By Sam Stovall In the run-up to this quarter's earnings reporting season, biotechs have been on a tear (the relative strength price chart for Standard & Poor's 1500 Biotechnology subindustry index is shown below). Year to date through July 15, the sector has surged 11.7%, compared to a 2.5% rise in the S&P Composite 1500 index. During 2004, this group gained 8.2%, vs. a 10% advance for the "1500."
Those are some impressive numbers, but such an advance can leave investors wondering if any upside potential is left for the group. Frank DiLorenzo, the S&P equity analyst who follows biotechs, thinks there may be some room to move higher. He recently raised his fundamental outlook on the biotech industry to positive, from neutral, based on S&P's expectations for a strong showing of new product and supplemental approvals in 2006.
AGGRESSIVE STANCE. DiLorenzo expects the flow of new products to provide a catalyst for the group and looks for industrywide share-price gains of about 20% over the next 12 months. Initial second-quarter results have been solid, in his view, and he expects this trend to continue for the second half of 2005.
But investors do have to be selective, notes DiLorenzo. S&P continues to recommend they concentrate their core holdings in established, profitable biotechs with solid growth prospects on an absolute and relative basis that haven't been riddled with bad news. DiLorenzo thinks a strong pipeline and prior pipeline success are important ingredients for core holdings in the biotech group.
What about the smaller players? DiLorenzo would also take a slightly more aggressive stance with smaller issues that have at least one major catalyst, such as a recently approved drug or positive late-stage clinical trial results, which could drive strong growth and lead to profitability by 2007. Smaller issues should be attractively priced on a market-cap basis in comparison to peers, in S&P's view.
GROWTH CATALYST. Cancer therapeutic sales and development should remain the primary catalyst for the sector's growth, according to DiLorenzo. He also expects growth prospects for autoimmune and inflammatory therapeutics to remain solid.
While there has been a bit of a gap this year in terms of late-stage pipeline offerings in 2005, DiLorenzo believes a clear improvement will show in 2006 with regard to potential FDA approvals of biologic therapies.
S&P projects stock-appreciation potential of about 20% for profitable biotech issues over the next 12 months, assuming that stock appreciation approaches its projected EPS growth rate of 23.7% (19.1% excluding industry giant Genentech) for the S&P Biotech peer group.
BRISK ACTIVITY. The peer group p-e-to-growth, or PEG, ratio is 1.4 times, based on S&P's 2006 EPS estimates. DiLorenzo thinks this is justified given S&P's view of the sector's above-market growth rate and good long-term pipeline prospects.
S&P views the overall fund-raising environment for biotechs as slightly positive. DiLorenzo believes that IPO activity will be moderate for the remainder of 2005, while the level of partnership and M&A deals should stay brisk.
So there you have it. The subindustry's fundamental outlook and current momentum are in agreement, in S&P's opinion, pointing to likely future advances in share prices. Standard & Poor's currently views Amgen (AMGN
; recent price, $82), Celgene (CELG
; $48), Genentech (DNA
; $88), Genzyme (GENZ
; $71), and Gilead Sciences (GILD
; $44) as core holdings. Genentech and Gilead carry 5-STARS (stong buy) rankings, while the remainder are ranked 4 STARS (buy).
Source: Standard & Poor's
Industry Momentum List Update
For regular readers of the Sector Watch column, here is this week's list of the industries in the S&P 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500) as of July 22, 2005.
Computer & Electronics Retail
Diversified Metals & Mining
Fertilizers & Agricultural Chemicals
Managed Health Care
Oil & Gas Drilling
Oil & Gas Exploration & Production
Oil & Gas Refining & Marketing
S&P STARS: Since January 1, 1987, Standard & Poor's Equity Research Services has ranked a universe of common stocks based on a given stock's potential for future performance. Under proprietary STARS (STock Appreciation Ranking System), S&P equity analysts rank stocks according to their individual forecast of a stock's future capital appreciation potential versus the expected performance of a relevant benchmark (e.g., a regional index (S&P Asia 50 Index, S&P Europe 350 Index or S&P 500 Index), based on a 12-month time horizon. STARS was designed to meet the needs of investors looking to put their investment decisions in perspective.
