IBB: Price Gouging Assertion Is Overblown
Summary Price gouging by Turing Pharmaceuticals and the subsequent comments by Hillary Clinton have exacerbated this sector decline. This price gouging incident has elicited widespread backlash, and in my opinion, rightfully so; however, this criticism has been unfairly painted across the entire sector. Attempts to heavy regulate the sector with government intervention will likely end in a futile effort in arresting drug price increases. The unprecedented secular growth streak in biotech has been more than tested as of late with the biotechnology officially in bear territory. IBB is down 25% from its 52-week high, from $400 to $295 per share during the recent market weakness, presenting a potential buying opportunity. Price gouging assertion and Hilary Clinton Recently, Turing Pharmaceuticals and its CEO Martin Shkreli garnered criticism after the company boosted the price of Daraprim from $13.50 to $750 per pill, resulting in a greater than 5,400% increase after acquiring the drug in August. This price gouging of a decades’ old drug drew fire from the general public on social media, and in particular, the presidential candidate and democratic front-runner Hillary Clinton (Figure 1). Figure 1 – Tweet by presidential candidate and democratic front runner Hillary Clinton referring to the drug price gouging This price gouging incident has elicited widespread backlash, and in my opinion, rightfully so; however, this criticism has been unfairly painted across the entire sector. It’s noteworthy to point out that democratic lawmakers have requested pricing policies and further information on pricing of drugs by Canadian drug marker Valeant Pharmaceuticals (NYSE: VRX ). Despite the public backlash and public statements by lawmakers, I believe this is a temporary headwind rooted in the public relations arena. Although the aforementioned example of Daraprim is an isolated and extreme example, at the end of the day, these companies are in business to make a profit, retain fiduciary responsibilities and return value to shareholders. Many contend that these prices are not sustainable, and the cost to the overall healthcare system is a huge financial burden. Qualitatively, this is true; however, this situation draws parallels to the housing market, education costs and social security. All of these areas of our economy are facing similar fates with unsustainable financial barriers to entry and unfunded liabilities. Attempts to heavy regulate the sector with government intervention will likely end in a futile effort in arresting drug price increases for the following terse reasons: 1) Companies spend billions of dollars in acquiring a company and/or billions of dollars and years of research and development costs to bring a given therapy to the market. 2) These costs must be reasonably factored into the pricing of the product. If government intervention is successful, this will hinder innovation and M&A activity since the back-end reward will no longer generate lucrative rewards. 3) Unlike education costs, housing price increases and social security, drug pricing is negotiated with many insurers and organizations that dispense drugs at a substantial discount to the market price and often along with rebate programs. 4) Loss of exclusivity; drug companies must also capitalize on their window of exclusivity to their drugs. Depending on patent expiration, after varying time on the market, patents will inevitably expire, and these drugs will no longer possess exclusivity and face generic competition. 5) Taken together in concert with the fact that the Affordable Care Act (ACA) is now law of the land, no one will be paying the market price of any drug since the annual deductible and maximum out-of-pocket is established depending on the tier of coverage he/she chooses. 6) Lastly, an often overlooked benefit is the cost savings to the overall healthcare system. This occurs when curative drugs or drugs that increase the overall survival and/or improve the quality of life are introduced to the market. These highly effective drugs can effectively remove patients from the system whereby eliminating years of high-cost medical treatment and hospitalization. While drug prices continue to rise, there’s substantive rational in the form of input costs, loss of exclusivity, curative treatments, increase in quality of life and removal of some patients from the overall healthcare system, thus reducing the overall cost burden of the given healthcare system. For the reasons stated above, I personally feel that these attempts by lawmakers will end in a futile endeavor. Overview The culmination of extraneous events such as sustained lower oil prices, an ostensibly imminent rate hike and weakness in China have indiscriminately plummeted the biotech sector in lock-step with the broader indices. Now, a second and more specific wave of sector-related stories such as price gouging by Turing Pharmaceuticals and the subsequent comments by Hillary Clinton has exacerbated this sector decline. These former events are ostensibly unrelated to the biotechnology sector; yet, this group has been taken along for the downhill ride with the broader indices. The latter events have been detrimental to all biotechnology stocks as this is a direct threat to pricing power and our capitalism-based structure. The unprecedented secular growth streak in biotech has been more than tested as of late with the biotechnology officially in bear territory. These latest events, some unrelated and others directly related to the biotech sector, may provide a unique opportunity to add to a current position or initiate a position over time as this correction continues to unfold. Based on annual and cumulative performance throughout both bear and bull markets, the iShares Nasdaq Biotechnology ETF (NASDAQ: IBB ) may provide the opportunity investors have been waiting for in the face