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: Seven reasons the beleaguered biotech sector is now a ‘buy’

If you have the discipline to think long-term as an investor, this is the time to take advantage of the steep discounts on great biotechnology companies.

That’s the key takeaway from industry veterans at OrbiMed Advisors, ClearBridge Investments and State Street Global Advisors who shared their views at a Jefferies health-care conference in New York last week.

“Now is the time to find the gems,” said ClearBridge portfolio manager Marshall Gordon at the “Managing the Turbulent Waters” panel. “There is good science out there. Now is the time to figure out where it is.”

It is admittedly tough to gather the courage because of how difficult it is to live through a steep and broad decline in the stock market. And it is spooky, because there’s no obvious external catalyst for this crash, as we had in prior big drawdowns, said Sven Borho, a founding general partner at OrbiMed Advisors who now heads its public equity team.

Previous major biotech selloffs were caused by Hillary Clinton’s proposed drug-price controls in 1994, the end of the genomics craze in 2002, and the financial crisis and health care reform in the past 14 years. There’s no comparable big-picture overhang now. That makes it more difficult to imagine when the doom and gloom might ease.

Of course the reason for this biotech debacle was the high valuations in areas such as gene editing. And Wall Street launched too many initial public offerings that were “science projects” (no clinical trials).

But that doesn’t really explain the severity of the damage. “We are in the longest biotech bear market, with the biggest absolute drawdown and the biggest relative underperformance,” said Borho. The average IPO is down 75%. The good news is the extensive damage may mean all the excesses have been wrung out by now.

Otherwise, here are seven factors that will turn the biotech sector around, followed by several stocks these biotech experts singled out as favorites.

1. Biotech buyouts finally pick up

“Mergers and acquisitions are very important,” says Borho. “It is typically how a bear market ends.”

The stars may be aligned. Fantasy buyout valuations are being reined in. The buyers have the means.

“There is a lot of money on the sidelines,” said Shalabh Gupta, a health-care portfolio manager at State Street Global Advisors. “Big pharma has the capital to get involved.”

There may still be a price gap between what target companies will accept and what pharmaceuticals want to pay. “When the market comes down, big pharma gets risk averse, too,” says Borho. “They don’t know if they can get a better price. They all want a billion-dollar-plus drug at a company trading at a 52-week low and sitting on a lot of cash.”

But they’re also starting to realize that’s not happening. Both sides are getting more deal-hungry. Recent news that Bristol Myers Squibb
BMY,
+0.96%

will buy cancer-therapy company Turning Point Therapeutics
TPTX,
+0.21%

could be a sign that sellers are more amenable, and no longer holding out for the higher stock prices of a bygone era, says Jefferies biotech analyst Michael Yee, who hosted the panel.

This deal may signal to other big pharma boards that it’s time to move on buyouts.

“This is exactly what we need to happen,” says Borho. “We don’t need 10 of those — we just need a couple. Once it gets going, everyone gets antsy and board members ask, ‘Why haven’t we made an acquisition? Are we missing the bottom?’ Turning Point could be the turning point for our sector.”

Time will tell. But Borho has been in biotech investing since 1991, so he has good intuition about sector trends.

2. Investors figure out the macro-economic trainwreck is not so relevant

Biotech is down in part because of the “risk-off” mentality created by fears of inflation and recession. But biotech exists mainly in the world of science. So, does this even make sense? Maybe not.

“The beauty of biotech is that it is idiosyncratic,” says Gordon, at ClearBridge. “You can create value from research and development. It has nothing to do with macro,” or broader economic trends. He cites the relatively good performance of Biogen
BIIB,
+3.55%
,
Gilead Sciences
GILD,
+0.59%

and Genentech during the bear market of 2008.

“Biotech can definitely work when macro is tough.” (Genentech went on to be purchased by Roche Holding AG
RHHBY,
+0.41%
.
)

3. There’s more positive news flow

“As we start to see new leadership and real drugs that work and make bigger differences, that’s what gets people reengaged in the sector and moving back in,” says Gordon. “We need more of this. We need news flow.”

