Don’t Wait for a Cure for Freckles Before Buying Biotech

Let’s be honest, biotech stocks are just way too intimidating for most of us to discuss with any confidence unless the letters CFA that follow your name are in turn followed by letters like MD, PhD and maybe OMG.

Say, hypothetically, a company announces it’s met the primary endpoint of a Phase III clinical trial examining a treatment for chronic irregular discoloration of epidermis due to ephelis clusters. By the time most of us Google all the words in the press release, some algo that can do it faster will realize the company found a cure for freckles and then bid its shares up approximately 1 million percent. Hypothetically.

No past sales? No past earnings? No problem if you’re sitting on the cure for freckles! Still, valuation studies are run, because that’s what you’re supposed to do, especially after the head of the world’s most powerful central bank proclaims that their ratios appear a little “stretched.”

For what it’s worth, the Nasdaq Biotechnology Index reached another record this week and is trading at 8.6 times its companies’ sales, which is 4.9 times the same metric for the Standard & Poor’s 500 Index. The average has been about 4.1 for the last decade and it peaked at 13.8 times the S&P 500’s price-to-sales on June 5, 2001.


The biotech index has whupped the S&P 500 for four of the five years of the current bull market. It’s rallied 373 percent since the bottom in 2009, beating the S&P 500 by 178 percentage points (or 154 percentage points on a total return basis that includes dividends). The outperformance was not just during the boom times either: It fell 31 percent in the rout that followed the financial crisis, compared with a 57 percent drop in the S&P 500.

In the last 20 years, the biotech index has beaten the S&P 500 11 times and on average has outperformed by 9.2 percentage points a year. That type of alpha is nothing to sneeze at, and even it were there’s probably some company working on a cure for sneezes.

There, of course, is more volatility to deal with. The biotech index suffered a bear market slide of 21 percent between February and April of this year before reclaiming its high this week, while the S&P 500’s biggest drop this year was less than 6 percent.

Yet even on a risk-adjusted basis, biotech comes out looking pretty good. The exchange traded fund that tracks the Nasdaq Biotech Index has a one-year Sharpe ratio, which measures return above the risk-free rate divided by volatility, that’s 40 percent higher than the main S&P 500 ETF over the past year.

Risk Adjusted

A Bloomberg spreadsheet that calculates risk-adjusted returns by dividing gains or losses by volatility shows that the biotech ETF scores about 27 percent higher than the main S&P 500 ETF since the market’s bottom in 2009. It ranks higher than all nine ETFs tracking the major industry groups in the S&P 500 except for consumer discretionary. Since there are a few more rows left in the spreadsheet, you might as well throw in the stocks of the five biggest U.S. companies, and on that basis biotech beat all of them except Apple Inc.

Using the same spreadsheet for the bear market from 2007 to 2009, biotech beat the main S&P 500 and all the sector ETFs except energy on a risk-adjusted basis. Even starting at that most stretched valuation in 2001, it ranked higher than the S&P 500 ETF.

The bottom line is that biotech press releases may be hard to understand, but the results these stocks have put up on the scoreboard are not. Think about that the next time you dump a bucket of ice water on your head. There are a lot of awful diseases left to cure. Not to mention freckles.

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