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How to Make a (Consistent) Killing in Biotech Investing in 2016

The stock market has shown a lot of love for biotech stocks. The Nasdaq Biotechnology Index, as measured by the iShares Nasdaq Biotechnology Index ETF (Nasdaq: IBB), has risen more than 295% since Jan. 5, 2009.

In 2015, readers following along with my Biotech Insider Alert investment research service saw gains more than 35 times greater than the broader markets.

Truth is, biotech is in the midst of its longest bull run in history, and there's every reason to expect it will remain an attractive outperformer this year.

But biotech can be one of the toughest sectors to crack for profits. We must know which shares offer superior returns over time, and it's important to know when to buy, too.

The need to know about these terrific shares has brought out some common threads in a few of the reader questions I've heard lately. Today I want to take a minute to answer some of the biggest, most important biotech investing questions out there.

Q: Is exposing our portfolios to biotech in 2016 a good idea?

The biotech subsector has outperformed the market for five years running, and all signs point to even more growth during the coming year.

After all, the medicinal market hasn't gone away, or even gotten smaller. The Food and Drug Administration (FDA) approved a record 45 new drugs last year, and the strong demand for new medications to treat illness and injury will continue. And after decades of small delivery on big promises, the industry is beginning to reach its potential and bring drugs to market that are making huge inroads on intractable disease.

Gilead Sciences Inc.'s (Nasdaq: GILD) Sovaldi may virtually wipe out hepatitis C. And some of the new CAR-T (chimeric antigen receptor T-cell) therapies, under development at companies like Juno Therapeutics Inc. (Nasdaq: JUNO) and Kite Pharma Inc. (Nasdaq: KITE), are making big gains on cancer, especially liquid neoplasms such as leukemia and lymphoma.

With more than new 3,400 drugs in the pipeline, I expect to see similar breakthroughs in the coming year for other terrible diseases.

The types of drugs being approved are as important as their number.

More than one-third of the new drugs approved in 2015 were "first-in-class," meaning either the first therapy to treat a disease, or the first to use a novel mechanism of action. That's a huge leg up for potential sales. And just as importantly, nearly half had "orphan" designation, meaning they treat rare diseases (those that affect fewer than 200,000 Americans). They will receive extended exclusivity and special tax advantages when they reach the market. These are also the drugs that generally fetch the highest prices.

So despite considerable volatility at the end of 2015, the biotech sector index finished up 11% for the year.

The outlook is bright, and I expect a similar, if not stronger, performance in 2016.

Q: Politics played a role, maybe even an outsized role, in biotech investing in the last half of 2015. Do you see a return of that?

As long as government plays a role in medicine, politics will remain one of the variables that drives biotech stock volatility.

For example, in August of last year, Turing Pharmaceuticals CEO Martin Shkreli announced he had decided to increase the price of an anti-parasitic drug that had been around for six decades, Daraprim, from $18 to $750 (more than 4,000%), after purchasing the rights to it from another company. The drug has found important use in protecting HIV and cancer patients from deadly opportunistic infections.

The move produced a general hue and cry among patient advocacy groups, physicians, pharmaceutical industry leaders, and finally, the general public.

In response, Hillary Rodham Clinton, by then a declared presidential candidate, made the following comment on Twitter: "Price gouging like this in the specialty drug market is outrageous. Tomorrow I'll lay out a plan to take it on. -H"

It's worth noting the plan she released contained nothing that would have prevented Shkreli from price gouging a legacy drug.

But her comment and plan certainly had an influence on biotech stocks. Prices tumbled, and the momentum helped exaggerate the effect of a generally bearish stock market.

We had seen something similar happen the previous year, when U.S. Federal Reserve Chairwoman Janet Yellen made a statement about biotechs being generally overvalued.

Will politics create similar effects in 2016? It's an election year, and there's no telling what mischief candidates, on either side of the aisle, will get up to. But it's safe to say that drug pricing will remain a hot-button issue, as it has been for many years, and politicians are unlikely to leave it alone.

Politics is only one variable among many that pushes share prices in a sector that is largely event driven. But the market has a short memory, and generally prices will rebound within a few weeks. This hasn't happened yet after Ms. Clinton's remarks, but as I mentioned above, that's more a ramification of the overall market turning bearish than anything else.

By the way, politics can also have a positive effect. President Obama's call for a precision medicine initiative toward a cure for cancer, that is, an effort to advance medicine tailor-made for each patient, will no doubt give a boost to more research and development funding in the near term.

Q: Companies like Martin Shkreli's Turing and Valeant Pharmaceuticals brought a lot of political trouble with some ethically questionable antics. How do you think the industry will respond- and do you think markets will understand?

