6 Reasons Why the Biotech Rally Will Continue

Biotech is back.

The XBI is up 43% since I wrote a bullish column on the sector June 17 at MarketWatch, outlining seven reasons why the sector was a buy. You can see the column here.

Can the rally continue? Short answer: Yes. I offer six reasons below.

But first, I wanted to check to see if the biotech stock selection system I use in my stock letter still works well.

So far, so good.

Since the new bull market in biotech began, I’ve offered subscribers two mini-biotech portfolios. The results are good.

The Cash Rich Biotech 8, published July 13, 2022, after hours
My stocks: Up 28%
XBI: Up 12.1%
IBB: 7.3%

Notes: In this portfolio, I identified eight of my favorite stocks out of around 120 biotech names trading near or below cash. The average market cap for my names is $855.9 million.

5 Catalyst-rich Stocks, published July 27, 2022, 10:28 am
My stocks: Up 21.3%
XBI: Up 12.3%
IBB: 7.1%

Notes: In this portfolio, I identified five of my favorite biotech stocks with near term catalysts, meaning mid-year through the end of the year. The average market cap for this group is $7.7 billion. Starting prices were the midpoints for the day the portfolio was published.

My system

To select biotech stocks, I have identified about a dozen characteristics I find are repeatedly associated with names that do well. I don’t reveal the whole system, but some of the characteristics include factors like the statistical robustness of study results, the nature of the science and patents, and insider activity.

Biotech from here

Now back to the sector. There are at least six reasons to remain bullish on the group, which I describe below. Please note, this is not a prediction about what will happen to biotech during next few trading days. The biotech sector is volatile. A consolidation and some backing and filling would be normal after such a big gain. Part of the big gain was caused by short covering, so at some point, at least, that effect will wear off. The best way to deal with this is to plan entries in several swipes. Take an initial position, say one fifth of what you want to own, then add on any weakness.

Otherwise, for the rest of the year and beyond more gains are possible for these six reasons.

1. The FDA is normalizing. This is a big one. For a few years the FDA got pretty erratic because it had to divert resources to Covid-related issues. Now it seems to be back into a more rational groove of reviewing therapies. This is bullish for the group if it continues, which I think will be the case. In the background, the decline in the severity of Covid means companies can enroll and gear up studies. For a while there it was difficult because a lot of studies require hospital visits for treatment and evaluation and many people shunned hospitals during the pandemic.

2. Bullish news flow is back. Most recently, Alnylam Pharmaceuticals (ALNY) announced positive Phase III results for a potentially big heart disease therapy, and Sarepta Therapeutics (SRPT) said the FDA offered favorable feedback on the path forward for a gene therapy that treats Duchenne muscular dystrophy. Going forward, two big ones that could move the entire sector are a Phase III readout on a schizophrenia therapy in Q3 from Karuna Therapeutics (KRTX), and Phase III data from Biogen (BIIB) on another possible Alzheimer’s therapy called Lecanemab, expected in the fall. Of course, there are many other potentially bullish study readouts and approvals in the cards.

3. M&A is picking up. This is also key. We’ve seen several buyouts in the past few weeks, most recently Amgen (AMGN)-ChemoCentryx (CCXI) and Gilead (GILD)-Miro. There are rumors of more on the way, particularly swirling around Seagen (SGEN) and Global Blood Therapeutics (GBT).

The context here is that for over a year there has been a standoff between buyers and sellers clinging to stale, very high stock prices as meaningful datapoints in negotiations. Sellers seem to be caving a bit. This may open up the floodgates. A buy side analyst at the Jefferies conference here in NYC in June noted that once a few buy outs happen, boards will start to get itchy about missing out, and the pace will pick up. Buyouts always spark a lot of interest in the group from generalists and otherwise, so this factor may continue to attract a bid.

4. Interest rates are down. For a while there, rates seemed to be unhinged as the bond markets priced in very aggressive Fed action linked to inflation. But now inflation is obviously rolling over, so interest rates have calmed down. The ten-year yield has fallen substantially from the mid-3% range. Now that inflation is in retreat and supply chain issues are calming down, the fears about spiking interest rates disrupting discounted cash flow valuation (DCF) models are being put to bed. The context: Higher rates increase the discount rate in DCF models, which lowers the estimated present value of companies.

5. Realization that biotech is asynchronous. A lot of investors are still worried about recession and macro issues. Since biotech marches to its own drummer (it’s more about study readouts and drug approvals), macro matters less. In a sense, this oddly makes biotech a kind safe haven for many investors. It is less linked to economic cycles.

6. Midterms go to Republicans. I’m apolitical so I can recognize this reality without getting emotional about it. This also means I can see the implications more clearly. One is that Republican control of Congress would lower the odds of more aggressive price control legislation. This would be perceived as bullish for the group. That said, a bill that will probably soon pass would implement some government price controls. This would happen for the top ten drugs in 2026 at nine years on the market for small molecule and related drugs; for biologics past 13 years on the market; and for the top twenty drugs at 2029 and later. This could be bad for smaller companies because the changes kick in at nine years on the market for a drug, which shrinks the profit window. Not good. But this is probably priced in at this point, and it is also a long way off.

I’m currently working on new biotech suggestions for my subscribers to consider. If you would like to learn about these and other stocks typically across all sectors as I am a generalist, please consider subscribing here.

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