Bio-check – When it comes to valuing the biotech sector, the devil really can be in the detail
In Electric blues and Forever with blue genes, we recently highlighted some concerns of Seth Klarman, one of The Value Perspective's favourite investors, including his reference to "the nosebleed stockmarket valuations of fashionable companies like Netflix and Tesla". We wonder whether the Baupost Group founder might also have had elements of the biotechnology sector in mind.
In the five years to 1 May 2014, the benchmark Nasdaq Biotechnology index has risen some 260%, significantly outpacing the sector's sales figures, which have doubled over the same period – and that in spite of the recent technical bear market that has seen the index fall by roughly a fifth from its peak at the end of February.
We deliberately used sales as a point of comparison just then because, when it comes to biotech, earnings can be tricky to pin down. To put it more bluntly, a significant proportion of companies within the sector do not have any earnings at all – and, if a company has no earnings, then arriving at a valuation by way of a price/earnings (PE) ratio is problematic. In case you think we overstate the issue, let's consider one of the ways an investor might reasonably look to gain exposure to the biotech sector – an exchange-traded fund (ETF) that aims to mirror the performance of a biotech index. Easily the largest of these is the $4.75bn (£2.8bn) iShares Nasdaq Biotechnology ETF.
According to the fund's factsheet, as of 1 May 2014, the ETF – and by extension the biotech industry – was trading on a PE ratio of a shade under 41x. That is certainly a big number but not a wholly outlandish one – in other words, one could just about come up with a set of scenarios where the sector could grow enough to justify that valuation.
However, the devil is in the detail. Three details to be exact. In arriving at that PE ratio of 41x, we are informed, negative earnings are excluded, extraordinary items are also excluded and PE ratios over 60x are set to 60x.
Now, here on The Value Perspective we hate to sound cynical but, taking that all into consideration, we suspect the biotech industry may really be trading on a lot more 41x earnings. Indeed, the 18 April 2014 issue of Grant's Interest Rate Observer quotes biotech short-seller Joe Lawler, a co-founder of Merus Capital, as suggesting the industry is actually on more than 2000x earnings.
How? Because, says Lawler, while some 25% of biotech companies are profitable, their earnings are more or less cancelled out by the losses of the 75% that are not – hence, according to his number-crunching, that 2000x multiple. Yes, it is a silly number but arguably no more so than the 41x earnings, on which the Nasdaq Biotechnology index is apparently trading should you still wish to buy it.
Fund Manager, Equity Value
I joined Schroders in 2004 as an equity analyst in the European Equity Team initially specializing in the Industrial sectors before moving on to Consumer-based companies and finally Insurance. In 2007, I became a co-manager on a fund investing in undervalued European companies and took on sole responsibility for the fund in May 2010. Prior to joining Schroders, I worked at Hedley & Co Stockbrokers and Deutsche Asset Management as a trainee analyst.
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