First, I don't believe the answer ultimately lies in legislation. Pricing is very tricky, and while I do think we need to develop a way for all patients to gain access to the drugs they need, we also have to be careful not to dis-incentivize innovation. There's no point in manufacturing drugs that patients won't buy because they can't afford them (or in driving truly desperate people into bankruptcy with drug pricing). But neither can we afford to push the small companies, where most research goes on, out of business.

Currently, only about 12% of all biotech and pharmaceutical companies are profitable. Valuation for the other 88% lies mostly in the expectation of future profits. Most new drugs are coming from small- to mid-cap biotechs that struggle for financing, not giant pharmaceutical firms making exorbitant profits.

So any legislation that stands in the way of reaching profitability for all those small companies that are developing important, innovative new drugs has no possibility of passing. It would simply be too destructive to the industry and to the healthcare of Americans.

First, I would say direct price controls are off the table. No one on either side of the aisle would want to make government that intrusive with regard to any particular sector of private enterprise.

What will be up for debate, however, is how long originating drug companies can maintain exclusivity over their products and prevent generics manufacturers from producing knockoffs.

We may also see a debate over Medicare's ability to negotiate drug prices, and we'll almost certainly see further legislation to close up the "donut hole" in Medicare plans, that is, a brief period of time at the end of every year when coverage runs out.

The greatest factor in controlling drug prices, however, will most likely come from the market itself.

Over the past few years, we have seen doctors refusing to prescribe drugs that are too expensive. In 2012, for example, Memorial Sloan-Kettering Cancer Center refused to prescribe a drug called Zaltrap for advanced colorectal cancer, which had an $11,000 per month price tag, but offered no particular greater benefit over older, cheaper drugs for the same condition.

That flew in the face of the government's requirement that Medicare reimburse for all cancer drugs, without distinction. The docs at Sloan-Kettering refused the high reimbursement simply because it was a waste of money.

However, I should note that had the drug in question proven in some way significantly better than the current standard of care meds, the hospital probably would have bitten the bullet and started prescribing it.

Which brings us to the insurance companies. Ultimately, the cost of drugs will come down to what companies will reimburse, and that, in turn, depends partly on the size of rebates they receive from Medicare.

Drug companies can, of course, help themselves and avoid even the possibility of draconian drug price legislation by regulating themselves. We may, at some point, witness the formation of an oversight group, run by the industry itself, that helps develop caps for drug prices – heck, they already do that in professional sports – or at least provides greater help for patients who can't afford care.

Q: Biotech is a sector in which "Holy Grails" loom large, but patients (and of course, investors) are fortunate in that there can be several at once. That is to say several different companies can bring most (or all) of their respective efforts and resources to bear on several different medical scourges. Should investors try and capture a few "grails" at once, and spread out holdings among different companies and avenues of research?

Diversity is key in biotech investing: It's wisest to invest only a small amount (1% to 2%) of your investable funds in any single position, and to spread the risk over a number of stocks.

As you're probably aware, biotech stocks tend to be hyper-volatile. Small- to mid-cap companies (greater than $200 million and less than $2 billion), where you can make the most money while maintaining liquidity, are vulnerable to many unpredictable market forces and can take you on a roller-coaster ride of red to green and back again.

More importantly, although you can stack the odds solidly in your favor with good advice based on a strong understanding of the science behind new drugs – as we provide in our Biotech Insider Alert research investment service – you never know what surprises R&D data or the FDA, in its wisdom, will spring on you.

And bad news can tank a biotech stock within minutes.

So again, investing over a range of biotech stocks to spread risk is your wisest choice. Look for stocks that have upcoming regulatory or developmental milestones – catalysts – such as results from a study or an FDA decision date. They'll be your biggest near-term moneymakers.

Also, make sure you have a couple of steady growth stocks, or companies that have already established a portfolio of commercialized products and don't depend so much on individual catalysts to increase their stock's value. These companies will often have higher valuations (market cap greater than $2 billion) and can even include big, full-service pharmaceutical firms.

In the same regard, look for companies that have diversity in their pipelines. Many biotechs focus on developing a single drug, primarily for a single medical indication (although they may have plans to try the drug on other illnesses in the future). These companies offer the highest risk for investors. If the drug fails in experimental trials or doesn't receive FDA approval, share prices could go to zero.

Companies that have several drugs in advanced-stage development provide the best balance between risk and reward. The failure of one drug won't mean the end of the company, and they offer multiple chances for big successes.

Q: Do you like any "foundational" biotech shares, stocks that may give investors steady growth?

There are a number of companies that come to mind, but one of my favorites is Neurocrine Biosciences Inc. (Nasdaq: NBIX), a $3.83 billion cap company headquartered in San Diego, Calif., which develops pharmaceuticals for the treatment of neurological and endocrine-related diseases and disorders in the United States.

The company's products in clinical development stage include elagolix, which is in a phase 3 study for endometriosis and in a phase 2b study for uterine fibroids.

It also has several other drugs in the pipeline to treat endocrine system and central nervous system disorders.

