No Bust in Biotech

For a large part of this decade, investors had been going gaga for biotech stocks. Between 2010 and July 2015, the S&P 500 biotech sub-industry index climbed by an incredible 360% compared with just 86% for the S&P 500. The gains might have continued but for presidential candidate Hillary Clinton, who mentioned that if she were elected, she would consider curbing drug price increases. Within days, the sector plummeted by 6% and then continued to fall, dropping by 24% between July 2015 and Election Day. Until Nov. 8, it was one of the worst performing sectors globally.

Even with a post-election boost--as of this writing, these stocks have jumped more than 6% since Donald Trump's victory--biotechs are trading at historically low levels. Currently, large-cap biotech stocks are trading at about 17 times 2017 price/earnings. Normally, these companies trade between 15 and 30 times earnings, says Todd Herget, portfolio manager of

, the average biotech stock in Morningstar's coverage area is trading 16% below its fair value; the overall market, meanwhile, is about fairly valued.

At these prices, biotechs are especially attractive. Why? Because the industry's long-term theme has only just begun to play out. Populations are aging, people are being afflicted with a number of different illnesses, and they need medicines to help them. However, biotech companies don't make your average drugs. They produce complicated compounds based on people's DNA. One day, a highly personalized drug could be created to treat a specific individual’s disease.

We're still years away from curing the many diseases out there, but the industry has also come a long way, hence the massive gains. A decade ago there was no biotech industry--the human genome was only fully mapped in 2003--but rapid technological advancements in the sector have increased the number of drugs being tested and the number of companies doing that testing.

"The tools available today were not available 20 years ago," says Herget. "There's been a wave of new technology that has allowed the industry to become more productive."

In addition, regulations have become more biotech-friendly, says Rajiv Kaul, who runs Fidelity Select Biotechnology FBIOX and contributes ideas to

The FDA is also paying more attention to biotechs in general. It approved 45 drugs last year, which is "pretty awesome," says Kaul, while 48 drugs have been granted breakthrough status over the last 18 months. He thinks that 150 to 200 drugs will be approved by the FDA over the next five years. "That gives me reason to say that the long term is going to be quite exciting," he says, adding we will likely see new medicines for treating Alzheimer's, Parkinson's, and even cancer.

As bright as the future may look for biotech, this sector isn't for the faint of heart. Individual stocks can be wildly volatile and can even go to zero if a promising drug fails one of three drug trial phases. Kaul points out that while the MSCI U.S. IMI Biotechnology 25-50 Index is up about 285% over the last eight years, it has also endured 18 corrections of at least 10% during that time. There's also a wide range of companies to choose from, from speculative small caps to multibillion-dollar large caps.

There are still some industry pressures to keep an eye on, too, even if a Trump win is seen as good news for these stocks. Karen Andersen, an equity analyst with Morningstar, says two pharmacy benefit mangers--companies that buy drugs in bulk for insurance companies--control 30% of the market. They have been putting pressure on pharmaceutical companies to keep costs under control, and they also have the ability to exclude particular medicines if they think another, perhaps cheaper version is just as good, she says.

Andersen also thinks the sector holds a lot of promise, but what you'll want to buy will depend on how much risk you can stomach. For her, the best companies are ones that are undervalued and have wide moats, which means they have significant competitive advantages against their peers. Although these businesses may not see the kind of gangbuster growth that a successful small-cap might, investors can still expect 20%-plus earnings gains, she says.

Andersen looks for several qualities in a biotech company. The best ones have a proven track record of success and are already generating earnings from the sale of drugs. They should be investing in R&D and have a strong pipeline--and the more products they can sell, the better. Investors can get into trouble by owning pre-earnings companies that have bet on a single drug, she says. Even if that drug passes all of its tests and is successful, the company is at risk of a competitor bringing a similar product to market.

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For those who like the industry's long-term story overall but would rather spread out their bets, there are several biotech-focused ETFs and mutual funds to choose from. Among actively managed funds, Fidelity Select Biotechnology and Franklin Biotechnology Discovery FBDIX are both well-established choices. On the passive side, options include SPDR S&P Biotech ETF XBI, iShares Nasdaq Biotechnology IBB, PowerShares Dynamic Biotech & Genome ETF PBE, and VanEck Vectors Biotech ETF BBH. More broadly, the actively run Gold-rated

However you buy into biotech, now may be the time to take the plunge. The industry is still trading below where it has been in the past--and that can change on a dime.

"R&D will continue to exist until there's a cure," says Herget. "And we still need cures for cancer, Alzheimer's and most other diseases."

Bryan Borzykowski is a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.com.