ROB Insight is a premium commentary product offering rapid analysis of business and economic news, corporate strategy and policy, published throughout the business day. Visit the ROB Insight homepage for analysis available only to subscribers.
Amgen Inc.'s blockbuster deal is stoking the red-hot interest in the U.S. biotech sector.
Following a month of speculation, Amgen agreed this past weekend to pay $10.4-billion (U.S.) for Onyx Pharmaceuticals Inc., developer of a treatment for cancer. This marks the ninth major biotech deal this year and raises the average value of the transactions to $3.2-billion.
Should investors be buying into the current fervour? Over the coming years, the expiration of patents on many key drugs, as well as the aging of the developed world, will provide a powerful tailwind for the biotech sector. But many of these stocks are already trading at nosebleed multiples of their earnings, which raises the risk that share prices may plunge back to earth if developments don't proceed at the pace that speculators hope they will.
To understand the risks, consider the three factors that have driven the S&P Biotechnology Index to an impressive 53.2 per cent return since August, 2011.
Initially, investors concerned about the U.S. economic outlook favoured defensive, non-cyclical sectors where performance didn't depend on economic growth. Biotechs, along with utilities and real estate investment trusts, fit the bill.
On top of that, the demographic outlook for Canada, the U.S. and other developed countries provided a built-in case for buying biotech stocks. A rising percentage of elderly people almost guarantees rising demand for pharmaceuticals.
According to the U.S. Centers for Medicare & Medicaid Services, 85 per cent of those 65 and older take at least one medication, a rate that is more than twice the level in the 18-to-44-year-old group. As a greater percentage of the population move into the 65-plus segment, pharmaceutical demand will rise, improving the profit outlook for the sector.
The third driver of biotech's great run was the large number of patent expirations at traditional pharmaceutical companies. Companies such as Roche Holding AG, Merck & Co. Inc. and Pfizer Inc. were unable to develop their own blockbuster drugs to replace revenues from previous successes and scrambled to buy the rights to new medications. Roche bought Genentech Inc. in 2008 for a tidy $44-billion, Merck acquired Schering-Plough Corp. ($47-billion) while Pfizer absorbed Wyeth LLC ($64.2-billion).
Patent expirations will remain a problem for drug companies. In fact, one big reason for Amgen's Onyx bid was the looming expiration later this year of Amgen's patent for anemia treatment Epogen.
Or look at Pfizer. Its Viagra medication for erectile dysfunction, which generated $2-billion in sales last year, went off patent in Europe earlier in the summer. Next year will see the end of its U.S. patent for pain reliever Celebrex, which last year brought in $2.5-billion in revenue.
Big Pharma's search of new acquisition targets will help support stock prices across the industry. But before investors start viewing biotech shares as a sure thing, they should take a hard look at valuations. They may find them a hard pill to swallow.
Biotech stocks are so insanely profitable – gross margins for the S&P Biotech Index average 84 per cent – that they'll never trade at below-market average price-earnings ratios. But investors might need more than a spoonful of sugar to swallow the current trailing P/E of 27.4 times earnings.
In addition, investors should be concerned that they're joining the party a bit late. It's not 2011 any more and there's less concern about the U.S. economy falling back into the abyss so defensive sectors are less attractive.
Still, the short- and long-term profit outlook for the sector is too good to ignore. My recommendation? Take a diversified approach through ETFs such as iShares Nasdaq Biotechnology Index Fund (IBB) and limit your exposure to no more than 5 per cent of your portfolio.
Scott Barlow is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here to read more of his Insights, and follow Scott on Twitter at @SBarlow_ROB.