Does the “B” Word Apply? It’s Complicated
December 22, 2020
Valuation matters quite a bit when you’re knee-deep in development-stage biopharmas. Of course, investors can’t rely on traditional metrics such as revenue, earnings, or cash flows when evaluating these types of companies. The calculus is quite a bit different. It’s often imperfect, messy, and open to interpretation.
Investors might be able to look at a high-flying SaaS company with durable advantages and justify a premium valuation. Perhaps it’s reasonable to pay a healthy premium because revenue will be much higher in two, three, or five years. Like it or not, that’s the new math required when interest rates will be held near zero for three or more years. But the same exercise doesn’t apply to development-stage biopharmas. There’s no revenue, let alone earnings, upon which to base valuations.
On the one hand, Wall Street is absolutely terrible at valuing development-stage biopharmas. The inefficient pricing of analysts gives the impression that investments in the space are binary, rising or falling on trial results alone, but it is possible to beat Wall Street to the punch by digging into the science and finding companies with durable technology advantages. That’s exactly what Manisha Samy and I are doing for 7investing.
On the other hand, the asset appreciation of 2020 has led to some very frothy valuations for development-stage biopharmas. As one of many examples, Beam Therapeutics (NASDAQ: BEAM) is developing a base editing platform, which is a technology I view relatively favorably. It seems like a much better genetic medicine approach than first-generation CRISPR gene editing as it doesn’t make double-stranded breaks in DNA.
That said, does this business deserve a $4 billion valuation when it isn’t expected to enter clinical trials until the second half of 2021? This seems to be riding the CRISPR hype train higher, rather than rising on clinical progress that has de-risked the investment. If there are unforeseen risks in CRISPR base editing — it’s possible that first-generation CRISPR anything is not a good idea, or that RNA base editing is better — then Beam Therapeutics would see its $4 billion valuation evaporate.
Translation: Investors have to be prepared for significantly more volatility for biopharma stocks in the year ahead — as in 50% or larger drops — especially considering many biopharma stocks have been handed higher valuations that haven’t been earned.
Speaking more broadly, is the market in a bubble? Does the “b” word apply? I think that’s the wrong question, as it only allows for a “yes” or “no” answer. Investors should instead be asking: Is a stock market bubble forming? That might change how the question is answered.
I do think a stock market bubble is forming, although I won’t dare try to pin down the reason(s). Here are a few:
Money is cheap. That makes it easier to justify healthy premiums across the stock market, but (most) businesses do still need to be valued based on the underlying operations. The more we justify current valuations by arguing where a business might be in five years, the more uncertainty — and risk — we’re accepting. At the very least, the unusual stock market performance of 2020 could sap long-term returns for investors by pricing in too much future growth up front.
Passive investing. Many investors buy ETFs or funds that track specific parts of the market, whether the entire S&P 500 or the most promising genomics stocks, and call it a day. This has worked pretty well recently. In fact, the S&P 500 has outperformed small-cap stocks in the last decade — an unusual feat. The problem is we’ve seen this end badly before. In the 1960s and 1970s, investors blindly bought into the Nifty Fifty, which were the largest blue chips at the time. Valuations eventually became detached from reality, and many underperformed in the 1980s.
Order flow data. Many new “investors” have entered the market, giving rise to meme stocks and zero-commission brokerage accounts. But Robinhood sells order flow data to large financial groups, which risks creating positive feedback loops for trendy stocks. The “big money” can spot trends as they’re happening and pour gasoline on the fire. Long-term investors also have to wonder if these new “investors” will stick around at the first sign of a pullback, which could exacerbate a future correction.
Here’s the thing: Bubbles are often only identifiable in hindsight. I had no idea what subprime mortgages were until they nearly wrecked the global economy. Likewise, we can probably only guess at what might tip the market into its next correction. Easy money? Passive investing? Unregulated order flow data? Something else?
I don’t know the answer. But I do know this: The bill always comes due one way or another.