Why Biotech Stocks Are So Wildly Unpredictable

To understand why some investors are growing nervous about the biotech sector, consider the recent IPO of Axovant Sciences. The company was founded last October, isn’t profitable, and has already racked up a $21 million loss. Its CEO has much more experience with hedge funds than he does with biotech startups. Axovant has only one product candidate, an Alzheimer drug it bought from GlaxoSmithKline last December after it was tested on 1,250 patients in 13 trials and then stalled in development.

Two weeks ago, Axovant went public in an offering that raised $315 million. Axovant, which paid $5 million for the Alzheimer’s drug, says it needs the cash because it will have to pay Glaxo as much as $160 million more if the drug makes it to market. Incredibly, the stock doubled on its first day to $31 a share, but has since fallen by nearly a third of that peak value.

And it could well fall further. But that’s not what worries longtime observers of the biotech sector. The real fear is that this kind of speculative behavior among investors is all too familiar from the biotech and dot-com bubbles of 2000.

“The fact that someone can make something of this size out of virtually nothing should be of concern to everyone in the industry,” Fierce Biotech editor John Carroll wrote about the Axovant IPO. “When biotech mania takes over and perfectly legal schemes like this rain money, the pitfalls start to look like the Grand Canyon.”

Of the 129 biotech companies that have gone public since early 2013, few are as speculative as Axovant. Many, though, have recently gone public with huge losses incurred by heavy spending on the development of drugs that may or may not find approval from U.S. and foreign regulators. Even those that do may be so specialized in the diseases they treat that they may not become blockbusters.

If the party in biotech stocks is over, a lot of investors don’t seem to have gotten the message. The S&P 500 Biotech Index has nearly tripled in the past three years. The index had stalled and moved sideway for much of the past spring, leading some to wonder whether the rally was spent. Instead, it’s gained another 11.3% over the past month. The Nasdaq Composite, by contrast, is up only 2.5%.

Several factors have been fueling the biotech rally of the past three years. For one thing, the U.S. Food and Drug Administration has been pushing to speed up approvals. According to Ernst & Young, the FDA approved 41 new drugs in 2014, up from 27 a year earlier.

Meanwhile, the genomics-based insights that emerged in the early 2000s are finally delivering on new drug therapies. That in turn has led biotech firms to increase their research and development spending by 20% a year. After a decade or more of few promising drugs, the new generation is finally bearing financial fruit. Revenue at U.S. and European biotech firms rose 24% last year, while net income rose 231%, Ernst & Young reckons.

While new drugs may continue to come through the drug pipeline, the risk is they won’t benefit any and all biotech firms, but rather a select few. In the meantime, more investor cash is pouring into the sector indiscriminately, even into more questionable startups like Axovant. Some investors suggest it’s safer to stick with the larger companies – the so-called Big Biotech firms – that have a few promising drugs in the works as well as a track record of high growth.

Biotech stocks are vexing for many individual investors because, more than Internet or other tech stocks, they involve arcane science, a long and complex approval process, and a business model that involves largely hit-or-miss products. At the same time, no one wants to sit on the sidelines while a stock – let alone an entire sector – can double in value over the course of a year.

Many individual investors have opted to invest in biotech ETFs and mutual funds. Both of them have outperformed the broader market, but of the two, biotech ETFs have been the stronger performers. The Fidelity Select Biotechnology fund (FBIOX), for example, has risen 27% so far this year, or nearly three times as much as the Nasdaq Composite.

Several ETFs are doing as well or even better. The iShares Nasdaq Biotech ETF (IBB), which tracks biotech stocks on the Nasdaq, is up 26%. The SPDR Biotech ETF (XBI), which tracks the S&P Biotech Index, is up 39%. And the ALPS Medical Breakthrough ETF (SBIO), which began trading in early 2015, is up 47%.

The XBI and SBIO funds have outperformed because they focus more on small and mid-sized biotech companies. Nine out of the ten largest holdings in the XBI have risen more than 50% this year, and seven of them have more than doubled.

The IBB, which has emerged as something of a proxy for the industry for many investors, is weighted much more heavily to bigger, more proven biotech companies. Its top ten holdings make up 59% of the ETF’s value, including giants like Gilead Sciences, Biogen and Amgen.

The volatility of small- and mid-sized biotech stocks mean they will fall sharply once the inevitable correction comes, whether they have promising drugs in the works or not. The wildcard in the sector is the possibility of a wave of M&A, which could drive up some stocks. Synageva Biopharma, for example, has risen 140% this month on news of a buyout by a larger biotech firm, Alexion Pharmaceuticals.

But if picking which company has the next blockbuster drug is tough, anticipating the next M&A target is even trickier. And the longer the biotech rally continues, the more important it becomes to pick the winners from the losers. At some point, for the average investors, staying on the sidelines becomes the smarter play.