S&P Earnings & Dividend Rank (also known as S&P Quality Rank): Growth and stability of earnings and dividends are deemed key elements in establishing S&P's earnings and dividend rankings for common stocks, which are designed to capsulize the nature of this record in a single symbol. It should be noted, however, that the process also takes into consideration certain adjustments and modifications deemed desirable in establishing such rankings. The final score for each stock is measured against a scoring matrix determined by analysis of the scores of a large and representative sample of stocks. The range of scores in the array of this sample has been aligned with the following ladder of rankings:
S&P Issuer Credit Rating: A Standard & Poor's Issuer Credit Rating is a current opinion of an obligor's overall financial capacity (its creditworthiness) to pay its financial obligations. This opinion focuses on the obligor's capacity and willingness to meet its financial commitments as they come due. It does not apply to any specific financial obligation, as it does not take into account the nature of and provisions of the obligation, its standing in bankruptcy or liquidation, statutory preferences, or the legality and enforceability of the obligation. In addition, it does not take into account the creditworthiness of the guarantors, insurers, or other forms of credit enhancement on the obligation. The Issuer Credit Rating is not a recommendation to purchase, sell, or hold a financial obligation issued by an obligor, as it does not comment on market price or suitability for a particular investor. Issuer Credit Ratings are based on current information furnished by obligors or obtained by Standard & Poor's from other sources it considers reliable. Standard & Poor's does not perform an audit in connection with any Issuer Credit Rating and may, on occasion, rely on unaudited financial information. Issuer Credit Ratings may be changed, suspended, or withdrawn as a result of changes in, or unavailability of, such information, or based on other circumstances.
S&P Core Earnings: Standard & Poor's Core Earnings is a uniform methodology for calculating operating earnings, and focuses on a company's after-tax earnings generated from its principal businesses. Included in the Standard & Poor's definition are employee stock option grant expenses, pension costs, restructuring charges from ongoing operations, write-downs of depreciable or amortizable operating assets, purchased research and development, M&A related expenses and unrealized gains/losses from hedging activities. Excluded from the definition are pension gains, impairment of goodwill charges, gains or losses from asset sales, reversal of prior-year charges and provision from litigation or insurance settlements.
S&P 12 Month Target Price: The S&P equity analyst's projection of the market price a given security will command 12 months hence, based on a combination of intrinsic, relative, and private market valuation metrics.
Standard & Poor's Equity Research Services: Standard & Poor's Equity Research Services U.S. includes Standard & Poor's Investment Advisory Services LLC; Standard & Poor's Equity Research Services Europe includes Standard & Poor's LLC- London and Standard & Poor's AB (Sweden); Standard & Poor's Equity Research Services Asia includes Standard & Poor's LLC's offices in Hong Kong, Singapore and Tokyo.
In the U.S.
As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services U.S. have recommended 30.2% of issuers with buy recommendations, 57.5% with hold recommendations and 12.3% with sell recommendations.
As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services Europe have recommended 34.4% of issuers with buy recommendations, 46.8% with hold recommendations and 18.8% with sell recommendations.
As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services Asia have recommended 33.3% of issuers with buy recommendations, 47.2% with hold recommendations and 19.5% with sell recommendations.
As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services globally have recommended 31.0% of issuers with buy recommendations, 55.4% with hold recommendations and 13.6% with sell recommendations.
5-STARS (Strong Buy): Total return is expected to outperform the total return of a relevant benchmark, by a wide margin over the coming 12 months, with shares rising in price on an absolute basis.
4-STARS (Buy): Total return is expected to outperform the total return of a relevant benchmark over the coming 12 months, with shares rising in price on an absolute basis.
3-STARS (Hold): Total return is expected to closely approximate the total return of a relevant benchmark over the coming 12 months, with shares generally rising in price on an absolute basis.
2-STARS (Sell): Total return is expected to underperform the total return of a relevant benchmark over the coming 12 months, and the share price is not anticipated to show a gain.
1-STARS (Strong Sell): Total return is expected to underperform the total return of a relevant benchmark by a wide margin over the coming 12 months, with shares falling in price on an absolute basis.
Relevant benchmarks: in the U.S. the relevant benchmark is the S&P 500 Index, in Europe the S&P Europe 350 Index and in Asia the S&P Asia 50 Index.
For All Regions:
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Readers should note that opinions derived from technical analysis might differ from those of Standard & Poor's fundamental recommendations. Stovall is chief investment strategist for Standard & Poor's