Possibilities here include updates this year from Alnylam Pharmaceuticals
ALNY,
+0.39%
,
Roche and Karuna Therapeutics
KRTX,
+4.15%

on therapies for amyloidosis (excessive protein buildup in the body), Alzheimer’s and lung cancer, and schizophrenia, respectively.

4. Investors realize mass-liquidation fears are overblown

With the sector trashed, investors shy away on fears that dedicated biotech funds will have to close and liquidate their holdings, creating waves of fresh selling.

But history suggests this might not happen, says Borho, at OrbiMed.

“If you look back 30 years, every biotech bear market had some funds disappearing. They always work their way out over several quarters. A fund doesn’t just simply disappear. There are not going to be 10 funds going out of business at the same time. There will be one or two.” He says the fear of redemptions is “exaggerated.”

One reason is that investors remember that the health-care sector can post decent returns for years. They like to average down, especially into a lower fee structure, says Borho. Once investors figure out the mass-liquidation fear is overblown, it will calm nerves and help stabilize the group.

5. The ‘shorts’ get creamed by good news and move on

“This sector has been massively ‘shorted’ by quant funds and hedge funds,” said Borho. The SPDR S&P Biotech ETF
XBI,
+2.64%

and unprofitable tech were the two main hedging instruments over the past year, he says.

Positive news flow like more M&A and blockbuster drug breakthroughs could squeeze the shorts out. “This will be a first step,” said Borho. “The opportunity is there and it will be a surprise because sentiment is so bearish.”

6. There’s a cleanup in aisle six

Over 120 smaller biotech names trade below their cash levels, according to research by Yee. This is so unusual, it troubles potential investors. Some kind of cleanup to get rid of this red flag would help. Borho doubts these companies will close up shop and give shareholders the cash.

“That never will happen. Especially when you have venture capitalists on the board. They do not want to return the cash. They want another shot on the goal.”

Instead, we might see a wave of reverse mergers into these smaller companies that makes them more attractive.

“Companies are lining up to reverse-merge into public companies with a lot of cash. In some instances, I have seen 20 to 30 proposals to reverse-merge. You end up with a really exciting company again.”

7. The FDA normalizes

When Covid hit, the FDA pulled workers from drug approval to deal with pandemic therapies and vaccines. This led to more clinical holds, which shook up investors because it delayed drug development. “There is a capacity issue,” says Gordon. If Covid continues to recede, this issue could reverse.

Stocks to consider

Gordon at ClearBridge singled out Karuna Therapeutics, which has a schizophrenia therapy in late-stage development called KArXT. “I am a believer in that drug. If it is successful, that is a mega-blockbuster. And that is not priced into the stock.” He also likes medical technology companies, as hospitals ramp up non-Covid procedures because the pandemic is waning. Gordon did not cite names, but large-cap examples include Medtronic
MDT,
+0.80%
,
Johnson & Johnson
JNJ,
+0.51%
,
Cardinal Health
CAH,
+0.53%
,
Stryker
SYK,
-0.05%
,
Baxter
BAX,
+0.29%

and Boston Scientific
BSX,
+0.08%
.

Gupta at State Street Global Advisors singled out Vertex Pharmaceuticals
VRTX,
+2.45%
,
which has promising therapies for cystic fibrosis, diabetes, sickle cell disease, pain, and kidney diseases.

Borho at OrbiMed says the one way to play the sector is to own a basket of potential M&A targets. “It’s tough to hit the real targets, but with a basket they go up together when we see M&A,” he said. He also singled out Natera
NTRA,
+0.55%
,
a diagnostics company developing liquid biopsies that detect evidence of diseases in the blood, and the cancer therapy company Mirati Therapeutics
MRTX,
+3.49%
.

Michael Brush is a columnist for MarketWatch. At the time of publication, he owned KRTX and MRTX. Brush has suggested BMY, TPTX, BIIB, GILD, ALNY, KRTX, MDT, JNJ and MRTX in his stock newsletter, Brush Up on Stocks. Follow him on Twitter @mbrushstocks.

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