S&P Likes a Trio of Biotech ETFs

Due to increased FDA approvals and takeover speculation, biotechnology ETFs have already been among the best-performing sector funds this year, but more upside could materialize over the next 12 months. That is the sentiment of S&P Capital IQ, which highlighted three biotechnology ETFs in a new research note.

"In 2011, the U.S. FDA approved 30 new drugs, compared to 21 in 2010," S&P said in the note. "Through September 2012, the year-to-date total was 22. We see an improving trend for FDA first cycle review approvals and a rise in the rate of new drug approvals for rare diseases, which we think is helping to boost investor sentiment for the agency, after years of criticism stemming from inconsistency in making and communicating its decisions.

"More important than the recent boost in approval count, in our view, is the approval of new drugs with what we see as robust commercial prospects and that have represented a significant advance over previously available therapies, reversing a trend seen over the prior five years. Of note, during 2012, the FDA has approved new treatments for rare respiratory disease cystic fibrosis and multiple others for cancer months ahead of their scheduled action dates."

In the note, the research firm applied Marketweight ratings to the following ETFs: The iShares Nasdaq Biotechnology Index Fund (NASDAQ:IBB), the SPDR S&P Biotech ETF (NYSE:XBI) and the PowerShares Dynamic Pharmaceuticals Portfolio (NYSE:PJP).

S&P also gave four-star ratings to Amgen (NASDAQ:AMGN) and Gilead Sciences (NASDAQ:GILD). That pair combines for over 16 percent of IBB's weight and almost 12 percent of PJP's weight. Year-to-date, IBB (the largest biotech ETF with $2.27 billion in assets) is up 30.8 percent, while XBI is up 31.6 percent while PJP has gained 21.6 percent.

One of the reasons biotech ETFs have surged this year is mergers and acquisitions; both realized deals and rumors. S&P highlighted deals for Amylin Pharmaceuticals and Human Genome Sciences as two examples and the firm expects the favorable M&A climate for biotech firms to continue.

"We see larger firms needing to offset revenues recently lost or soon to be lost from expiring drug patents, which is referred to as a "patent cliff" in the pharmaceutical industry. In addition, we also see larger biotech companies becoming more active in this regard, seeking to boost their drug pipelines amid maturing legacy products and declining R&D productivity trends," according to the note.

S&P noted that, as a group, large-cap biotechs were recently trading at 18 times the firm's 2012 earnings estimate on these companies. However, that is below the historical average for the group. IBB is more richly valued with a price-to-earnings ratio of 31.1. PJP has a P/E ratio of almost 13.7, perhaps helped by the ETF's exposure to traditional pharmaceuticals names such as Merck (NYSE:MRK) and Pfizer (NYSE:PFE). XBI is in the middle with a P/E ratio of 20.3

Surprisingly, the First Trust NYSE Arca Biotechnology Index Fund (NYSE:FBT) was not included in the S&P note. FBT, which has $228.2 million in AUM, has outperformed IBB, PJP and XBI this year with a gain of 32.6 percent. FBT differs significantly from the other ETFs mentioned here, particularly IBB. For example, IBB is home to almost 120 stocks with an average market capitalization of nearly $18 billion. FBT holds just 20 stocks with a median market value of $4.67 billion.

For more on biotech ETFs, click here.