Are Biotechs In A Bubble?

About:IBB Includes:AMGN, BIIB, CELG, GILD

Summary

  • IShares excludes companies with negative earnings in P/E.
  • TTM adjusted P/E is approximate 104.
  • Majority of earnings growth came from only top 32% of holdings.

The Biotech sector has been on a similar epic bull run as the late 90’s tech sector. Below are the returns for the iShares Nasdaq Biotechnology Index (NASDAQ:IBB), the biotech ETF, over the past several years:
Screen Shot 2015-07-02 at 1.07.28 PM

Total returns were 421.06% from the close of 12/31/08 to 7/2/15 and 523.73% from the lows on 3/9/09.

By comparison, the only period I can find that is close in terms of total returns and time is the 1995-2000 Nasdaq bull market, which generated returns of 441.21% over that time period. That bubble occurred over a shorter time period than the recent biotech bull run (5 years vs 6.5 years for Biotechs) so the resulting negative performance after the Nasdaq bubble popped was most likely more severe than what we should most likely see with biotechs after they peak. The late 90’s tech run resulted in an 85% drop over a few years. I don’t see the same happening with biotechs, but valuations in the biotech space are similar to the valuations seen in the Nasdaq bubble right around its peak, as I will show below.

Returns for the Nasdaq during that time period are listed below (I included the subsequent 3 years after the peak of that bubble as well):

Screen Shot 2015-07-02 at 3.20.42 PM

According to iShares, the trailing P/E of IBB is 31.10, which is high but not necessarily unheard of. However, iShares has a small almost hidden disclaimer that states that the P/E excludes those companies with negative earnings from its calculation. Considering the fact that roughly 60% of the holdings of IBB lose money, it’s safe to assume the P/E isn’t 31.10. The only way to calculate the P/E is by going through the financials of each component of IBB and weighting them according to the pro rata share that they make up in IBB. I went through this tedious task below for the top 33 holdings, which account for 82% of the weighting of IBB.

I randomly chose to look at 33 of them primarily because I didn’t have time to go through all of them. However, my suspicion is that the majority of the companies making up the remaining 18% of the index are losing money and would result in a higher p/e than the one I calculate below (indeed a quick glance at the next 12 holdings shows 9 companies losing significant money – over $300 Million net losses).

Can the REAL Biotech P/E please stand up?
General consensus is that holding IBB instead of individual stocks will shield you from overall risk with biotechs because the bigger ones like Gilead (NASDAQ:GILD), Biogen (NASDAQ:BIIB), Celgene (NASDAQ:CELG), and Amgen (NASDAQ:AMGN) are cheaper and bring down the valuation of the entire ETF. While this is true to a certain extent, investors need to keep in mind that they only make up about 30% of the ETF and a closer look at the valuations of each of the components of IBB yields an extremely expensive ETF.

As I mentioned above, an important thing to note with IBB is that iShares excludes companies with negative earnings from the calculation of the p/e for the ETF. This is especially noteworthy considering 17 of the top 33 holdings that I analyzed, which account for 82% of the holdings in IBB, are losing money. By weighting, 28% of the top 82% of the holdings of IBB loses money. See the note below from iShares’ website regarding negative earnings:

Screen Shot 2015-07-02 at 1.21.19 PM

To get to the real p/e, I’ve gone through the exercise of calculating the trailing twelve months (NYSE:TTM) earnings for each of the top 33 holdings of IBB, which again account for 82% of the holdings.

Below is a list of the top 33 companies and their weightings. Again, I could have gone through the exercise of calculating earnings for all of the holdings but I figured with these 33 companies I would capture the lion’s share of the ETF’s holdings. Note that the prices below are as of the close on 6/22/15.

Screen Shot 2015-07-02 at 1.29.44 PM

I went through the financials for each of these 33 companies and highlighted in gray and boxed those quarters that were either negatively or positively impacted by one time charges and I adjusted those earnings by removing those one-time items to get a better reflection of actual earnings. See each of the holdings and the last 4 quarters of earnings below:

Screen Shot 2015-07-02 at 1.53.52 PM

To calculate a weight adjusted price to earnings ratio for the entire ETF, I then assumed I purchased 1,000 shares of IBB to illustrate how many shares I would get of each holding. This is helpful in visualizing earnings per share for the entire ETF.

Since I only looked at the top 33 holdings which make up 82.3% of the holdings of the ETF, the total shares I would get is 822.5 shares. This is what I used as a denominator in calculating p/e.

