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This Biotech Bubble Is Bound to Burst

Just when it looked like biotech-buyout mania was coming to a close, Actavis (ACT) and Novartis (NVS) stirred the pot again. Actavis announced early in the week it would be spending $2.5 billion to acquire Forest Labs (FRX), while Novartis is diving deeper into the immunotherapy game with its purchase of CoStim Pharmaceuticals.

And yes, once again the market celebrated the news with indiscriminate buying of most of these biotech stocks, as if these deals had no downside at all. FRX stock jumped 27% the day after the deal was unveiled, while shares of ACT stock — the suitor — advanced 5% the same day, as if it were nabbing Forest Labs for free. While NVS stock didn’t move much on its acquisition, its 17% run-up over the past 12 months didn’t leave the stock much room to run.

It wasn’t just shareholders of biotech stocks Forest Labs, Novartis, and Actavis that won, however. Anyone with any stake in the industry or a position like the iShares NASDAQ Biotechnology Index ETF (IBB) or SPDR S&P Biotech ETF (XBI) also saw another buyout-driven bump in their trade’s value, as any company in the sector instantly became a potential suitor or buyout candidate. Both possibilities are seen as bullish.

There’s just one problem with the current assumption that most biotech stocks are eventually going to be acquired, though — that kind of thinking has priced most potential buyout targets right out of the market, as hope/speculation has driven most of these stocks to prices that are out of reach for most buyers.

Biotech Stocks Reach Their Peak

To give credit where it’s due, it was Merrill Lynch’s Savita Subramanian who pointed out how the average biotech stock is more expensive, on a forward-looking basis, than it’s been since 2006. All told, the biotech sector’s forward P/E ratios are 60% greater than the market’s current average. That’s twice the norm for biotech stocks … a condition largely spurred by a huge and long-lived wave of M&A speculation.

And two other big clues suggest that biopharma valuations have reached their peak, and suitors aren’t interested any longer — that there’s no more room for higher, speculative-driven prices.

The first is that biotech and biopharma IPOs have been flowing like crazy. We’ve already seen 15 biotech names go public since the beginning of the year. In fact, in the first full week of February, the pace of public fundraising for biotech companies broke a record, with eight biotech outfits raising more than half a billion dollars.

And why wouldn’t they? Investors are passing out money to new biotech names like candy on Halloween. Why pass up money when nobody’s even questioning what you’re going to do with it? Problem: IPO mania has a funny way of looking red-hot right at major peaks. Consider the dot-come IPO bubble in 1999 that preceded the dot-com bust from 2000.

The second reason hopeful biopharma investors may want to reel in their visions of M&A riches from their biotech stocks? The biggest potential buyers have explicitly said target companies are (mostly) too expensive to scoop up.

If it were just Roche (RHBBY) CEO Severin Schwan saying it, it might be easy to dismiss his complaint voiced late last year that biotech valuations were so frothy that his company was skipping deals it might previously have acted on. But it’s not just Roche. Heads of another major biopharma suitor, Eli Lilly (LLY), also opined late last year that biotech valuations had raced out of control, to the point where very few acquisition deals make fiscal sense.

Bottom Line

It’s admittedly tough to go against the grain and bet against more acquisition mania from biotech stocks, especially when most media sources are looking for more of the same. Just bear in mind this was the same financial media that was bullish on the housing market in 2007, bullish on gold in 2011, bullish on solar stocks in 2008, etc. When they’re pounding the table the hardest, it’s time to be afraid.

And right now, the biotech M&A drum is banging pretty loudly.

And no, neither the iShares NASDAQ Biotechnology Index ETF nor the SPDR S&P Biotech ETF will shield investors from this looming paradigm shift. For the same reason merger mania pushed most all these stocks upward, the deflation of that bubble will guide them all lower as well.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities.

Article printed from InvestorPlace Media,

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