Despite signs the biotech rally is getting "toppy," market watchers ranging from buysiders to bankers to technical analysts think it can continue into this quarter. They say the market still has momentum and investors still have an appetite for risk.

Buysiders expect micro- and small caps could benefit the most, as many think valuations for large- and mid-cap biotechs have peaked.

One signal these valuations may have topped out is that biotech indices were largely flat or down since early February, although they did show a bit of resurgence in the final weeks of March.

The tech-heavy NASDAQ rose 19% last quarter, outperforming the BioCentury 100, which rose 17%, and the NASDAQ Biotechnology Index (NBI), which gained 18%. The S&P 500 and Dow Jones indices gained 12% and 8%, respectively.

Healthcare fund in-flows were strongest in January, when the stock performance was the best. In February and March, fund flows were in negative territory. IT fund flows performed better in the last two months of the quarter, as did the NASDAQ index (see "Healthcare/Biotech Fund Flows," A2).

Another indicator of a potential top is that the gains in biotech were broad-based, with at least two gainers for every decliner across every market cap segment (see "Results by Market Cap," A3).

Indeed, most of the market cap segments rose by double digits last quarter, with small caps worth $200-$499 million adding the most.

Even then, there may be more room up for smaller caps, given the sharp declines the group endured in 2H11. At the end of last quarter, 38% of small cap and 86% of U.S.-listed micro-cap biotechs remained more than 25% below their intra-day 52-week highs (see "The Upside of Micro-Caps," A8).

The gains in this rally - and its length - are already near the top of what is typical for the sector. The NBI has added 46% in about eight months, while the BioCentury 100 is up 37%.

In the past decade, the only rally with comparable performance was the prior one, which ran from July 2010 to July 2011 and saw an increase of 46% for the NBI and 50% for the BC100 (see "Inflection Point," A4).

Not surprisingly, a financing boom has accompanied the rally. In fact, the 34 biotech follow-ons last quarter was an all-time record. The financings averaged $60.2 million each and totaled $2 billion.

The last time more money from follow-ons was raised was in 4Q09, when $2.4 billion was raised in 26 deals averaging $93.1 million. But the total was $1 billion and the average size was $44.1 million when three outliers are excluded - $501 million raised by Vertex Pharmaceuticals Inc.; $477 million by Human Genome Sciences Inc.; and $427 million by Dendreon Corp.

Moreover, small- and micro-cap biotechs reversed the trend of recent years by raising more than their mid-caps brethren in 1Q12 (see "Raised by Market Cap," A3).

In all, 104 public biotechs valued below $500 million raised more than $2.4 billion last quarter. That eclipsed the $2.1 billion raised by eight companies valued between $500 million and $4.9 billion. And it was 33% of the $7.3 billion total raised by public companies in 1Q.

Given the open window, bankers are uniformly advising their biotech clients to finance now if they can.

Still some upside?

Despite indications the rally may be getting old, technical analysts are cautiously optimistic about biotech's prospects. Absent any major negative events in the broader markets, they note sector indices will likely continue on their upward trend.

"Whenever we try to take money off the table, we are told by the market that we're wrong in timing it," said Behzad Aghazadeh of venBio. "After a strong run-up everyone expects a pullback. I don't see any pullbacks absent a cataclysmic event in the world. The biotech rally should have legs well beyond what we've seen so far."

Aghazadeh noted that at a mid-March gathering of 17 specialist investors, only three expected the NYSE Arca Biotechnology Index (BTK) would be up 10% by June 30, and everyone else expected it to decline in that time frame.

"There's not a better contrarian indicator," he said.

Aghazadeh is not alone in seeing more upside for the sector. "We expect to continue the trend of increasing stock prices in the next few months, as there are few, if any, negative triggers," Stefan Kraft of Medical Strategy told BioCentury.

Sven Borho of OrbiMed Advisors had a similar but slightly more cautious take.

"A lot of ships have been raised with an incoming tide. The nervousness about biotech valuations has almost become consensus. Everyone is waiting for the next biotech bear market. So we're probably not really done," he said.

"Do I expect biotech to outperform NASDAQ?" Borho added. "I'm not sure. We've had a very, very good run. First the single product stories and then everything else started to move. When the group moves, that's when it becomes questionable. In early February, that's when I got cautious."

Borho has opted to rotate more into emerging market healthcare and specialty pharma, as well as tools and diagnostics, which haven't performed as well as biotech.

"On a relative basis, my position is lower in unprofitable, no-cash-flow biotechs than usual," he said.

Technical strategist Craig Johnson of Piper Jaffray expects there could be a few more months of upside for biotech. But he anticipates a correction on the order of 20-25% could start by May and play out through the summer as investors take profits.

Another technical analyst, Benjamin Sokol of Thomson Reuters, also sees biotech indices continuing to rise into 2Q. He expects the large- and mid-cap oriented BTK to climb through June, but not at the steep pace of December, January and early February.

The BTK finished last quarter at 1,413. Sokol thinks the index could hit new highs above 1,500, maybe up to 1,550. If the market corrects, as many are predicting, he expects 1,300 and 1,240 would be key support levels.

"If it breaks those, it could get ugly and freefall from there to 1,060. The 1,001 mark was the low in November, so it should get more support there," said Sokol.

