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You Can No Longer Ignore Biotech

Like other high tech sectors, biotechnology knows its fair share of boom and bust on a regular basis. Riding the roller coaster can be nerve-wrecking, and most investors choose to classify the sector as too hard to value.

I would argue the contrary. Yes, there are a lot of development stage biotech companies that are highly risky and depend solely on the result of clinical trials or regulatory approval. However, once the product is on the market, and the demand for it is established, the sector's cash flows can be some of the most predictable on the market.

First of all, biotech companies are protected by patents and exclusive periods granted to them by the regulator when they bring innovative products to the market to treat an unmet medical need. So the probabllity of having a competitor come and disrupt your product is essentially close to nill for two reasons:

1. The existing drug compound, while easy to replicate, cannot legally be sold on the market because of patent infingement issues.

2. Any innovative competing product would be flagged years ahead of it being marketed due to the clear-cut approval process (regulatory trial + NDA submission + time for FDA to revie and approve).

Besides non-existing competition, one of the most incredible aspects of the way the health care sector is structured, especially in the U.S., is that the drug company has a monopoly on products that people who need them would do anything to have. Of course there are negotiations with health plan providers and payers, but looking at the past decade or so of new drug development, it appears pharma companies can get away with murder regarding pricing. Nowhere is this more clear than in companies who specialize in rare diseases (known as orphan and ultra orphan diseases). These are diseases where the prevalence is very low (at most 1 in 10,000) and where the regulatory landscape is even more lax to encourage companies to invest in the R&D necessay to market and compensate for the small patient population. The system works so well because pharma companies can make huge returns on R&D costs if the drug is successful. We have seen a few transformational discoveries that made companies like Genzyme (acquired by Sanofi), Alexion and Biomarin so profitable.

Clearly, we are focusing on companies with drugs that have been approved by the FDA, not necessarily development-stage companies. However, even these companies can be very risky if for instance the FDA withdraws its authorization due to a new realization that the drug might not be as safe as initially thought (see recent ARIAD share price reaction).

Having said that, these events are relatively rare, and can (or should) be diversified away through constructing a well-balanced portfolio.

The performance of the biotech sector is staggering: The Amex Biotech index advanced over 50% year over year after rising over 40% in 2012, easily outperforming the broader S&P 500 index and the Nasdaq index. Even with the recent market pullback in 2014, the Amex Biotech index has outperformed both broader indices, as year-to-date it is actually all up almost 5% while the S&P 500 and Nasdaq composite are up are approximately 5% and 4%, respectively, for the year. The sector can no longer be ignored by serious long-term investors. Yes, clearly some pockets are witnessing overly optimistic valuations, but most of the upside of the sector comes from established biotech companies beating and raising guidance quarter over quarter for the past two years (GILD, CELG, AMGN, BIOG, etc.).

I believe the sector deserves careful research. I wish we could develop together as a community a list of health care-focused Gurus to help us with the screening for promising stocks.

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