External forces shaping the move include comparables with the big boys as well as safe haven from Asia. Here's what they said about the big boys:
Externally, we see two factors that make biotech attractive relative to other groups
in the stock market.
Pharmaceutical
company valuations are
at historical highs.
Pharmaceutical Company Comparables
One of the primary beneficiaries of investor interest in this market has been the
pharmaceutical sector. Attracted by the sustained, above-average growth potential of
pharmaceutical products, these stocks have attracted every mode of investor over the
past two years - growth, momentum, value, and defensive. The result has been a
phenomenal run for the sector, with the DRG index up over 110% since January 1, 1996
and some companies in the group, like Warner-Lambert and Pfizer, up over 200%
during that period. This growth over the past 27 months has increased the market value
of the top 10 pharmaceutical companies by over $450 billion, which is four times the
value of the entire biotech industry. Investors in most pharmaceutical stocks are now
paying EPS multiples of 35 to 55 times next year's earnings. These multiples are usually
about twice the companies' growth rates, which are in the 15% to 25% range.
Meanwhile, profitable, large-cap biotech companies with existing or potential EPS
growth exceeding 30% are selling at EPS multiples below their growth rates, often at
market multiples or even below.
Discount between the
two groups - pharma
and biotech - is
excessive.
Since the pharmaceutical companies usually have revenue streams with greater
breadth than biotech companies, we believe it reasonable that biotech earnings receive
a discounted multiple when compared to pharmaceutical earnings. However, the current
valuation metrics appear unjustifiably discordant. One could argue that the valuation
gap should be closed by a decline in pharmaceutical stock prices, but we support the
theory that drugs will play an increasing role in disease management within the
healthcare industry over the long term, and that pharmaceutical companies will be
beneficiaries of that trend. A more likely market scenario is that investors in the pharma
sector will peel off some of the profits from the highest valuation stocks and deploy
these assets in biotech. Historically, such spillover investor interest begins with the large
cap, profitable companies, and then generally moves on to the emerging second-tier
companies that have products in late-stage development (Phase III) or are just entering
the market. As highlighted in the table "Approching Biotech Product Launches," in
Exhibit 2 on page 6, if this spillover occurs again, investors will have a rapidly
expanding universe from which to choose.
Moreover, if the rising number of new products coming from biotech companies is
the beginning of a long-term trend, as we believe, one could make the case that the P/E
multiples of these companies should exceed or at least equal those of Big Pharma. With
a smaller revenue base, products which are only modest commercial successes by
pharmaceutical standards can result in dramatically higher EPS growth rates. Most
potential $100-million products are likely to be dropped from development by the large
pharmaceutical companies, whereas for virtually every biotech company, such products
would dramatically impact the bottom line.
Biotech may be better
positioned in
fragmented markets.
As with many industries today, pharmaceutical leaders are looking to get even
larger via consolidation, as evidenced by the recent Roche/Boehringer Mannheim
combination and the proposed mergers of American Home Products/SmithKline
Beecham and Glaxo/SmithKline Beecham. However, while the companies may be
getting bigger, products may be getting smaller. As the genomics revolution deciphers the genetic and biologic underpinnings of disease, it is fragmenting the size of many
large disease indications. For example, breast cancer, currently one of the largest patient
populations in oncology, is now being parsed into smaller subpopulations, based on the
varying genetic profiles of the tumor, such as presence of her-2, estrogen, or PDGF
receptors. These different subtypes are proving responsive to different therapies, and
specific treatments for each subtype are emerging. This trend will yield an increase in
drugs that are better targeted to patients. The result could be fewer blockbuster (greater
than $1 billion in annual sales) drugs, but rapid growth in the number of smaller drugs
($50 million to $500 million in annual sales). As biotech companies were founded on
genomics, we believe they will remain at the forefront of discovering and developing these
more targeted therapeutics. With smaller revenue bases and market capitalizations, these
products will provide significant earnings leverage for biotech companies. |
