(Reuters) - Biotech stocks are so hot that even some of the bulls are starting to find themselves on edge.
An index of biotech drugmakers’ shares has climbed nearly 50 percent in the past 12 months to all-time highs as the industry starts to launch drugs developed by identifying genes associated with disease - a revolution made possible by decoding the first human genome more than 10 years ago.
The rise at such a fast pace is triggering the inevitable talk of a bubble, especially when investors are reminded that more than 90 percent of experimental drugs that reach mid-stage testing in humans do not make it past that point.
“Genetic information is providing a big opportunity for new drug development,” said Rajiv Kaul, portfolio manager of Fidelity Investments Select Biotechnology Portfolio, in Boston. “There are exciting new opportunities, but you also need to be careful because most drugs fail.”
Compared with a year ago, the Nasdaq Biotech Index, which is weighted by market cap, is up 45 percent, the dollar-weighted Arca Biotech Index has risen 35 percent, and the Pharmaceutical Index of large U.S. and European drugmakers’ shares has increased 32 percent. Over the same period, the S&P 500 Index has gained 25 percent.
A more favorable regulatory environment and lower capital costs are helping fuel the rally. The U.S. Food and Drug Administration approved 39 drugs last year - a record beaten only in 1996. Deutsche Bank, meanwhile, estimates that interest costs for large-cap biotechs to borrow in the capital markets are about 2 percent lower today than in 2007, and are likely to remain there for several more years.
Still, with the Nasdaq Biotech Index trading well above its previous all-time peak in 2000 - just before the epic dot-com bust - some investors are thinking about locking in profits.
“The biotech industry is in good shape, but there’s going to be a pause in news from medical conferences after ASCO (the American Society of Clinical Oncology), and I am thinking of taking profits on some of the large biotech names and switching some of the money into mid-cap companies,” said Nathalie Flury, manager of the Julius Baer Biotech Fund at Swiss & Global Asset Management, in Zurich. “There are no big conferences to provide catalysts between June and August.”
The annual ASCO meeting, where companies unveil their latest cancer drug research, will take place in early June in Chicago.
“I still think the sector has some room to grow, but it is not going to be as easy as it has been,” said David Heupel, senior healthcare analyst at Thrivent Investment Management, in Minneapolis.
He and others said the sector’s latest run-up is also being prompted by a newfound attraction to medical biotech from managers of general-interest mutual funds hunting for strong earnings growth potential.
“The reason is because they are looking for significant earnings growth, driven by new products over the next few years at Gilead, Biogen and Celgene,” said Michael Yee, an analyst at RBC Capital Markets, in San Francisco.
Gilead Sciences, the world’s largest maker of branded HIV drugs, is viewed as the leader in a race to develop a more safe and effective therapy for hepatitis C, a market Wall Street expects to garner billions of dollars in annual sales.
Short interest - a potential red flag that measures shares borrowed by investors expecting a price drop - has changed little over the past year for large-cap biotechs, standing at 2.3 percent of outstanding shares in early May, according to Jefferies & Co.
Short interest in biotech companies with market caps between $2 billion and $10 billion has fallen to 9.2 percent from 11.3 percent in the past 12 months, while short interest for companies with market caps of $500 million to $2 billion has increased to 15.2 percent from 12.7 percent over the past year.
Wall Street analysts estimate that shares of large-cap Gilead, which have more than doubled over the past year, trade at about 26 times 2013 earnings and 12 times 2015 earnings.
“That type of earnings growth is very impressive,” Yee said. “And it all comes against a backdrop of a really tough macro-environment.”
Concerns about overall consumer sentiment have served to cool investor interest in other growth-oriented sectors, including technology. The S&P Information Technology Sector Index has gained about 13 percent in the past year.
“That’s why you are seeing more money moving into biotech,” Yee said.
Even with the rally, some investors say biotech valuations remain attractive.
“These companies seem to be earning a much better return on their capital,” Heupel said. “They are not off the charts expensive.”
Earnings multiples for biotech shares remain well below the levels seen before the latest stock market crash in 2008.
The discount is even steeper when compared with multiples reached before the bursting of the biotech bubble in 2000. Amgen, for example, traded at an average price-to-earnings multiple of 59 in 2000, compared with its current P/E ratio of 14.4 times expected 2013 earnings, according to Deutsche Bank.
The question is how long the rally will continue.
Consensus estimates call for average combined annual earnings growth of 21 percent for biotechs in the next three years, compared with 9 percent for S&P 500 companies, according to Deutsche Bank.
“Biotech is both the worst business in the world and the best business in the world,” Kaul said. “It is high risk ... but when you have a good business, there tends to be value there over long periods of time.”
Additional reporting by Ben Hirschler in London; Editing by Ed Tobin and Jan Paschal