NBIX shares rose from about $33 to $57 per share in 2015, a 72% gain, and despite falling off some in the early part of this year, along with the rest of the stock market, still promises to be a strong gainer in 2016 as it reaches regulatory milestones.

I also like Eagle Pharmaceuticals Inc. (Nasdaq: EGRX), a $1.03 billion cap company headquartered in Woodcliff Lake, N.J., which surged from about $19.50 per share in January to $87 (nearly 450%) by year's end.

Eagle Pharmaceuticals focuses on developing and commercializing critical care and oncology injectable products in the United States.

The company's strength lies not only in its products, but in the commercialization partnerships it develops.

For example, last year it licensed its bendamustine rapid infusion product, Bendeka, to Teva Pharmaceutical Industries Ltd. (NYSE ADR: TEVA). Bendaumstine is a drug that treats leukemia and lymphoma.

Teva Pharmaceutical paid Eagle $30 million up front and agreed to pay up to $90 million in milestones and double-digit royalties on Bendeka sales.

Although Eagle may not see growth on quite this scale next year, I do believe it will continue to be a strong performer.

I hope these answers to some of your questions prove useful in your biotech investing strategy this year.

As always, I'm thrilled to hear from Money Morning Members, and invite you to join us at Biotech Insider Alert for exclusive insights and actionable recommendations in the world of bioscience stocks.

Editor's Note: Ernie is following an imminent FDA decision that could end surgery as we know it… forever. It could also spark a 224,000% sales surge for a tiny $2 company holding critical patents. This company is part of a unique market sector responsible for gains of 10,000%… 14,000%… even 25,000%. While these gains are exceptional, the powerful potential of this market is clear. Insiders, including the company CEO, have already grabbed up 96% of available shares alongside institutions. And one famous billionaire has already taken a massive stake in this tiny $2 stock. Get in on this story now

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About the Author

Ernie Tremblay has more than 25 years of experience in following and analyzing the latest developments in health, medicine, and related technologies. He understands the FDA approval process, as well as the "hard science" behind new, experimental drugs and the market demand for them - and has a comprehensive grasp of the complex dynamics that determine whether a new drug will be a breakthrough winner, or just another casualty of the FDA approval process.

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  1. Max | February 1, 2016

    From 2000 to 2002 the Nasdaq Biotech Index fell by 2/3rds. That shows you how vulnerable this sector can be. And due to the extreme run up of the last 6 years, it now ranks with the biggest bubbles in stock market history. I expect it to make one of the loudest crashes as this bear runs its course. Good luck trying to pick the winners in that kind of environment.

  2. Ernie Tremblay | February 2, 2016

    Thanks for your comments. Another point of view is always appreciated.
    I would, however, quibble with a couple of your arguments.
    For example, the characterization of the lengthy bull market in the biotech sector as a “bubble” would seem to beg comparison with the real estate and dot com bubbles, which were inflated with a lot of fraud and chicanery—worthless mortgages in the first case, and empty offices with a name on the door in the second.
    Although biotech valuations are always a matter of perception, built more upon expectations and risk assessment than past performance (most of these firms, as opposed to big pharma companies, are pre-profit), they are not, like the two bubbles mentioned above, based on smoke and mirrors.
    Bioscience investors are under no illusion about the risks they take, but we know up front what those risks are. They’re based primarily on the likelihood that a new drug can harrow the regulatory gauntlet, prove safe and effective, and make it to market. The process is long, difficult, and transparent enough so that we can be pretty certain we’re not dealing with misrepresentation of risk. No bad mortgages, no empty offices.
    Of course, the volatility built into biotech can take it through wild swings and corrections, but in its ups and downs, it behaves like the stock market more generally—with more exaggerated fluctuations because of its relatively greater inherent risks.
    So while we may see steep slides in the sector, I don’t see a collapse—a bubble burst—on the horizon. And as things calm, I anticipate these stocks will rise again.
    Perhaps more germane, however, is your comment about predicting winners in a bearish environment.
    What I look for, in assessing near term gains from a biotech, is the likelihood that upcoming catalysts will give stock price a boost. And that’s happening even now, with the general market clearly in a downturn.
    Investors don’t need the sector to do well, or even for particular stock picks to do well over the long term. Near term investors who can make informed judgments about the success or failure of upcoming regulatory catalysts, such as data releases from clinical studies and FDA decisions, can still, on balance, do very well in this market with a long hypothesis (confidence that share price will go up rather than down).
    Informing those judgments is what we try to do both here, in Money Morning, and in Biotech Insider Alert.

  3. Rick deGeurin | February 10, 2016

    Ernie:
    If FDA approval is given April 15th & Google or Warren Buffett were to entertain a buyout, how would you arrive at a fair market value considering
    current sales now and or the future potential of this company. How would they
    put a value on now, once it is approved and for the future???

    Regards,

    Rick deGeurin

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