Biotech Looks Healthy

Anyone who has paid any attention to the U.S. stock market over the past several years knows the biotechnology sector has been one of the best-performing industries. Over the past decade, the S&P 500 biotechnology subindustry index has surged 344%, compared with a 102% rise for the overall index as of this writing. The biotech index has done nearly 100 percentage points better than the technology index, which counts

Over the past three years, though, the sector has taken a bit of a step back, underperforming the S&P 500. Since Feb. 1, 2015, the biotech sector has returned a paltry 5.3%, while the broader index has delivered a 34% return. While the two indexes are moving more in line today--the biotech sector is up 16.8% compared to the S&P 500's 14.8% since Feb. 21 of last year--investing experts think the once-mighty industry could soon outperform again.

There are several reasons as to why the sector took a breather. Valuations were part of it: Biotech stocks had such a good run for so long that valuations were stretched and some investors started taking profits. But two things had an even bigger impact on prices: politics and cycles.

In the year leading up the U.S. presidential election, there was a lot of talk about capping drug prices and making other changes to America's healthcare system. Most of the chatter centered around what Hillary Clinton might do as president--and with most Americans thinking she was a shoo-in, it seemed inevitable that the sector was going to undergo a material change.

"There was a lot of uncertainty, with Clinton proposing some ideas that could have hit the drug industry," says Karen Andersen, a sector strategist with Morningstar. When Clinton didn't win, biotech shares started rising again.

"People got more comfortable with the idea that Donald Trump wouldn't make any substantial changes," she says.

At around the same time, the drug cycle that helped propel biotech stocks to new heights came to an end. In 2012 and 2013, new medicines were only starting to materialize, with most of those years being focused on innovation, says Eddie Yoon, manager of

"We saw an enormous amount of sales growth in those years," he says. "Then that cooled off."

The biotech sector tends to move in waves, he says, with the first big cycle happening in the mid-to-late 90s, another cycle happening in the mid 2000s and the last one occurring between 2012 and 2016. For the last couple of years, the sector has had to "re-start their engine," he says. Only now are we seeing innovation pick up again.

A Promising Future

While biotech stocks prices have improved over the last 12 months, Andersen says the environment is ripe for a bigger rebound. Firstly, new and potentially revolutionary drugs are being developed, she notes. Cell therapy, where living cells are injected into a patient, is a major area of growth. Oncology is a central area of research, with new drugs from

Dale Chan, manager of

Helping the sector's prospects is a speedier approval process by the U.S. Food and Drug Administration. In 2012, the FDA was given the authority to designate certain drugs as a "breakthrough therapy," which then allowed that drug to move through the approval processes more quickly. Andersen has seen some drugs get FDA approval in just three months. The sooner a drug gets approved, the sooner it can start generating revenue.

As well, demographics in America--more people are getting older--and emerging-markets countries getting better access to medicine should also keep business booming for the foreseeable future.

"Basic demand dynamics will drive the healthcare industry for the long run," says Yoon.

An Increase in M&A As good as the future may look, is the biotech landscape is somewhat of a different space today from what it was a few years ago. The larger players are now more mature, which means they could have trouble generating the same kind of benchmark-busting returns as they once did, says Chan. However, they're certainly trying to increase revenues and share prices, especially via acquisitions.

M&A in biotech has been heating up, says Andersen, with several deals getting done in 2017. One of the more notable transactions happened in August, when Gilead, which has been struggling to increase revenues due to declining sales of its flagship hepatitis C drug, purchased Kite Pharma for $11.9 billion. The acquisition gives Gilead cutting edge cancer-fighting cell therapy technology and access to other promising drugs.

Other companies are on the hunt for buys, too. In February,

Go Small for Innovation, Large for Valuation The most innovation, though, is happening in the small- to mid-cap space, says Chan. Valuations are higher among smaller companies, as many have had good runs over the years, and some also have an M&A premium built into them, he says. But it's these companies that hold the most promise. Most put all their energy into making a single drug. They then sell their companies to larger businesses after that drug wins FDA approval or at another promising point in the drug development cycle. With many of the bigger business still depending on older medicines and facing patent cliffs, "the outlook of the small and mid-cap names is as exciting as it's ever been," says Chan.

Saying that, the most attractive names from a valuation perspective are the largest-cap companies, with many of them trading a 10% and 30% discount to what Morningstar thinks they're worth, says Andersen. She expects returns and valuations on these companies to climb from here. While maturity has a lot to do with the cheaper prices, renewed talk about drug price capping is also suppressing stock prices.

"We're now getting some proposals that could start to hit some of these companies," says Andersen. "There could be an overhang here for a little while."

Still, with M&A increasing and more promising drugs on the way, valuations won't stay this low forever, she says. Several biotech companies have 5- and 4-star Morningstar ratings as of this writing, suggesting that they're undervalued.

Andersen is most bullish on

"We agree that there are biosimilar threats, but the pipeline has more potential than the market is assuming right now," says Andersen.

Narrow-moat Shire, which has run into some financial issues related to its 2016 purchase of Baxalta, has more debt than Anderson would like. However, she says the firm is paying it down, and while its pipeline may not be as robust as those of others, it does have some gene therapy drugs in the works. It's also been able fend off competition in the lucrative hemophilia space, she says.

Not everyone will want to buy individual stocks, though. As well as some of these companies have done, there have also been numerous companies, especially in the small- and mid-cap areas, that have gone belly up after their drugs either couldn't get FDA approval or failed to move beyond their initial testing phases. Those who want to take a more diversified approach to healthcare might consider one of the broad-based sector funds earning Medalist ratings from Morningstar, including Gold-rated

While biotech will likely see more ups and downs in the short-term, its likely to outperform over the long-term again. In fact, since 1963, health care has been one of the best performing sectors, posting an 11% annualized return over that time, says Yoon. That's right up there with consumer staples.

"In consumer staples you're going to need detergent whether you're in a recession or not and whether you're in the U.S. China or Indonesia," he says. "It's the same with healthcare, but on top of that there's innovation, which adds a growth kicker."

Bryan Borzykowski is a freelance columnist for Morningstar.com. A Toronto-based business and investments writer, Bryan has contributed to the New York Times, CNBC, BBC Capital, CNNMoney and several other publications. The views expressed in this article do not necessarily reflect the views of Morningstar.com.