Biotech stocks are way up—but the boom may just be starting

Forget fears of a biotech bubble. This time there are good reasons for the sector’s gains

Lab tech working at a lab bench

Gilead Sciences made $10 billion off its Hepatitis C drug last year. (David Paul Morris/Bloomberg/Getty)

Investors tend to get nervous when a class of stocks soars. They think a bull run will be followed by a crash. But just because something’s gone up doesn’t mean it has to come back down. Take the biotechnology sector. Over the past five years, the S&P Composite 1500 biotechnology sub-index has risen 319%, while the broader index has only gone up 77%. Sure, you would have made a mint if you’d put money in this market years ago, but take a look at what’s coming down the pipe, and it’s clear there are more gains to be had.

Granted, the drug discovery business has had false starts before. Previous bull runs were based on the expectation that new science—in particular, the mapping of the human genome, completed in 2003—would yield a class of biology-focused drugs, distinct from traditional, chemistry-based ones. Today’s run-up is grounded in actual results—clinical and financial—resulting from those advances, says Brian Bloom, co-founder and president of Bloom Burton & Co., a research and investment firm that specializes in biotech. And the more doctors learn about how our genes interact, the more biomedicines are created. “A lot of important work has occurred, but the fruits of that labour are just coming now,” says Bloom. “Over the past five years, knowledge of our biology has exploded.”

Biotech companies make money in a couple of ways. The small ones primarily conduct research and development, and often have no cash flow, making valuation difficult. They concoct the drug and put it through the initial phases of testing. But when they then sell the company or the drug to a large pharmaceutical manufacturer that puts it through the last, and largest, phase of trials, investors can see a huge windfall. The pharma company will then sell the drug to the public. There are also companies with hybrid business models that merge the two.

Today, a lot of companies are focusing on drugs that can target specific and rare diseases. While these drugs won’t have the sales volume of traditional medicines, companies can charge upwards of $400,000 a year for a single patient’s course of treatment. Last year, Gilead Sciences made about US$10 billion off a revolutionary hepatitis-C treatment and could bring in another US$13 billion this year.

S&P Capital IQ analyst Jeffrey Loo estimates that there are 10 to 12 drugs in development today that could each yield at least US$1 billion in sales over the next few years. “These have blockbuster potential,” he says, and that will translate into big revenue and earnings growth. In 2014, the seven biotech companies included in the S&P 500 grew their top lines by 41% on average. Since they’re working off a bigger base today, that number won’t grow as quickly, but Loo still expects double-digit revenue expansion.

This sector remains risky. If a drug fails a trial, the developer’s stock can wither. If a lot of companies are working on similar drugs, only one or two may succeed. If you don’t want to play the guessing game, buy a basket of stocks in an ETF or managed product, advises Bloom, whose firm offers a hedge fund made up of Canadian biotechs.

The sector’s momentum continues to stand out against lacklustre growth in the broader market. That should continue, says Loo. “It’s still going to grow faster than most other industries next year.”