Junior Biotechs: The Potential for Future Earnings

08/21/2015 9:00 am EST

Focus: ETFs

Matt McCall

Founder and President, Penn Financial Group

Traditional valuations for the biotech stocks are high compared to other sectors, but when the growth potential is taken into consideration, it tells a different story. Since this is especially true for the smaller junior biotechs, Matt McCall, of Penn Financial Group, highlights several names for investors to consider.

The biotech sector has been a focus for both the bulls and the bears recently as the latter are calling for the bursting of the bubble. On the other side, the bulls remain positive on the future despite a pullback of 9% from an all time for the iShares NASDAQ Biotechnology Index ETF (IBB).

The argument from the bears that the sector is overvalued has been a colossal
failure for over a year as IBB is up 40% in the last 12 months. Traditional valuations for the biotech stocks are high when compared to other sectors, however, when the growth potential is taken into consideration, it tells a different story. This is especially true for the smaller biotech stocks that are often referred to as “junior biotechs.”

There are several new ETFs within the last year that concentrate on the smaller names in the sector. The ALPS Medical Breakthrough ETF (SBIO) will only include biotech stocks that have a market capitalization between $200 million and $5 billion, but they must have at least one drug in Phase 2 or Phase 3 of FDA clinical trials. The ETF began trading on the last day of 2014 and is up 41% in 2015, easily outpacing its larger peers.

The majority of the stocks that make up SBIO are losing money as they progress through the stages of the FDA clinical trials. The reason investors have been pouring money into the high risk stocks is based on the potential for future earnings based on FDA approval. Another catalyst for the performance of the junior biotechs has been a flurry of takeovers by larger pharmaceutical companies.

An example of this type of company is Seattle Genetics (SGEN), which is a $5.8 billion company that is working on drugs to battle cancer. Even though the company is expected to lose $0.96 this year, the stock is up 45% in 2015. The reason for the investor interest is that the company is expected to earn nearly $2 per share by 2019 according to the analysts that cover the stock.

There are two ways to play the huge potential upside in the junior biotech stocks. The first would be to attempt to pick a stock such as SGEN and look for a big gain, however with that comes very high risk. If the company received negative news from the FDA it could lose over half its value in a matter of minutes. The second option involves an ETF such as SBIO that would give investors exposure to the junior biotech sector without company-specific risk. Granted the upside potential is not as high, neither is the risk of taking a huge loss.

Matt McCall, Founder and President, Penn Financial Group

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