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Biotech Bull Making a Comeback

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In October of 2015, I wrote a special report for Zacks Confidential titled "Biotech Outlook: Bursting Bubble or Buying Opportunity?"

At the time, the Nasdaq Biotechnology Index (IBB - Free Report) had fallen over 25% from its peak at $400 in the 3rd quarter of 2015. Here's was my introduction...

It’s probably fair to assume that the Biotech Bubble has finally burst.

And with lawmakers and Presidential candidates threatening to offer a cure for “price gouging,” the upward momentum that fueled that bubble is probably not coming back anytime soon. In fact, despite violent short-covering rallies, the primary momentum might be to the downside for a quarter or three as Biotech enters its own bear market.

So it’s a very good time to revisit the case for Biotech investing and see if there are still opportunities amidst the new risks. We begin with my 3 main drivers of the secular Bio Bull that I have been preaching since 2009...

3 Drivers of the Secular Biotech Bull

1) Aging Population Living Longer and Needing More Advanced Medicines

2) Revolutions in Genetic R&D Curing Hundreds of Diseases Potentially (drives earnings with new blockbuster drugs)

3) M&A War Chests from Mega-Pharma Buying New Science to Fill Their Pipelines (and curtail "patent cliff" impacts)

Obviously, you could add the Obamacare dynamic here, but that hits both ways lately with insurers and pharmacy benefit managers (PBMs) pushing back on "wonder drug" pricing.

The prime example has been the war against Gilead (GILD - Free Report) and their mega-blockbuster Hep-C cures Sovaldi and Harvoni from the science they bought via the Pharmasett acquisition.

But recently, Valeant Pharma (VRX - Free Report) became the target of Federal subpoenas for documents related to drug pricing.

(end of excerpt from October 12, 2015 Zacks Confidential)

On that day, Valeant shares were trading around $175 after bouncing off of $153 in late September. Little did we know then that a week later Valeant Pharma would start to become the poster boy for pharma excesses and questionable pricing practices when the stock plunged nearly 50% in 3 days from $170 to $90.

By the middle of November, shares were trying to find their footing around $70.

I made a video presentation exploring the collapse and Bill Ackman's attempts to "average down" with options strategies...

Synthetic Stock: How Ackman Doubled-Down on VRX

Unfortunately for Ackman, his investors, and anyone else buying the falling hatchet that was Valeant, his strategies did not work out so well. Not only did all those options worth hundreds of millions crumble into worthless dust, but we learned last week that Ackman's Pershing Square finally liquidated the last of his VRX stock holdings and probably locked in losses exceeding $4 billion.

If you watch that video, you'll learn how some of Ackman's options strategies where he sold "naked puts" ended up multiplying his losses by forcing him to buy more shares of VRX as the stock cratered through the $60 level.

In the Chicago trading pits, many of us learned to trade options from Sheldon Natenberg, author of Options Volatility & Pricing. Shelly used to say something like this, "Options are power tools. And just like a saw, you can use their leverage to profit, or to cut off your hand."

Maybe Ackman losing a figurative hand could be the capitulation needed to mark a true bottom.

Especially since he wasn't alone. Bob Goldfarb, the CEO of Sequoia-fund manager Ruane, Cunniff & Goldfarb, reportedly lost his job over the disaster. The Sequoia fund owned over 35 million shares and if that type of concentration is of interest to you, you might enjoy my expose of all the big owners in this video presentation...

Valeant Pharma Autopsy: Counting the Lost Billions

Could the Biotech Bull Come Back?

I believe it already is because of the 3 drivers I listed above. And because the cyclical bull market in stocks and the economic cycle that feeds it are not over.

Then there's the recent price action. The correction from IBB $400 to $240 was approximately 40%. We saw something of a triple-bottom near $240 in the first half of 2016.

Then in November, the index made a lower high at $246. If it can solidly take the $300 level soon, then my next target would be $340.

During this 18-month bear market purgatory, GILD has kept the IBB down as it continues to make new lows every quarter. That's not the best sign as GILD would definitely be one of the big biotech companies most susceptible to pricing regulation.

But meanwhile, Celgene (CELG - Free Report) and Amgen (AMGN - Free Report) have been on the verge of new post-bubble burst highs.

