower quality companies rushing to market before the unbridled optimism fades and the IPO window closes. Today, the quality of recent IPOs has deteriorated significantly. Consider the following:
24% of all small cap Biotech companies have neither products being distributed, nor any ongoing trials at any stage. In 2012 this number was 8%.
32% of Russell 2000 Biotech companies currently generate little or no revenue. In 2012 this number was 14%.
* Source: Furey Research Partners
Assuming a drug does receive FDA approval, getting it to market takes six to eight years. Add the cost of building a sales force and most of these companies are almost a decade away from earning a profit in the best case scenario. These statistics suggest that even if every drug in development is ultimately approved, nearly 25% of small cap Biopharma companies are a decade away from generating any revenue. Unfortunately, the approval mirate of drugs is far from 100%. In fact, only 2% of all the drugs that have entered Phase 1 of human clinical trials have been approved. We believe that the degradation in the quality of the Biopharma industry suggests an erosion in the value of the drug pipeline.
High Valuation. Valuing early stage Biopharma companies is a challenge because most do not have current sales, let alone earnings. We therefore evaluate the group on a variety of valuation metrics to triangulate current valuations. We conclude that the group appears to be discounting near-perfection and may still be 50% overvalued.
EV/Revenue. The small cap biotechnology stocks are trading at almost 30x EV/Revenues compared to approximately 10x only three years ago. The group is approaching two standard deviations above the average multiple over the last 15 years. This valuation metric highly correlates with the forward relative returns of biotechnology stocks, as the industry underperformed in the two prior instances in 2001 and 2004.
Figure 3: Enterprise Value/Revenue
Forward P/E. The return potential for the largest biotechnology companies in the Russell 2000 Growth Index using a forward P/E methodology also confirms our view that valuation for the group has become excessive. Even assuming an aggressive 40x P/E multiple on earnings in year-2 after a company’s primary drug hits the market (generally 2020 or 2021) yields a compounded annual return potential for the stocks of 13%. By comparison, this same methodology generated a 28% expected return two years ago. Given the business risks, we believe that a 25% - 30% expected return would be average, implying that many of these stocks could be 50% overvalued.
Market Cap/Revenue Opportunity. An analysis of the biotechnology stocks in the Russell 2000 Growth Index estimates that the cumulative market capitalization represents 169% of the estimated product pipeline compared to the historical average level of approximately 100% and trough valuations of near 60%.*
* Source: Furey Research Partners
What might be the catalyst that pops the biotech bubble?
Identifying the catalysts that cause an investment bubble to burst is challenging. We believe that some possible catalysts could include 1.) Rising Interest Rates 2.) Reduced Access to Public Equity Markets 3.) Shifting Investor Sentiment.
Rising Interest Rates. As evidenced above, Biopharma stocks have significant inherent fundamental risks and long payback periods. From an investment standpoint, their long duration can be viewed similarly to zero coupon bonds. In a rising rate environment, long dated zero coupon bonds are the most volatile securities and decline in price more than any other type of fixed income security. Over the last few years, low rates and buoyant markets have created an environment in which investors can justify buying stock in early-stage Biopharma companies despite their inherent risks and long payback period. When rates rise we expect Biotech stocks to act poorly.
Reduced Access to Public Equity Markets. Prior bubbles have run out of steam when financing early-stage biotech has become more challenging. This was evident during the 2001 Biotechnology peak. Access to low-cost equity capital is critical for Biopharma stocks since it takes many years of expensive clinical trials to achieve an FDA approval and yet more capital to launch and market a new drug. If the financing window were to close, many biotechnology companies could run out of capital, which in turn would exert downward pressure on stock prices.
Drug Failures. Biopharma’s recent run has created an optimism amongst investors. Historically, the success rate of products that enter human clinical trials and eventually become FDA approved and marketed is a mere 2.1%. Only 30% of Phase III clinical trials ultimately proceed to the FDA for approval. As the optimism from the strong recent performance fades, investors will be faced with the reality that failures in the Biopharma industry are the norm and that many drugs being developed today will fail outright or face delays in their clinical development. As companies announce product failures momentum investors may rotate out of Biopharma, further exacerbating the underperformance.
Where might we be wrong?
Therapeutic Revolution. It is possible that the world is entering a “therapeutic revolution” driven by new technology with more targeted therapies enabling more FDA approvals. Redwood believes this is dangerous assumption, and so far the data does not support it. The number of drug applications to the FDA has held steady at 39 - 41 annually over the past four years.
M&A. Many large Biotechnology and Pharmaceutical companies have invested in multiple small cap Biopharma companies. They are also acquiring many companies at significant stock price premiums after the targets achieve research milestones. This M&A trend could continue because large cap pharmaceutical companies need by to refill their R&D pipelines after so many drugs have gone off patent over the past years.
Biotechnology Stocks and Portfolio Risk
The Redwood Small Cap Growth strategy has a significant underweight in Biopharma stocks today. This exposure represents one of the largest contributors to “active risk” in the portfolio. While we could neutralize that active risk by owning a market weight of 11% in Biotech stocks we believe that doing so would increase our portfolios’ absolute risk while decreasing the expected return. As with every investment decisions, we weigh the risk-and-reward proposition. We believe our clients’ portfolios will be amply rewarded for this risk.
In summary, Redwood believes that small cap biotechnology stocks are in a precarious position. Given our steadfast conviction that fundamentals, valuation and quality are the key characteristics of long-term stock outperformance, we are increasingly concerned by the erosion of quality and excessive valuations in the Biopharma industry and anticipate a significant reversal of the group’s performance.