3 Signs We Could Be Entering a Biotech Bubble

The resiliency of the stock market as a whole has been practically unparalleled since the recession in 2009. It's certainly gotten a little bit of help along the way with multiple stimulus offerings from the Federal Reserve, which has helped lower long-term lending rates making it easier for consumers and businesses to refinance their debt, and helped restore faith in the housing market.

Yet, if there was one sector that's has thoroughly outperformed its peers, it would be biotech stocks. Although the broad-based S&P 500 has returned just shy of 150% since the market bottom, the SPDR Biotech ETF is up a staggering 201%. With few exceptions, biotech stocks are soaring. Clinical-stage cancer drug developer Pharmacyclics is up a staggering 16,484% since the market bottom, while ACADIA Pharmaceuticals, Regeneron Pharmaceuticals, and Incyte have followed with respectable gains of 3,136%, 2,364%, and 1,735%, each!

Source: Urbanicsgroup, Flickr.

Big gains like these definitely bring biotech enthusiasts out of the woodwork, but it also tends to bring inexperienced biotech traders into the sector as well. The end result usually is that valuations tend to get a bit ahead of themselves. Three specific factors along these lines have begun to rear their head, and, if I didn't know better, I would say we're entering a biotech bubble.

Concern No. 1: Big pharmaceutical companies are reaching badly for growth.
Don't get me wrong, mergers and acquisitions are a good sign of sector strength. M&A activity is often viewed as a sign that companies are willing to take on added risk for a chance at a heftier return. But, there's also a line that has to be drawn between snagging a good deal and blatantly chasing a company higher for no particular reason.

To this I point to Perrigo's recent purchase of Elan for $8.6 billion. Why did Perrigo go after Elan? Primarily because Elan is based in Ireland, and the corporate tax rate in Ireland is a very favorable 12.5%, which will help it keep more of its hard-earned cash. But, what did Perrigo really get with Elan other than with it being a tax haven? Honestly, not a whole lot.

Elan sold off its global rights to multiple sclerosis drug Tysabri to Biogen Idec earlier this year, netting it $3.25 billion. Elan does still retain certain royalty rights to Tysabri, but that revenue isn't going to amount to very much at all. In addition, its interest in Alzheimer's disease drug bapineuzumab last year proved worthless as the drug failed to provide a statistically significant improvement over placebo in multiple late-stage studies. In other words, Perrigo purchased what looks like an early stage biopharmaceutical company with a history of recent clinical failures. Good job, Perrigo... I think?

Bristol-Myers Squibb also gets a dunce-cap award here for its purchase of Inhibitex for $2.5 billion in January 2012 -- a 163% premium to Inhibitex's previous closing price! The purchase was made so Bristol-Myers could get its hands on INX-189, an oral hepatitis-C treatment that had shown promise in early-stage trials. Unfortunately, the dream wouldn't even last a year for Bristol-Myers, which was forced to shelve BMS-986094 (Bristol-Myers changed the name of the drug from INX-189 to BMS-986094 following the closing of the deal) after it caused the death of a patient and hospitalized others in a clinical study. Chalk up a $1.8 billion writedown on that deal for Bristol-Myers!

Even Amgen's recent purchase of Onyx Pharmaceuticals leaves me somewhat skeptical. If you recall, I arrived at a valuation of $145 per share for Onyx in early July based on the assumption of the company hitting peak sales for all of its existing drugs. The worry is that new competition is almost always in the offing and rarely do drugs wind up hitting their peak sales potential anymore. Therefore, even with Amgen nabbing Onyx for $125 per share, it's really difficult to understand where Amgen is going to pull value out of this deal. Essentially, Amgen handed over $1 now to get that same $1 back at a later date.

Concern No. 2: Biotechs with thin pipelines are begging to be bought
What's worse than big pharma chasing growth at insane valuations? How about small and medium-sized biotechs with questionable pipelines putting a "for sale" sign out in their front yard?

