Yes, the Biotech Crash Could Actually Get Worse

Source: Flickr user Jim Makos.

Since the stock market hit its trough in March 2009, few industries have performed as well as biotech. Over just the trailing five years the broad-based S&P 500, arguably the most all-encompassing indicator of market health, is up 62% through Sept. 29, 2015 -- compared to the near-tripling in the SPDR S&P Biotech ETF.

Why have biotech stocks been such outperformers? It's not uncommon for investors to flock to industries with higher growth potential and more risk when a bull market is romping higher. With the bull market about six years old now, investors' appetite for biotech has been mostly insatiable... until recently.

Is the biotech crash just beginning? Within the last 10 weeks the SPDR S&P Biotech ETF has plunged by 33%, completely erasing all of 2015's gains. The move lower has been decisive and unexpected, and it's sent quite a few traders scrambling for cover.

But here's the grim reality: the biotech crash we're witnessing may not be anywhere near over. There are quite a few reasons to support the idea that the biotech crash has only just begun.

Source: Hillary Clinton.

1. The "Hillary" effect Last week, presidential hopeful Hillary Clinton proposed radical reforms to prescription drug pricing that would cap out-of-pocket costs for consumers of eligible drugs at $250 per month, allow for the importation of cheaper drugs from overseas markets, and use the power of the federal government to negotiate better prices for social programs like Medicare and Medicaid.

As you might imagine, this didn't sit well with drug developers -- especially those focused on cancer care or orphan diseases, where a high price point is needed to help recoup the costs of drug development, as well as help subsidize treatment costs in emerging markets where drug developers would otherwise be unprofitable.

Furthermore, a Gallup poll from last month showed only 35% of Americans have a positive view of the pharmaceutical industry, down from 40% in the year-ago period. As long as Clinton is championing drug price reform, it could cast a cloud over biotech stocks.

2. Most lose moneyA big problem that's overlooked until you can't overlook it any more is that the majority of biotech stocks are losing money.

Source: Flickr user Purple Slog.

This probably shouldn't come as a huge shock considering the tens of millions (or hundreds of millions) of dollars that can go into the drug development process, and the length of time it can take before a first or second drug is approved by the Food and Drug Administration. Of the 351 publicly traded stocks in the biotech sector, based on data from Finviz, just 42 have reported a trailing 12-month profit, with a few of those companies recognizing a one-time milestone payment or tax benefit instead of generating a recurring profit. If investors are leery of growth in the U.S. and abroad, the first investments they may look to jettison are the money losers.

3. Emotions rule allBecause biotech stocks are predominantly money losers, the peak sales potential of a drug developer's pipeline, and the emotions and perceptions of investors, are what's left to guide the valuations of biotech stocks. Standard fundamental analysis typically doesn't work with this industry.

Source: Social Security Administration.

The problem with emotions is that investors have a strong tendency to overshoot both to the upside and downside when evaluating a stock. It can be darn near impossible to place an appropriate value on a first-in-class biotech therapy that delivered positive results in a phase 1 study considering all the variables that are still left to play out in mid- and/or late-stage testing, cash burn, and competition. Long story short, when emotions boil over, biotech stocks can suffer.

4. Share dilutionIn addition to losing money, biotech stocks are notorious for diluting investors through common stock offerings. Whereas most businesses sell a product or service, and a bank can analyze that product or service and offer a loan to the business, bank financing or private-equity lending is no guarantee for the biotech industry since the success of a future product is far from guaranteed.

Instead, one of the few pathways biotech companies have available is to issue shares of common stock to raise cash. Doing so can provide immediate capital to keep the lights on, but it comes with a price for existing shareholders: diluting their holdings. As I look around at small- and even mid-cap biotech stocks, the stock offerings have been flowing freely over the last couple of quarters.

5. Statistics aren't in biotech companies' favorIf you happen to snag the next Pharmacyclics, which ran from a Great Recession low of $0.57 to being bought out a few years later for $261.25 per share in cash and stock, you probably won't care what the statistics have to say. But, for the majority of us who don't have crystal balls handy, the simple fact of the matter is that most clinical trials will fail.

Medscape pegs the chances against a drug in preclinical trials making it onto pharmacy shelves at around 5000 to one! More recent data from KMR Group between 2007 and 2011 for new molecular entities shows that 94% of therapies that worked in animal testing failed once they reached human trials. In other words, the perception of a high clinical failure rate could weigh on biotech stocks if sentiment continues to shift toward pessimism.

Source: Pictures of Money via Flickr.

6. Few pay dividendsBiotechnology is also a very capital intensive sector. It requires regular investments into research and development in order to maintain and grow a product portfolio and pipeline over the long term. Because of this, few biotech companies actually divert free cash flow to shareholders in the form of a dividend payment. In fact, just seven biotech stocks currently pay their shareholders a dividend out of the aforementioned list of 351 publicly traded companies.

Why's this important? Dividend stocks act as beacons for investors during turbulent trading environments, pointing them in the direction of stable business models. If only a couple biotech stocks offer a shareholder incentives such as a dividend, few long-term-minded investors may flock to the sector in its moments of weakness. Plus, without a dividend there's nothing to help soften downsides, like the one investors are currently dealing with.

7. Rising rates could stymie deal-makingThe biotech growth engine has also been fueled in recent years by mergers and acquisitions. According to DealLogic, we witnessed $277 billion in M&A in 2014, a record year for biotech. This year M&A deals hit a value of $270.9 billion through mid-August, putting biotech on pace to crush its previous M&A record set last year.

But there's one potential problem. The Federal Reserve signaled in its latest meeting that a rate hike will most likely come sometime this year. Higher lending rates make M&A less attractive because they make borrowing money costlier. Unless businesses have ample cash on hand to finance deals, or are able to finance their deals with a potentially dilutive share offering, the M&A growth engine could begin to slow down.

Source: Amgen via Flickr.

How to survive a biotech crashIf biotech stocks do indeed continue to crash back to Earth, which is somewhat inevitable from time to time (stocks don't go up in a straight line), you can survive, or even thrive, by keeping a few things in mind.

First, seek out profitable businesses. Keep in mind that I'm not talking about a company expecting a big milestone payment that'll move its P/E to some single-digit figure here. I'm talking about biotech stocks that have recurring profits. Biotech stocks that are profitable are among the few that can be valued by traditional fundamentals. As such, they're considerably more likely to draw in investors with a long-term mentality, and potentially be less volatile in the face of a correction.

Secondly, focus on diversity. There's certainly a case that could be made for biotech stocks with FDA-approved ultra-orphan products facing no competition, but you're probably going to get better returns over the long run when seeking out well-diversified product portfolios and pipelines. This is why blue-chip biotech giant Amgen, for example, might holdup well, because it's working in multiple therapeutic areas, including inflammation, neuroscience, cardiovascular, hematology/oncology, and bone health.

Lastly, consider edging into new or existing positions on a regular basis. Market timing is nothing that can be done with any consistency over the long run, so your best bet is to make regular investments into the sector from time to time. This way you can help minimize or remove your emotions from your portfolio altogether and get back to the basics of investing.

The article Yes, the Biotech Crash Could Actually Get Worse originally appeared on Fool.com.

Sean Williamshas no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen nameTMFUltraLong, track every pick he makes under the screen nameTrackUltraLong, and check him out on Twitter, where he goes by the handle@TMFUltraLong.The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.