Why I'm Shorting Biotech

By Markets Fool.com

Biotech and biopharma have had an incredible run over the past few years. And like many investors, I've been able to crush the broader markets simply by buying and holding top names in the industry likeAbbVie,Gilead Sciences, andIsis Pharmaceuticals.

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GILD Chart

An odd thought, however, keeps popping up in my mind as I look over my rocket-fueled biotech portfolio these days. Namely, why aren't stocks like Gilead doingevenbetter?

Although this leading biotech stock is up a stately 21% so far this year, I've become so accustomed to rapid-fire increases in share price with this company that such an eye-popping gain is no longer good enough. A quick look at the headlines surrounding this stock suggests that I'm far from alone in holding this ridiculous notion.

The sheer silliness of this expectation, along with fact that it's become pervasive throughout the investing community of late, led me to a frightening realization. Namely, the biotech blowout party looks like it's likely about to come to an abrupt and painful end. And although timing the market perfectly is impossible, I believe now might be a good time to cut back on long positions and, dare I say it, start shorting biotech.

Though there are bound to be many single companies that will continue to deliver strong returns, here's a look at my three major reasons for shorting this currently high-flying industry.

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Reason No. 1: The rate of innovation is starting to hit a wall
One of the main reasons biotech has exploded higher is because the industry has been undergoing an innovation boom, leading to the advent of breakthrough therapies for hepatitis C, HIV, high cholesterol, and even cancer. What most investors aren't aware of, though, is that this golden age of biotech and biopharma took decades to achieve.

Source: Merck.

Science progresses in fits and starts. Cancer immunotherapy, for instance, has been grabbing headlines left, right, and center lately, fueled by the stunning clinical performance ofBristol-Myers SquibbandMerck'sPD-1 inhibitors in advanced melanoma, non-small cell lung cancer, and other hard-to-treat malignancies. The twist to the story, however, is that immunotherapy as a field has been around for decades and is only now bearing fruit.

The next stage of scientific inquiry for immuno-oncology is the brutal part for scientists, patients, and investors alike. We know PD-1 inhibitors work for about 30% of patients in some cancers. So, the challenge going forward is to find potent combinations of all-oral treatments and immunotherapies that are effective in a broader array of patients and, most importantly, types of cancer.

We are therefore looking at another couple of decades of slow, painstaking work to figure this all out. Worse still, the same can be said for most of the other new classes of drugs like direct-acting antivirals, PCSK9 inhibitors, etc., being developed by the pharmaceutical industry these days. Eventually, this stark reality is going to dawn on the investing community, and unfortunately, they are probably going to lose interest at some point.

Reason No. 2: Drug prices could crater in the U.S.
Pharmaceuticals products in the U.S. have long enjoyed premium pricing structures. But the super-high demand and mind-boggling price tags for new game-changing drugs like Gilead's Sovaldi for hepatitis C is putting the healthcare system under an immense amount of pressure. Public and private payers have even gone as far as saying the burden on the healthcare system from these breakthrough drugs is simply unsustainable.

Dr. Steve Miller of Express Scripts thus decided to pit AbbVie's Viekira Pak against Sovaldi as a means to bring prices down. And he was stunningly successful, negotiating a discount on Viekira Pak in exchange for exclusivity on the pharmacy benefit manager's preferred formulary drug program.

Now, Miller and his PBM colleagues are eyeing pricey new cancer drugs. Their idea, in short, is to institute a performance-based reimbursement scheme. Under this scheme, a drug would only get reimbursed for its full price if it led to say, a rare event, like a complete remission.

The scary part for investors and drug companies is that cancer drugs tend to have little or no effect at all in most patients. So, a performance-based reimbursement system has the potential to absolutely crush the cash flows of cancer specialists and biotech bellwethers like Celgene Corp. .

Reason No. 3: A trend reversal is long overdue
The ProShares UltraShort Nasdaq Biotech Index is trading near its 52-week lows right now, and it's down a whopping 97% over the past five years. By the same token, the Nasdaq Biotech Index has more than tripled in value during that same time span:

BIS Chart

Given that what goes up must come down -- even high-flying biotechs -- it stands to reason that the biotech surge can't go on forever. And in light of the dark clouds currently forming around the industry, I think that time is nigh.

Key takeaways
Biotech has been one of the best-performing industries for a while now. But the confluence of a slowing rate of innovation in the broad sense (entirely new classes of drugs being discovered), and pricing pressures emanating from the payer side of the healthcare equation, have the potential to weigh this group down for a long time to come.

The headwinds for Gileadalready appear to be taking their toll on the biotech's share price. After all, the market is no longer willing to pay a premium for its earnings, and other key biotechs like Celgene are starting to experience a similar level of disinterest from the Street. And although the market is nothing if not unpredictable, I personally think we're looking at the start of an emerging trend reversal in biotech, making now a good time to get short.

The article Why I'm Shorting Biotech originally appeared on Fool.com.

George Budwell owns shares of AbbVie, Gilead Sciences, and Isis Pharmaceuticals. The Motley Fool recommends Celgene, Express Scripts, Gilead Sciences, and Isis Pharmaceuticals. The Motley Fool owns shares of Express Scripts and Gilead Sciences. 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.