Investors Need to Be Discerning About Biotech

"Merck's $10.8 billion acquisition of Prometheus Biosciences, which is developing a promising treatment for inflammatory bowel disease, is giving the entire biotechnology sector a lift.

On Monday, the SPDR S&P Biotech ETF, which has underperformed other growth sectors this year, closed up 4.7%. For the year, the Biotech fund is down 1.4% versus the Nasdaq-100's gain of 20%.

The biotech jump was higher than when Pfizer agreed to buy Seagen for $43 billion in March or when Amgen agreed to acquire Horizon Therapeutics for $27.8 billion in December.

The lack of a significant rally in the biotech sector so far this year despite a significant amount of deal making left many investors and analysts scratching their heads. But there is a certain logic to it. While the Pfizer and Amgen deals were large and pricey, they were bets on companies with approved products and growing sales. There are a handful of biotech companies with such a profile.

The Merck deal, while smaller, gives the industry more confidence. That is because Prometheus is an earlier-stage company. While Prometheus reported positive study results in midstage testing for ulcerative colitis and Crohn's disease, it has yet to prove the drug works in a larger study. If Merck was willing to acquire Prometheus at a 75% premium to where shares closed on Friday, the thinking goes that many other companies with no approved products could be undervalued, too.

But Jefferies healthcare strategist Will Sevush argues there are too many publicly traded companies with very little chance of ever launching a product. A 2021 bubble in the sector allowed many companies with highly speculative products to come to the market, and many of those companies will be a drag on the sector for some time.

The sector will likely continue to be volatile, especially with the presence of so many short sellers. Short interest, while significantly lower than the peaks reached in the summer of 2022, had been edging up in recent weeks, says Mr. Sevush. Many probably had to cover their bets after this past weekend's Merck news. While the sector tends to outperform during short periods of excitement, such as during the vaccine hype, it hasn't been a good long-term investment. In the past five years, the S&P Biotech ETF is down about 10% versus a gain of more than 90% for the Nasdaq-100.

The more promising strategy might be to bet on winners, companies that are on the cusp of a breakthrough or might be soon acquired by pharmaceutical companies. Prometheus was in Mr. Sevush's takeout basket, which includes other biotech stocks such as Madrigal Pharmaceuticals, Sarepta Therapeutics, BioMarin and Argenx SE.

Another biotech that outperformed on Monday was Roivant. While the company has holdings in different therapeutic areas, it is developing a treatment targeting the same TL1A protein as Prometheus. The stock was up 20% at Monday's close and rose 4.1% on Tuesday.

What many of these companies have in common is that they either have approved products gaining traction on the market, or, like Prometheus, they have compelling clinical data that backs up their scientific approach. Merck's splurge on a midstage company is no doubt encouraging news for the sector. It is even better news for companies with a credible pipeline." [1]

1. Investors Need to Be Discerning About Biotech
Wainer, David.  Wall Street Journal, Eastern edition; New York, N.Y. [New York, N.Y]. 19 Apr 2023: B.14.