of our current market conditions. IBB is down 25% from its 52-week high, shares have plunged from $400 to $295 per share during the recent market weakness, presenting a potential buying opportunity. Debunking the bubble thesis Many content that this sector is in bubble territory based on its overall high P/E ratio, lack of adequate cash flows, and in some cases, lack of any marketable products. Thus, many companies are not deserving of this generous P/E. Many also try to draw parallels to the dot.com bubble that occurred in the early 2000s and use this as a proxy for the current biotech “bubble”. I would counter that after the most recent correction of ~25% this narrative holds much less weight and that traditional metrics on which to evaluate stocks are not applicable when evaluating clinical-stage biotech companies. Clinical-stage biotech companies are solely evaluated and priced based on potential sales of pipeline candidates and/or valuation to a potential acquirer. Holding clinical-stage biotech companies to the same standards as a traditional Dow Jones stock isn’t appropriate, and thus, I feel that this argument is flawed. Comparison to the dot.com bubble is not an accurate proxy either as the Internet companies relied heavily on user growth, subscribers, ad revenue and crowd-sourced content. This is in sharp contrast to biotech companies that innovate in the many different disease states and may have a multi-billion life-saving blockbuster drug around the corner to drastically change the trajectory of the company and its future. Additionally, major M&A activity has always been a driving factor in this sector due to the fact that companies are willing to pay very high premiums for the rights to potential blockbusters or a robust pipeline to replenish its own outdated pipeline. Taken together, I feel that after the recent sell-off and lack of any substantive argument against the biotech sector, this may be a great entry point. Perennial performer in bear and bull markets Despite the headwinds outlined above, the biotech sector has exhibited its resilience in both bear and bull markets with secular growth over the past decade. The returns for IBB have been very impressive in both annual and cumulative performance, unparalleled by any major index. Over the past 10- and 5-year time frames, IBB has posted cumulative returns of over 310% and 265%, respectively. These results are unrivaled by any major index, outperforming on a 10-year cumulative basis by 3-fold or greater when compared to the S&P 500, NASDAQ, and Dow Jones (Figure 2). These returns are accentuated during the previous 5 years. IBB notched cumulative returns of 265%, outperforming the S&P 500, NASDAQ and Dow Jones by roughly 2.5-fold or greater over this 5-year time frame (Figure 3). (click to enlarge) Figure 2 – Google Finance; comparison of IBB returns relative to the S&P 500, NASDAQ, Dow Jones over the previous 10 years (click to enlarge) Figure 3 – Google Finance; comparison of IBB returns relative to the S&P 500, NASDAQ, Dow Jones over the previous 5 years IBB has displayed impressive resilience in the face of the market crash in 2008, the bear markets of 2011 and the choppy market thus far in 2015. During the market crash of 2008, IBB posted an annual return of -12.2% while the S&P 500, NASDAQ and Dow Jones posted returns of -37.0%, -40.0% and -31.9%, respectively (Figure 3). During the bear market of 2011, IBB posted an annual return of 11.7% while the S&P 500, NASDAQ and Dow Jones posted returns of 2.1%, -0.8% and 8.4%, respectively (Figure 4). Thus far, during the choppy market of 2015, IBB posted an annual return of 4% while the S&P 500, NASDAQ and Dow Jones posted returns of -6.3%, -1.4% and -8.6%, respectively (Figure 5). These data suggest that IBB outperforms during bear markets as well as bull markets to establish itself as a secular growth sector. (click to enlarge) Figure 4 – Morningstar comparison of IBB’s annual returns relative to the NASDAQ over the previous 10 years (click to enlarge) Figure 5 – Google Finance; comparison of IBB’s annual performance thus far in 2015 relative to the S&P 500, NASDAQ and Dow Jones Conclusion As the confluence of broader disconnected factors and price gouging inquiries by leading politicians continue to bring down the biotechnology sector, it may be time to consider capitalizing on this correction via adding to existing positions or initiating a new position in this cohort given this opportunity. As the United States continues to absorb an ageing population alongside growing overall healthcare costs, more specifically prescription drug costs, the biotech sector looks poised to benefit and continue to outperform the broader market. Data suggests, provided a long-term position that volatility within the biotech sector is negated by its long-term performance that is unparalleled by any major index. This sector provides high returns unrivaled by any major index with moderate risk (based on its resilience during the bear markets of 2008 and 2011 and thus far in 2015) and volatility. IBB may be providing investors with a great opportunity to add or initiate a position for any long portfolio desiring exposure to the biotechnology sector with a long-term time horizon given the recent market conditions. Disclosure The author currently holds shares of IBB and is long IBB. The author has no business relationship with any companies mentioned in this article. I am not a professional financial advisor or tax professional. I wrote this article myself and it reflects my own thoughts and opinions. This article is not intended to be a recommendation to buy or sell any stock or ETF mentioned. I am an individual investor who analyzes investment strategies and disseminates my analyses. I encourage all investors to conduct their own research and due diligence prior to investing. Please feel free to comment and provide feedback, I value all responses.