How Far Will Biotech Run?

Long-term readers of this letter have prospered mightily from my addiction to biotech stocks in recent years, one of the most reliably top performing sectors in the stock market.

But have we visited the well one time too many times? Is biotech turning into a bubble that will eventually deliver the same grievous outcome of other past bubbles?

Not yet.

Still, one has to ask the question. No less a figure than Federal Reserve governor Janet Yellen has indicated that she thought valuations in the biotech sector were getting ?substantially stretched.? The Fed doesn?t single out stocks for commentary very often.

Biotech certainly has been a money-spinner for followers of my top performing Trade Alert service, which delivered a 30.5% profit in 2014.

Readers made three round trips in hepatitis C drug developer Gilead Sciences (GILD) in the past four months, adding 5.77% to the value of their portfolios. I believe the company?s blockbuster drug will become the most profitable in history. So do a lot of others.

Longer-term investors bought the Biotech iShares ETF (IBB) on my advice, which gained an impressive 45% last year, and is still rising.

However, biotech has long been a hedge fund favorite.

That means many shareholders are only dating these stocks and are not married to them. The hot money regularly flows in and out, giving the sector more than double the volatility of the main market. A 10% correction in any other stock is worth at least 25% in biotech.

This also makes biotech stocks great to buy on a dip. My last foray into (GILD) occurred after cautious guidance took the shares down a heart stopping 10% in a single day.

This is a great example of how unusually sensitive biotech stocks are to headline risk. I?ve ridden stocks to tremendous heights, watching them pour billions into a single treatment, only to see them crash and burn on failed stage three trials.

That is just the nature of their business. It?s all about all or nothing bets.

It?s just a matter of time before one of the major companies gets stuck with a hickey like this, flushing billions down the drain. That could herald a generalized sector selloff that could last months, or even years.

Biotech is a high-risk sector that should only be held within a well diversified portfolio. You may notice that in the Mad Hedge Fund Trader?s model trading portfolio I never have more than 10% in biotech at any given time. I figure I could handle a total blow up and lose the whole 10% and still stay in business.

When I speak at conferences, strategy luncheons and on TV, I tell listeners of my lazy man?s guide to long-term investment. Only follow three sectors, technology, biotech and energy, and ignore the other 97. You?ll save yourself a lot of time reading pointless research.

Biotech currently accounts for a mere 1% of US GDP. It is on its way to 20%, about where technology is today. That means that a disproportionately large share of earnings growth will spring from biotech over the coming decades.

One way to protect yourself is to stick with the big caps, which are undervalued relative to the sector, and are expected to haul in 20% earnings growth this year.

Many smaller companies prices are assuming a total certainty of the success of their drugs. The reality is that this only happens about half the time.

If you do go with small caps, I would take a venture capital approach. Buy a dozen with the expectation that many will go under, a couple do OK, and one goes through the roof. Never put all your eggs in one basket.

It also helps that you have someone with a scientific background making your picks, like me. Because drug companies promise such amazing results, like curing cancer, the sector has always been prone to hype and over promotion. I never met I biotech CEO who didn?t believe his company was about to deliver the next panacea, taking his shares up tenfold.

One plus for biotech is that it has unusually strong patent protection, which usually extends out 20 years for new products. There are not a lot of Chinese companies that can imitate their drugs.

That means earnings can be predicted far into the future, and are largely immune from the economic cycle. If you?re sick, you want to get cured regardless of whether the GDP is growing or shrinking, or whether interest rates are low or high.

Make sure that your investments have plenty of new developments in the pipeline. Expiring patents on past winners with no replacements can spell certain death for a stock price.

Publicly listed drug companies are now venturing into research fields that were only science fiction when I was in the lab 45 years go. ?Gene editing? whereby genes can be repaired, edited and then turned on and off at will, is now becoming a burgeoning new science.

It promises to cure the whole range of human maladies, including heart disease, cancer, obesity and a whole range of degenerative diseases (including some of mine).

Expect to hear a lot more about TALENs (transcription activator-like effector nucleases) and CRISPR (clustered regular interspaced short palindromic repeats). You heard it here first.

What is truly fascinating is that hybrid computer science/biochemical scientists are now taking algorithms developed y the National Security Agency hackers and using them to decode human DNA. (I hope I?m not speaking too much out of school here.)

Gene editing is the natural outcome of the discovery of recombinant DNA technology developed during the 1970?s by Paul Berg, Herbert Boyer, and Stanley Cohen, all early heroes of mine.

Since none were the equity participants of private companies, the initial rewards for the breakthrough were minimal. I remember that one received a new surfboard for his efforts.

Berg went on to found Genentech (GENE) in 1977 and got rich. If I hadn?t gone into the stock market, that is almost certainly where I would have ended up.

How things have changed.

The short answer here is that biotech does have further to run. A lot further.

The rate of innovation of biotechnology is accelerating so fast that it will continue to spew out fantastic investment opportunities for the rest of your lives. So expect to receive many more Trade Alerts in this area in the years to come.

But it is definitely an ?E? ticket ride. So fasten your seatbelt on your path to riches.

As for me, I?m thrilled that I got to live so long to see this stuff happen. At times, it was a close run race.

GILD 2-13-15

IBB 2-13-15

Scientist Bio LabThis One Looks Like a Winner