Why Ben Graham Might Be Wary of Biotech

Ben Graham, sometimes known as the father of value investing, often cautions against paying too much for a stock. In his famous work, The Intelligent Investor, he notes that stock prices tend to get unreasonably high when investors get overly enthusiastic. The biotech area seems to be showing some signs of excessive exuberance. Would Graham be wary of the sector? I think so, here's why.

Excessive enthusiasm means increased risk
Enthusiasm for stocks isn't necessarily a bad thing. But excessive optimism can be harmful as it often taints one's judgment on a stock's true potential. This hopefulness can be especially prevalent in high growth sectors like biotech, where optimistic estimates are the norm. Graham warns about such excesses, writing, "Evidently it is not only the tyro who needs to be warned that while enthusiasm may be necessary for great accomplishments elsewhere, in Wall Street it almost invariably leads to disaster."

Dendreon is a good example. This company made news with the 2010 approval of cancer-fighting product Provenge. Analysts at the time believed that the drug would generate sales of more than $1 billion a year by 2013. Unfortunately, the limited acceptance of Provenge and the advent of competitive products dashed those expectations. With a current run-rate of around $300 million in annualized sales, Dendreon shares fell from a high of more than $40 to less than $3 a share.

Merger fever might imply overexuberance
There are some recent signs that sentiment in the biotech area may be overly enthusiastic. One indication is the amount of excitement surrounding any merger rumor.

Onyx Pharmaceuticals, a company with a highly regarded cancer treatment drug called Kyprolis, started merger fever when it confirmed a $120 per share offer from large drug company Amgen in July. Thoughts of a potential bidding war pushed Onyx shares to more than $130 with analysts issuing possible buyout prices ranging up to $180 per share.

Shortly after, acquisition mania intensified with rumors that Swiss drug leader Roche was going to make a bid for Alexion Pharmaceuticals . Alexion, a biotech company with an orphan-drug product called Soliris, saw its shares jump. The idea that someone might look to purchase the company made some sense. It did have the approved orphan drug -- one that is highly lucrative with limited competition -- and an ongoing development program focusing on ultra-rare diseases. However, the deal fervor overshadowed legitimate concerns over the $20-plus billion price tag, European patent issues and developmental effectiveness questions. (More about factors related to an Alexion deal can be found here.)

Then, in mid-September, merger expectations erupted again as reports indicated that Roche was going to make a play for BioMarin Pharmaceutical . BioMarin shares rose about 10% on that rumor.

The idea also had some logic behind it. BioMarin has successfully developed and commercialized drugs for rare but serious medical conditions. The company also seemed to have a stronger pipeline than Alexion with a portfolio of four approved products and multiple clinical and pre-clinical product candidates. The cost of a possible deal, still a hefty $10-plus billion, was less extravagant than an Alexion bid, and in association with the company's current sales and future possibilities might seem to make a transaction more likely.

But the resolution of some of these stories was more subdued than investor expectations. Roche, seemingly tired of being named a wanton biotech suitor, had come out quickly and publicly denied any interest in BioMarin. Onyx, after a lack of new bidders, ended up going to Amgen for $125 a share, a minor 4% premium over the initial offer.

One might think the ardor toward biotechs would have cooled given the misses by Onyx and BioMarin. But the continued eagerness to "get in on" the next big deal indicates there still might be some excessive enthusiasm for the sector.

A torrent of IPOs could be a confirming sign
Another possible sign of extreme optimism could be the flood of IPOs. There have been more than 30 new biotech offerings this year, the most since 2000, and many firms put to market have shown extraordinary gains.

Graham notes that an increase in IPOs should be viewed cautiously. He writes:

Somewhere in the middle of the bull market the first common-stock flotation's make their appearance. These are priced not unattractively, and some large profits are made by the buyers of the early issues. As the market rise continues this brand of financing grows more frequent; the quality of the companies becomes steadily poorer; the prices asked and obtained verge on the exorbitant. One fairly dependable sign of the approaching end of a bull swing is the fact that new-common stocks of small and nondescript companies are offered at prices somewhat higher than the current level for many medium-sized companies with a long market history.

The froth in biotech stock offerings looks to still be going strong with four smaller-cap companies all announcing IPO intentions just in the week ended Oct. 4.

Given the signs of excessive enthusiasm, Graham would probably say it is prudent to be cautious on the biotech sector. But that doesn't mean he would dismiss them outright. He believed that any security could be considered if it looked fundamentally sound and, most importantly, was priced right. Even those that went public during times of exuberance. He opines, "Some of these issues may prove excellent buys-a few years later, when nobody wants them and they can be had for a fraction of their true worth."

One recent IPO that I'm watching is Enanta Pharmaceuticals , a research and development biotech firm focused on infectious disease. In March, the company went public at $14 per share.

Enanta looks to have a lot going for it. Its lead drug called ABT-450, which in collaboration with large drugmaker AbbVie, is aimed at fighting the devastating hepatitis-C virus. Six phase 3 studies that include ABT-450 are ongoing, and its New Drug Application is expected to be filed in 2014. The company also has other candidate drug studies with AbbVie currently under way.

The biotech space is certainly very exciting. It will produce a number of important discoveries that will help many patients. But investors might want to be cautious that they are not getting overly enthusiastic and paying too much for their shares. The idea being, as Graham suggests, "The habit of relating what is paid to what is being offered is an invaluable trait in investment."

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The article Why Ben Graham Might Be Wary of Biotech originally appeared on Fool.com.

Bob Chandler has a short position in Alexion Pharmaceuticals. The Motley Fool recommends BioMarin Pharmaceutical. 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.

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