Bubble in Biotech?

03/23/2015 9:00 am EST

Focus: STOCKS

James Oberweis

President, Oberweis Asset Management, Inc.

Valuations in biotech these days have us scratching our heads, cautions Jim Oberweis, Jr., small-cap expert and editor of The Oberweis Report.

Big pharma and investors have been dumping billions into speculative enterprises that have yet to produce a viable drug.

Global drug makers, facing a cliff of expiring patents and rising R&D costs, seem desperate to scoop up promising molecules, with cash stockpiles and cheap debt adding fuel to the fire.

That said, promising is a long ways from profitable. In fact, most drugs won’t ever be approved. According to a recent study by Tufts University, only 11.8% of compounds move from Phase I trials to clinical approval, at an average cost of $2.6 billion per approval.

While we expect some spectacular winners, valuations for the industry broadly seem absurd. At a minimum, we believe many investors have become caught up in the hype and are underestimating the probability of failure.

For some companies, valuations seem to imply that their pipeline of drugs is guaranteed to be approved; a poor assumption that contradicts historical evidence.

In short, it looks to us like—as in many bubbles of the past—the market may be dramatically overpaying for pipelines while underestimating the downside risks.

Besides the risk of clinical failure, biotechs also face the risk of eventual pricing pressure. Formulary exclusions, in which pharmacies or insurers offer one company’s drugs while excluding others, are becoming more common.

Be wary of paying lofty valuations for biotechs unless the probability of clinical failure and risk of pricing volatility are appropriately discounted. Broadly, that isn’t happening today.

Our recommended holdings, like Diplomat Pharmacy (DPLO), which distributes specialty drugs and biologics, will also benefit from the industry’s growth but without the binary risks.

Others, like ANI Pharmaceuticals (ANIP), still offer an exceptional growth profile, but at a minimum, have revenue and profits to form the framework for a reasonable valuation, even if not cheap by traditional metrics.

Or consider other innovative medical products companies like Abiomed (ABMD) or Cardiovascular Systems (CSII), both of which appear to be driving sales at much faster rates than analysts predicted.

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