Biotech Index Funds Will Outperform The Market Through 2026

Since 2011, Lockheed Martin has been compounding at a rate of 30% per year. It has beaten the S&P 500 by over fifteen points annually over that time frame. It is one of my greatest personal investment acts of omission to ignore it when it caught my attention in the $80s as it now trades around $240 per share for a solid tripling in the course of five years (plus the dividend got jacked up.) The reason why the stock prices of Lockheed and other defense manufacturers got so low in 2011 is that there was a strong political dialogue in the United States calling for the curtailment of aerospace and weaponry defense spending.

The defense sector as a whole traded at its lowest valuation since 1991, and investors that scooped up shares in Lockheed Martin and some other defense firms ended up generating some of the best five-year total returns that they will ever achieve in their life.

I think about this moment often because I like to keep in mind that sentiment weighing down a sector in anticipation of actions from lawmakers is almost always overstated. In my entire life, there have only been three political acts in my lifetime that have had a substantial effect on businesses–the Americans with Disabilities Act, Sarbanes-Oxley, and Dodd-Frank.

And the latter two may have made it more difficult for financial institutions to grow earnings, but they have also had an entrenchment effect in that it is going to be much more difficult for a start-up community bank to compete with the likes of J.P. Morgan who have armies of lawyers and accountants that can comply with the paperwork of running a financial house while the administrators at a local start-up have no idea what rule 10b-6 means for their ability to raise and grow capital.

The latest iteration of this trend is that investors are now shying away from the biotech sector. In August 2016, Hillary Clinton released a statement with the following: “Epipen pricing is outrageous, and it’s just the latest troubling example of a company taking advantage of its consumers…But it’s wrong when drug companies put profits ahead of patients, raising prices without justifying the value behind them. That’s why I’ve put forward a plan to address exorbitant drug price hikes like these. As part of my plan, I’ve made clear that pharmaceutical manufacturers should be required to explain significant price increases, and prove that any additional costs are linked to additional patient benefits and better value. Since there is no apparent justification in this case, I am calling on Mylan to immediately reduce the price of EpiPens.” That week, Mylan’s stock price fell 14%.

The biotech sector is now trading at its lowest valuation since biotech index funds were launched during the dotcom bubble excluding the 2008-2009 recession. The iShares Nasdaq Biotechnology Index (IBB), which is the $8 billion powerhouse ETF in the industry, is now trading at only 13x earnings. The fund is down to $289 per share from $343 in December. Given that it is a collection of biotech firms that have a ten-year track record of 13.5% earnings growth, you are now getting more than double the S&P 500’s projected growth at slightly above half the S&P 500’s P/E valuation if you purchase this index fund.

Since its 2001 launch, IBB has delivered returns of 7% annualized. That is incredible because the biotech industry was in a huge bubble prior to 9/11, and the fact that investors have earned returns that have doubled the inflation rate is an incredible testament to the earnings growth of this sector over the past fifteen years.

To use a starting period that doesn’t include an absurd starting valuation, consider the performance of IBB over the past ten years: Investors that purchased the IBB exchange traded fund have compounded their wealth at 13% annualized so that every $1 put into the fund has turned into nearly $4 today. And if my contention that the sector is undervalued because of the political climate proves accurate, then these 13% annual returns for IBB over the past decade are even more impressive because the end point of our measuring period includes low valuation.

Given the fact that I run a website that usually covers individual stocks, you might wonder why I’m talking about an ETF.

There are two reasons:

First, from a pragmatic perspective, a lot of people reading here are confined to retirement account investing with no individual brokerage option and have to choose from a list of mutual funds and ETFs. IBB is a frequently included sector fund on the menu of 401(k) options, and is one of the few that offer “more likely than not” prospects of double-digit future returns.

And secondly, the biotech sector has unique characteristics that warrant a basket approach. The average drug takes almost a decade to bring to market from the point it is first publicly disclosed to the first date of public sales, and there are wild swings in perceptions of success that mean individual stocks are going to be wildly volatile (50% swings in a given year are not out of the ordinary.)

Biotechs are the exact opposite of the typical names I discuss. With Hershey chocolate, it can keep producing the same product in 2020, 2025, 2030, and 2035 and its investors will receive ever-rising dividends. Heck, that’s what the customer base wants as confectionaries have a nostalgia element tied to the purchase. When maintaining the status quo perpetually is a formula for further enrichment, you know you’ve found an exceptional business worthy of being a lifelong holding.

You can’t say that about any biotech company. Here, the premise is the exact opposite–you may not be doing all that much now, but five to ten years from now, you will be selling millions of some product that is in the research and development stage now.

And most importantly, success doesn’t require you to pick the specific winners. You can do just fine moving forward on the theory of “I don’t know who the winners will be, but of these 100 stocks, about 10-20 of them will grow so fast that it will overcompensate for the lack of growth from the others.”

The reason why I like IBB is that you don’t have to choose. You get Biogen. You get Gilead. You get Amgen. You get Celgene. You get Alexion. You get Shire. You get Seattle Genetics. You get Mylan. You get Tesaro. You get ACADIA. You get Incyte. You get Vertex. You get Regeneron.

By 2030, five of those may have done absolutely nothing to create wealth. But three of them might have septupled in price. The magnitude of the gains from the winners will eclipse the lack of wealth creation from the losers.

I’m startled to find the biotech industry trading at 13x earnings right. Given the creative innovation of the sector, I would not be surprised to see IBB post earnings growth in the 9-14% range over the next ten years. Plus, you get the probability of some P/E expansion as well. An investment in the IBB exchange traded fund is one of the few times where you get to be the casino and set the house odds in your favor. It would take exceptionally onerous regulations coupled with a staggering lack of medical innovation in the next decade for this fund to not offer competitive returns. I’d say there is a nine out of ten shot that IBB will outpace the S&P 500 between now and 2026.

Originally posted 2016-10-02 23:24:55.

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