I won't speculate today on whether new bull market highs above $400 are in store for the IBB. I'll just say that there will be plenty of trading opportunities in quality pharma, biotech, medical device, and hospital and insurer stocks the rest of this year.

Revisiting My 3 Drivers of the Secular Biotech Bull

Allow me to share more of my 2015 report to see how my predictions unfolded that the bursting bubble would become a buying opportunity...

Now it’s time to re-think the drivers of the Bio Bull and see if the trends deserve our hard-earned investment dollars, or if it’s just too risky.

And this is especially important to address because as any market veteran will tell you, once a bubble bursts, it takes a long time to come back and there is usually bear market-type pain for many quarters, if not years, for investors who keep trying to buy falling knives.

So let’s talk about each driver and see what kind of total picture it paints.

Driver #1: Aging Population Living Longer and Needing More Advanced Medicines

Boomer power is alive and kicking! Demographics are still the primary driver of Healthcare and Biopharma top line sales growth. Mark this down as a big plus for the Bio Bull.

Driver #2: Revolutions in Genetic R&D Curing Hundreds of Diseases Potentially (drives earnings with new blockbuster drugs)

Earnings and science power are also alive and well. As the science advances, so do the applications and new cure possibilities. Yes, there is “creative destruction” as new discoveries eliminate entire classes of drugs. But on the whole, the horizon for genetic medicines and cancer cures is wide open as the revolution is still in its early stages. Remember, this kind of R&D takes years of clinical trials. Major Biopharma companies have wish lists a mile long of all they want to explore so think decades of fantastic progress to come! And score another Long-Term point for the Bio Bull.

Driver #3: M&A War Chests from Mega-Pharma Buying New Science to Fill Their Pipelines (and curtail "patent cliff" impacts)

M&A power may have peaked. I’m not saying for certain it has, but the real possibility is there. Now to say that a half-trillion dollars in deals is the peak means that we were averaging $80+ billion a year since 2009! So if the new average for the next 5 years is only $50 billion, that’s still pretty healthy M&A. I have to give this one to the Bio Bull too.

The Big Wildcard: Politics and Regulation

But here’s the big caveat -- which is no longer the big elephant in the room keeping everyone silent: Ever since Hillary’s famed tweet and Federal subpoenas to Valeant Pharma by House Democrats, everyone knows that drug companies are under fire about “price gouging.”

As much weight as these political rumblings might carry, nothing happens to drug pricing unless a law is passed. And little new legislation is likely to happen before the big election next year. So one could look at that as either a) a year to worry, or b) a year to forget about it.

The reality is probably somewhere in between as the campaign rhetoric will keep Biopharma investors cautious, if not shy, looking for clues about how serious lawmakers might get in 6-12 months about price controls. So, we’re probably still looking at a 3-9 month rough patch where a news story, or a tweet, could send gun-shy Biopharma investors running for the hills.

The more time that passes, the more certainty about political agendas and their impact will become visible.

And in the end, in Healthcare the only “cure” for price controls is more new life-saving and life-improving science that makes regulations irrelevant or obsolete. In this way, the sector may not be “immune” to legislation the way it is to a Fed rate hike. But it is certainly being recognized for the long-run secular wave that it is with our three big drivers which are here to stay.

(end of 2nd excerpt from Zacks Confidential October 2015 report)

The only thing that has changed since my "wildcard" assessment of the political and regulatory landscape is that now President Trump has taken to tweeting about drug pricing.

But the market has shaken it off quite well this year, with the IBB making a higher low above the December $265 base and climbing roughly 10% since Inauguration Day. And to me that's another validation that the fundamental tailwinds are still in place and that biotech values and opportunities are all around.

I could almost add a fourth driver to my list...

Payers Like Drugs Better Than Surgery

With this one, I always give the simple example that Gilead's Sovaldi and Harvoni Hep-C cures may have cost nearly $100,000 but the alternative of a new liver "installed" at nearly $500,000 made insurers gladly pay.

This is still a valid force for many types of illness and treatment. There are no perfect solutions or price equations between drugs and surgery, but we know that the insurers are doing their homework all the time about the balance of trade-offs.

Bottom line: Biotech investing is still a life-long pursuit. Next time, we'll take a look at smaller company investing opportunities in the space.

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