I then used the price to earnings ratio of each holding (arrived at by dividing the above TTM earnings by the total shares outstanding of each company) and then I multiplied each p/e by the # of shares of each holding I get with my hypothetical purchase of 1,000 shares to arrive at earnings for each holding.

The last step to calculate the p/e for the entire index is to add up the earnings for each of the 33 holdings and divide that number by the 822.5 shares above. This calculation yields a TTM p/e of 97.84. See my calculations below:

Screen Shot 2015-07-02 at 2.16.51 PM

Accounting for More One Time Items
In addition to iShares not including companies with negative earnings and many quarters having one time items that benefited earnings, I also noticed that the tax rate at 3 of the top 4 holdings were abnormally low: GILD had a tax rate of 17%, CELG had a tax rate of 13%, and AMGN had a tax rate of 8%. The only company sporting an abnormally high tax rate was REGN, which had a tax rate of 59%. In order to arrive at a normalized p/e I assumed a tax rate of 27% for each of these 4 holdings. The net impact was a reduction in earnings from the $3,113.46 shown above to $2,916.66. The net effect is the p/e rises from the 97.84 above to 104.44 using the closing price on 7/2/15 of $370.35.

What’s worse is a quick glance at the remaining holdings of IBB making up 18% of the ETF shows a majority of money losing companies, which would ultimately drive the p/e higher. As I mentioned above, the next 12 holdings had a combined net loss of over $300 Million last year. After including the remaining holdings the P/E would be closer to 110.

So how does this stack up with the P/E of Nasdaq stocks during the late 1990’s bull market?

P/E During Nasdaq Bubble
The best chart I could find with TTM earnings for the Nasdaq during the 90’s/2000 bubble is below:

citi-nasdaq-bubble

The TTM P/E for the Nasdaq crossed above 110 in February 2000, about a month before the top. The biotech index currently sports an adjusted p/e of around 110.

What about Earnings Growth?

The bull argument is that earnings are growing rapidly. However, a closer look reveals that 87% of the earnings growth last year for the 33 companies that I analyzed came from the top 4 holdings, which only accounted for 32% of the weighting of the fund. A better way to illustrate this is if earnings of those top 4 holdings jump by 100% they will only increase earnings for the entire fund by 32%. The remaining holdings barely increased earnings year on year and those top 4 holdings are expecting a significant slowdown in earnings growth going forward, making it hard to justify a P/E of ~110.

When I look at the forward analyst estimates from Yahoo, I calculate a P/E close to 70 using non-GAAP numbers, which is extremely high by historical standards and given a history of drug failures and choppy earnings growth within the biotech space over longer periods of time.

Summary
Valuations in biotechs as represented by the IBB ETF are on par with the peak valuations in tech stocks in 2000. Returns in this space since the 2009 bottom are also similar to the late 1990’s tech bull market. In my exercise above, I did not include the remaining 18% of the holdings of IBB, which most likely would increase the adjusted TTM p/e above the 104.4 I calculated. As I mentioned, a quick glance at the next 12 holdings shows 9 of 12 losing money, with the combined net loss of $317 Million for all 12. Realistically, the TTM p/e is most likely around 110 after including the rest of the holdings.

It seems reasonable to me that we should see a significant (ie 30-40% or more) correction in this space fairly soon just to get valuations back down to somewhat rational levels.

I also think it’s important to keep in mind the spillover effects a large drop in this sector might have on the overall market, not only from a pricing perspective, but also from a sentiment perspective. I’ve been reading quite a few articles recently from noteworthy investors like Byron Wein suggesting that biotechs are a safe haven. My takeaway from reading these articles is that there is a good deal of money hiding in this space as not too many people have taken the time to look closer at valuations of the entire space. Additionally, I think most people have forgotten the history of biotechs, which is one littered with drug failures. All of these factors could combine to add a lot of downward pressure when momentum starts waining.

Given how most market or sector meltdowns tend to occur around September/October, I have been on the lookout for a potential blowoff top in biotechs sometime this summer. I’m keeping open the possibility of this blowoff top having already occurred last week, which is why I started a short position in IBB on 7/2/15. I’m not sure what impact this will have on the overall market. My suspicion is we might see a 10 to 20% drop in overall market if we do get a 30-40% correction in biotechs. But whatever transpires, I have been and will continue to substantially reduce my holdings over the next month. I think it’s the prudent thing to do.

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