Is There a Biotech Bubble?

As the biotech index (NASDAQ:NBI) soars to historic highs, industry investors are seeing gains of 50% in the past year. A record 85 pharmaceutical companies went public last year and the momentum has continued into 2015.

But while some investors are cashing in on medical breakthroughs, others are issuing a warning. Will we continue to see robust sector growth or will this boom come down crashing?

“Many companies with bad science will ride the coattails of the winners,” predicted Kathleen Smith, principal at IPO ETF manager, Renaissance Capital. “It will end badly,” she cautioned.

Biotech stocks can be volatile, spiking on favorable clinical trials, but sinking when facing obstacles from the FDA. Unlike big pharma, many of the biotech companies are one-trick ponies. If their marquee drug runs into problems, the business can go bust.

“There are certainly some stocks and sub-sectors in biotech that are likely overheated today,” said Bruce Booth partner at Atlas Venture. Yet “lots of companies are more modestly valued relative to their potential.”

Healthcare stocks have “dramatically outperformed the overall stock market,” said Booth, referring to the fact that the biotech index is outpacing the S&P 500. “Great medicines make great investments.”  And an uptick in M&A activity is driving up valuations, Booth pointed out.

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In the short run, newly public biotech companies outperform other industries. The average three-month return for pharmaceutical IPOs was 33% last year, compared to 22% for other sectors, according to Dealogic. And the biotech index is up 46% since last July, when Fed chairwoman Janet Yellen warned of “substantially stretched” valuations.

Those averages are being lifted by standout stocks like cancer drugmaker, Ignyta (NASDAQ:RXDX), which is up 86% this year. “Amidst many losers, there are a few big winners,” said Smith.

Nelson Griggs, executive vice president of listing services at the Nasdaq, said that instead of betting on one company, the biotech “index will be a solution for investors who don’t have the ability to do the research” on a new drug.

The Nasdaq Composite Index recently hit a record, and Griggs pointed out that “biotech has been a big driver.”  The vast majority of biotech companies list on the Nasdaq, partly due to different listing requirements.

And with $6 billion in venture capital invested in biotechnology startups last year, it is likely that the IPO momentum will persist for the foreseeable future. “I suspect there will be continued IPO interest in lots of new small-cap biotech stories over the next 6-12 months,” said Booth.

But whether the stocks continue to surge or crash and burn remains to be seen. “Only time will tell, as bubbles are only apparent in the rear-view mirror,” said Booth.

Bubble or no bubble, “if out of the rubble we find cures for cancer, it may be worth it,” said Smith.