What could sustain the rally

Figuring out fundamental valuations in biotech is notoriously tricky business. This can be true even for the top-tier companies with earnings, as the question of how much value should be assigned to early-stage projects determines how much of a multiple to future earnings per share they should be given.

The answer to that question appears to depend more on the optimism or pessimism of the market than anything else. And for the companies without earnings, assigning fundamental valuation is essentially educated guesswork. Nevertheless, the issue is important in trying to predict the lifespan of the current biotech rally.

When prices during the bear market apparently fell below fundamental value, the patient investor reasoned that share values, at some point, had to rebound. But turnabout is fair play, and the fact is that prices in this market ultimately will rise above fundamental value and will have to come down. So the question is how much can valuations increase without looking too frothy, and when that will occur.

Conflicting forces

Two sets of conflicting forces are at work in this market. Strongest right now is a set of factors working to drive prices up. Most important is a continuing stream of pivotal clinical data, FDA advisory panel meetings, the prospect of FDA approvals and market launches. Based on data released thus far, much of this news is likely to be good, providing a higher concentration of positive product news than ever before in the history of the industry.

"We have never had a stream of late product news as dense as we have now," said Reijer Lenstra of Smith Barney. "Product approvals and clinical data will create a warm and fuzzy feeling for biotech, and people are reacting to early data. So the bull market is likely to continue. I hope it will last into the spring of 1996."

These value-adding or value-affirming milestones build on the underlying valuations of companies. Whether investors react to those milestones by driving prices beyond the underlying value added is another issue, as is whether the price rise spills over to companies without news.

Joe Edelman of The Aries Fund cautioned that investors are starting to buy stocks just for the upcoming events, and that could get dangerous. "There could be corrections once the market shifts to being sales and earnings driven," he said. "Market caps are reflecting not only a positive sequence of events, they're also reflecting assumptions that companies will meet analysts' expectations in terms of sales and earnings. But this is very rare - it has only happened once, with Amgen."