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Biotech Stocks Are Cheap. Is It Time for Blockbuster M&A?

Valuations for biotech stocks have slumped. This in particular opens up great opportunities for mergers and acquisitions.

Biotech stocks took a beating over the past 12 months, but their cheap valuations could be good entry points for investors, experts say. It could also open them up for opportunities to be acquired or merged with another larger biotech.

Why M&A Will Help Biotechs Gain Momentum

M&A will be a key catalyst to the sector's recovery, Thomas Hayes, chairman of Great Hill Capital in New York, told bovada. The cash balance of Russell 3000 Health Care companies exceeds $500 billion, an increase of 400% in the past 20 years, according to data from FactSet, FTSE Russell and Jefferies.

“With Big Pharma losing their patents on many blockbuster drugs, but having tons of cash on their balance sheets, they will be forced to aggressively buy innovation in the biotech sector to maintain and accelerate growth,” he said.

While M&A in biotechs fell near historic low levels in 2021, that will change soon, Hayes said.

M&A is always a key driver for biotech investors, Steve Sosnick, chief strategist of Interactive Brokers, a brokerage based in Greenwich, Conn., told bovada. The “game plan” is for a company to begin researching a drug, vaccine or therapy, spend investors’ money while it goes through the R&D and approval processes and then cash out either through more stock sales or M&A.

“Major pharmaceuticals have been known to pay significant prices and premiums for access to biotech innovations that they deem promising and commercially viable,” he said.

Blockbuster Companies Are a Challenge to Find

Only 15% of biotech companies ever generate free cash flow, so it remains challenging for investors to choose which ones will be the next blockbuster companies or take-outs, Hayes said.

The best way to play this group is through the SPDR S&P Biotech ETF (XBI). The ETF currently owns 157 stocks - the top four holdings are Ocugen (OCGN), Editas Medicine (EDIT), Iovance Biotherapeutics (IOVA) and Moderna (MRNA).

“It gives you a broad basket of exposure and you'll benefit from the aggregate undervaluation as the group reverts back to its long-term mean over time,” he said.

Since biotech is an industry that benefits from scale and companies having a diversified mix of products, M&A activity is a common occurrence, Todd Rosenbluth, head of research at ETF Trends, an Irvine, California-based finance company, told bovada.

The largest of the biotech ETFs is iShares Biotechnology ETF (IBB), which is concentrated in the mega cap companies that have scale advantages. However, SPDR S&P Biotechnology (XBI) provides more exposure to the small-cap companies that are candidates for being acquired, not just the large cap companies.

Investors could consider adding AbbVie (ABBV), Amgen (AMGN), Incyte (INCY), Moderna and Vertex Pharmaceuticals (VRTX), which CFRA currently has buy/strong buy ratings, Stovall said.

The outlook for biotechs, which are a historically defensive sub-industry, is good due to “solid drug sales growth driven by Covid-19 therapeutics, the continued adoption of many new and innovative therapies, a favorable M&A environment and a low prevalence of patent expirations in 2021,” Sel Hardy, a CFRA biotech analyst, wrote in a recent research note. “We also expect drugmakers to benefit from a return to normalcy, since lower in-person physician visits during the pandemic had a negative impact on prescription growth.”

Investors must be prepared for major price swings, Mike Loewengart, managing director of investment strategy at E-Trade from Morgan Stanley, an Arlington, Virginia-based brokerage company, told bovada.

The volatility in the sector can be avoided by investing in a broad-based health care fund or ETF could often be the best course of action for investors, such as the Janus Henderson Global Life Sciences (JAGLX) and Vanguard Healthcare ETF (VHT) that have some biotech exposure.

“Despite the heightened attention to biotech stocks fueled by the pandemic, the sector finished 2021 as a considerable laggard in an otherwise up market,” he said. “So while opportunistic investors may be eyeing the beaten down area of the market, it’s key to understand that with potential reward comes risk. The biotech sector isn’t necessarily for the faint of heart.”

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