(Reuters) - With biotech's bull run nearing its third year, some savvy investors believe it is time to seek safety in size.
The promise of drugs reaching the market at a faster pace has overshadowed rising risk in the sector. But signs in the past few months that a booming IPO market may be peaking and reversals for some fast-tracked drugs, are starting to give investors second thoughts about expensive smaller-cap biotechs.
"The small and mid-sized biotechs have been extremely hyped up," said Bill Smead, portfolio manager of the Smead Value Fund. "The most healthy thing would be a correction to flush some of that hot money out."
U.S. biotech shares have surged since 2011 on the back of Food and Drug Administration regulations to speed development of innovative drugs. While good news for patients, the effort has introduced more risk since the drugs are not fully tested until they are on the market.
Small-cap biotechs have always been a risky bet. Look no further than Ariad Pharmaceuticals Inc, which last month suspended sales of blood cancer drug Iclusig after a clinical trial showed that nearly a quarter of patients treated with the drug suffered heart problems and more than half had high blood pressure.
The FDA, which approved Iclusig last year for two rare types of leukemia based on a single trial, asked that it not be used on new patients. Shares of Ariad, which started the year near $20, had crashed to just over $2 at the end of October.
Sanford Bernstein analyst Geoffrey Porges said that while the whole biotech group had had a "spectacular run" it was "pretty clear that's not going to repeat itself over the next 18 months."
The sector has seen a bumper crop of initial public offerings this year - 38 in the first 11 months of 2013 - the most since the bursting of the 1999-2000 biotech bubble, according to Credit Suisse. But those shares have come under pressure in the fourth quarter, with returns falling short of the broader market. The investment bank calculated an average price drop of 11 percent for the 11 biotech IPOs 0f 2013 that had passed the date after which insiders were allowed to sell their shares.
Last month, prices for two biotech IPOs were slashed amid weak demand. And California-based Celladon Corp, which is developing drugs to treat heart disease, shelved its IPO plans entirely.
"There was a bubble in the biotech IPO market ... there was no discrimination between good and bad ones," said Sven Borho, a founding partner of OrbiMed, the world's largest healthcare-dedicated investment firm. "One thing is clear: healthcare investment bankers will always do their best to end any biotechnology bull market by issuing too many shares."
He still sees good value in large-caps like Gilead Sciences, Biogen Idec and Celgene, but said many of the small-caps and recent IPOs are too risky.
At the same time, the wider macroeconomic environment - chiefly interest rates - could be problematic for biotech companies, which are often valued on cash flows that would be discounted as rates rise.
"I think that the next 12 months is going to be a little bit more of a stock picker's market," ISI Group analyst Mark Schoenebaum said in a webcast commentary on Friday. "I think it's going to get a little bit more discerning in 2014."
Shares of high-growth, low current earnings companies like smaller biotechs have benefited tremendously from a backdrop of low yield and weak global growth over the past few years, Bank of America said in an early December note to investors. "They have begun to derate but there is more to go," the bank said.
As interest rates pick up and the economy accelerates, BofA advises investors to shed the extremes of high-growth, as well as high-yield stocks, and instead put money into cyclical sectors such as industrials, technology and energy.
On a tear for nearly two years, the market cap-weighted Nasdaq Biotech Index has gained 55 percent in the past 12 months, but is down 5 percent from its all-time high set early this month. The dollar-weighted NYSE Arca Biogech Index has risen 44 percent over the past year.
The sector's year-to-date performance outstrips a 34 percent gain for the Nasdaq Composite Index and 25 percent jump in the S&P 500, but biotechs have lagged the wider market in the fourth quarter.
Shares of Gilead, which received FDA approval for a likely multi-billion dollar hepatitis C drug, are up 89 percent over the past year. Shares of Amgen Inc, the world's largest biotech in terms of revenue, have gained 25 percent.
"The large-cap biotech companies like Gilead, Biogen and Celgene have done a wonderful job to justify a lot of their premium valuations - but that has got nothing to do with small biotech companies with products still in early-stage development," said Andy Smith, London-based chief investment officer at Mann Bioinvest, which invests in biotech and healthcare companies worldwide.
All three companies introduced new multi-billion dollar drugs this year, while continuing to build pipelines of promising experimental products.
Meanwhile, no one knows if general investors will eventually move on to the next hot sector.
Chris Rowane, manager of the Huntington Mid Corp America fund, said he still sees plenty of growth opportunities, particularly as big pharmaceutical companies look to biotech to boost their own drug development pipelines. But he is cautious that attempts to control healthcare costs could narrow the market for new, expensive biotech drugs.
The FDA's new "breakthrough" pathway for medicines that show promise in early testing - spearheaded by patient advocacy groups - has ignited investor interest in small-cap biotech. The expedited effort could shave years, and millions of dollars, off the traditional drug approval process.
As of November 22, the FDA said it had granted breakthrough status to 35 experimental drug applications, but not all of them have been made public by sponsor companies.
Shares in Danish biotech firm Genmab jumped 8.5 percent on September 16 when the FDA granted breakthrough status to its experimental leukemia drug. The stock has gained 7 percent more since then.
Dutch drugmaker Prosensa Holding saw its stock soar 54 percent in their U.S. market debut on June 28, a day after the FDA granted breakthrough status to the company's experimental muscular dystrophy drug. But the party was short-lived and the stock fell 70 percent in September when Prosensa and partner GlaxoSmithKline said the drug failed to show effectiveness in a late-stage study.