Perhaps the poster child to this is Clovis Oncology , a developer of cancer therapies focused currently on solid tumors and non-small-cell lung cancer. The early-stage results from rucaparib in treating ovarian cancer and CO-1686 in creating a partial response for patients with the dominant resistance mutation T790M was encouraging. However, shareholders pushed Clovis to a valuation topping $2.2 billion just weeks ago, quadrupling it in a year's time, on the heels of these results, all while pushing aside the fact that its most advanced late-stage drug CO-101 for advanced pancreatic cancer failed miserably in a mid-stage study in November.

Then came word that Clovis was going to put itself up for sale. I called the move nothing more than Clovis acting like a wolf in sheep's clothing and questioned which company in their right mind would pay a premium for a pipeline that consists of just two early-stage drugs and one preclinical partnership. Not surprisingly, Bloomberg reported earlier this week that Clovis had drawn no buyout interest. Big shocker there!

No example will do justice to Clovis' ridiculous attempt to find a buyer, but I'd even point to ViroPharma hiring Goldman Sachs to help it explore its strategic alternatives as another sign of biotech exuberance.

Rumors on Wall Street have ViroPharma being purchased as high as $60 per share, or about a 100% premium from when these rumors first came to light. It makes me wonder what ViroPharma is really going to offer a potential suitor? It lost its previous lead drug Vancocin to generic competition, and it failed once already to bring anti-megalovirus drug maribavir to market. For ViroPharma, Cinryze, which treats the ultra-rare disease hereditary angioedema, is its work horse. Unfortunately, the global peak sale estimate for Cinryze is just $700 million, which is already steep for the $2.6 billion biotech. ViroPharma does have a few other early-stage studies ongoing, but they're hardly a lock to bring success.

In short, the "buy me next" mentality among small and mid-cap biotechs is starting to get worrisome.

Concern No. 3: The IPO market is on fire... a little too "on fire" if you ask me
According to a recent report from Forbes, through just the first nine months of 2013 the biotech IPO market has already raised $2.5 billion, its second-busiest year in the 30-plus years of biotech IPO record-keeping. Furthermore, biotech IPOs are up this year by an average of 64%, handily trouncing all other sectors' IPOs .

Forbes detailed numerous reasons for this recent IPO success, including bigger pharmaceutical names recycling their profits into smaller growth stories, investors witnessing the success of recent IPOs, and traders chasing sector performance. However, I have a different view.

The majority of biotech companies filing for an IPO are doing so with largely preclinical or early-stage pipelines. There's nothing wrong with early-stage success as phase 1 results can help cue investors into the potential of an experimental drug. On the flip side, success in phase 1 of the clinical study process hardly qualifies as a drug that investors should count as an imminent approval. The Centre for Medicines Research International in the U.K. conducted a study recently that showed that 82% of all mid-stage studies fail while about half of all phase 3 studies trip up. To put it another way, less than 1-in-10 successful phase 1 drugs will be a success in late-stage trials, yet investors are perfectly fine pumping up IPOs with small pipelines into the stratosphere!

Stemline Therapeutics is a perfect example. This biopharmaceutical company debuted in late January, and its shares have quadrupled since on the heels of intriguing early-stage results for SL-401, an IL-3 receptor inhibitor that targets cancer stem cells and could be used as a treatment for acute myeloid leukemia and other blood cancers. While the results are certainly noteworthy, it's probably unwise of investors to pump up the share price knowing full well that these drugs are likely years away from reaching the market, and a lot could happen between now and then when testing a larger subset of patients.

Is the end near?
I'm not ready to proclaim the end of the biotech rally just yet, but the ominous warning signs that the sector is becoming overvalued are definitely there. Investors should do their best to corral their investments in the sector to established or diversified pipelines and avoid the flashier names that have run up based on rumors and early-stage results.

Two unique cancer plays to keep your eye on
The best way to play the biotech space is to find companies that shun the status quo and instead discover revolutionary, groundbreaking technologies. In the Motley Fool's brand-new FREE report "2 Game-Changing Biotechs Revolutionizing the Way We Treat Cancer," find out about a new technology that big pharma is endorsing through partnerships, and the two companies that are set to profit from this emerging drug class. Click here to get your copy today.

The article 3 Signs We Could Be Entering a Biotech Bubble originally appeared on Fool.com.

Fool contributor Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.The Motley Fool recommends Goldman Sachs. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Copyright © 1995 - 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.