Hougan: Biotech ETFs In A Bubble

Biotech ETFs are going parabolic. Are they in a bubble, and when should you bail out?

The question of whether biotech is in a bubble has been top of mind for me over the past few weeks. The SPDR Biotech ETF (XBI | A-31) is up 75 percent in the past year, and more than 15 percent year-to-date. Other biotech ETFs like the iShares Nasdaq Biotech ETF (IBB | A-55) are up similar amounts.

Chart courtesy of StockCharts.com

In a previous life, I was a biotech analyst for an actively managed mutual fund, so charts like this make me giddy. Being a biotech investor can be very rewarding. Stocks can jump 100 percent, 200 percent or 300 percent on a single day’s news. Just last week, one of XBI’s holdings—Intercept Pharmaceuticals—ran up 281 percent after getting positive news on its liver drug (as our friends at ETF Trends reported).

From a big-picture perspective, seeing biotech rally makes sense to me. This is a sector that saves lives and changes the way science works. It’s protected from patent expirations and attracts the best talent in the world.

But over recent years, investment returns have been hard to come by. Biotech lovers have seen big rallies come and go. It took more than 11 years of painful, sideways grinding for biotech to recover the levels it saw during the 1999/2000 bull era. Is the recent run-up recognition of 11 years of scientific progress? Or will the sector come crashing back to Earth as it has in the past?

Chart courtesy of StockCharts.com

Focus On Earnings

The place to start is with earnings. The knock on biotech has always been that it’s full of promise and nowhere on profits. But over the years, more companies have gone from promise to products. A few companies are now truly behemoths.

Gilead Pharmaceuticals (GILD), for instance, is now the fourth-largest pharmaceutical company in the world by market cap, producing $10 billion in annual revenues and $4 billion in earnings per year, and growing fast. It’s bigger than Bristol-Myers Squibb.

Is that true throughout biotech? Has the sector grown up into a profit-generating machine?

You can’t fault investors for thinking that’s true. If you punch one of these biotech ETFs into any of the major financial websites, you’ll get a fairly sanguine picture of their health.

Here’s Morningstar’s view of XBI’s portfolio:

Source: Morningstar

Note the forward-looking P/E estimate. Thirty-four is a lot to pay for any investment, but considering the sector is growing 20 percent a year (and changing lives), 34 is not that bad. Besides, XBI is the riskiest biotech ETF out there. The market-cap-weighted iShares Nasdaq Biotechnology ETF (IBB | A-55) has a P/E of just 26 in Morningstar’s system.

Yahoo Finance backs them up looking at trailing 12-month actual earnings:

Source: Yahoo Finance

You could easily look at these stats and think, hey, it’s worth a flyer. The entire market’s a little pricey these days. At least you know you’re buying real companies with real profits, not just hope.

Real P/E And Why It Matters

Unfortunately, you’d be wrong.

Here at IndexUniverse, we calculate P/E on every equity ETF ourselves. We do it because we don’t trust how most of Wall Street runs the calculation. And based on our calculations, the biotech industry is still losing money hand over fist.

To be precise, XBI has a P/E ratio of -20.69.

Source: IndexUniverse

What gives? How is our P/E that different from the P/E of Morningstar and Yahoo Finance?

The difference lies in the way P/E is calculated.

Most data providers calculate the P/E of a fund by looking at the P/Es of all the stocks it holds and adding them together, adjusting for how much weight each stock has in the fund. If you had a fund that held two equally weighted stocks, and one had a P/E of 10 and the other a P/E of 20, the fund’s P/E would be 15.

Companies with negative P/E ratios throw off that calculation, unfortunately. The problem is the odd way that negative numbers work.

Imagine you have a company trading for $100/share and it’s losing $1/share. Its P/E, obviously, is -100. If the same company is losing $10/share, its P/E is -10.

Because large negative P/Es are “better” than smaller negative P/Es, you can’t just add them up like you would the positive numbers. Your result turns upside down. As a result, sites like Morningstar and Yahoo either throw them out or randomly assign them a high positive number (often 300).

Most of the time, this doesn’t matter. Few companies in the S&P 500 lose money, so you can throw out the losers and not really notice.

But in sectors like biotech it matters a lot. Only 15 of the 56 companies in XBI are profitable, so its “P/E” in the Morningstar and Yahoo systems is wildly off. In fact, as a whole, the ETF is losing money hand over fist. That’s captured when you take the actual losses—in dollar terms—and roll them all together into a portfolio profit or portfolio loss, and then divide that by a portfolio price. That’s how we calculate P/E—all the prices divided by all the earnings—and that’s why we get a negative 21 for XBI’s P/E.

So Is It A Bubble?

So is biotech a bubble? It’s definitely frothy.

The biotech industry has come a long, long way. XBI’s market-cap weighted competitor, IBB, is actually profitable on the whole. It’s not as profitable as Yahoo or Morningstar’s stated P/E of 26 would suggest—IBB’s actual P/E is 784—but the companies inside are turning a profit.

Biotech has a long and attractive future. The industry has digested the lessons of genomics and is rapidly turning from a period of discovery to one of profitability.

But despite what some statistics would tell you, it’s not there yet. And all that makes me nervous.

These periods of excitement can go on much longer than I expect, and the scientific progress and revenue momentum coming out of the sector is truly impressive. But until it gets closer to turning profits, a 75 percent run-up in one year … well, that makes me just a shade nervous. It may well be time to rebalance, rotate into the least-risky biotech ETF (IBB), or exit the sector entirely.

At the time this article was written, the author held no positions in the securities mentioned. Contact Matt Hougan at [email protected].