As for the small cap oriented NBI, which finished 1Q at 1,281, Sokol sees it reaching about 1,350 or even 1,400 this quarter. But on a correction, he expects "a nasty drop if it breaks below 1,200, and if it went below 1,100, look out."

A third technical analyst, Stan Weinstein of Global Trend Alert, is also cautiously bullish on biotech.

"Even the picks I like, I'm having clients do trimming," he said. "But we're still buying short-term corrections."

Some specialists noted that continued biotech performance is at the whim of the broader markets.

International Biotechnology Trust's David Pinniger said his "sense is that the sector is broadly overbought."

"The sector's near-term prospects are dependent on broader markets and if people are willing to chase beta," he added, suggesting that many specialist investors share this opinion.

Too much paper could start to be an issue, said Nicole Vitullo of Domain Associates. "It does feel like there are a lot of follow-ons. Historically, the oversupply has put a lot of pressure on run-ups. Investors get overwhelmed and say, 'Just stop showing me stuff,'" she said.

"The other factor out there is what happens in the back half of the year with the election and a macro backdrop for equities that is less favorable," Vitullo added.

Indeed, buysiders and bankers remember how difficult 2H11 was, and they worry that 2H12 will be similar. This year, they anticipate that the U.S. election will cool equities and the U.S. Supreme Court decision on healthcare reform may stymie healthcare stocks.

Rising tides

Last quarter, biotechs valued at $200-$499 million were the top performing group, with a gain of 16%. Those valued at less than $200 million added 14%.

Despite this, small and micro-cap biotechs continue to lag their larger peers over the longer term. Because of this, a number of buysiders think small companies still have room to run up (see "Thinking Small Again," A8).

"If you look at the mean regression of the performance of large caps versus small caps, the large caps have really outperformed in a big way. On the last 12 months, large caps are still way ahead," noted Fidelity's Rajiv Kaul. "The small- and micro-caps have a long way to go to regress to the mean vs. large caps. I don't know if that happens in one or two quarters, but that mean regression should occur at some point."

Small-cap specialist Selena Chaisson of Bailard noted that for her group, 1Q was "the strongest quarter that I can remember going back 10 years. It was overdue, given how long small cap has underperformed large- and mid-cap. I think they are going to continue to outperform, but then have some kind of retrenchment - at least a 10% sell-off before they move higher. We're starting to get back to 2008 levels."

She added: "Downturns always last a shorter amount of time than upturns, and I would be really surprised if it lasted the whole summer. If we come out of it, we can take out the old highs and have small caps outperform mid-caps."

G. Steven Burrill of Burrill & Co. said he and other VCs who invest in public companies remain active in the small- and micro-caps. "From an investor perspective, it's still an attractive place to invest," he said. "Public companies are at a substantial discount to private companies and are a better investment than late-stage private companies."

Joep Muijrers of LSP-Life Sciences Partners argued there's still room to play in Europe because those markets are lagging the U.S. "Small mid-caps in Europe still haven't recovered as much," he said. "If you believe location doesn't define quality, then there's a lot of value out there."

Borho sounded a contrarian note, arguing the small and mid-caps are largely picked over. He likes big cap names like Gilead Sciences Inc., Celgene Corp. and Biogen Idec Inc., all of which he said have big data events in the back half of the year.

Domain's Vitullo, who is focused on small caps, also is largely on the sidelines now because of climbing market caps. "I do feel like there will be a breather in 2Q," she said.

Cashing out, buying in

Indeed, given the aging rally, it's not surprising that fundamental investors now have differing strategies. While some are on the sidelines, others are trimming their positions in winners, and some are actively investing.

Pinniger, for example, has about 10% of his portfolio in cash. He's taken some profits from his winners, and he also did well on antibody company Micromet Inc., which was acquired by Amgen Inc. in mid-March for $1.2 billion.

Micromet was the biggest position in his portfolio, at about 5% of assets.

He's not particularly interested in reinvesting right now. "I'm not willing to chase stocks that are running so hot," he said.

While some stories have delivered, Pinniger said, money is crowding into names like cancer, ophthalmic and inflammation company Regeneron Pharmaceuticals Inc. and Orphan disease play Alexion Pharmaceuticals Inc.

Regeneron added 110% on the quarter after settling litigation with Genentech over Eylea aflibercept. Regeneron launched the VEGF inhibitor to treat wet age-related macular degeneration (AMD) in November 2011 (see "Doubling Down," A13).

Alexion was up 30% last quarter, during which it reported better than expected earnings and closed its acquisition of bone disease company Enobia Pharma Inc. for $610 million up front and up to $470 million in milestones.

"Stocks like these just keep going and going with valuations becoming detached from fundamentals," said Pinniger. "There aren't that many fresh ideas at the moment - investors are scrabbling around for great 'off-the radar' small cap ideas, but there aren't enough of them, and ultimately people seem more comfortable chasing momentum names."

He added: "It's funny - specialists, including myself, spend years complaining that no one loves the sector, how it's underappreciated. Then when it goes up 30% in two months, we whine that it's all got a bit overheated and there's nothing to buy."

Andrew Bogan of Bogan Associates was also a long-term Micromet holder, and he plans to reinvest the proceeds. He still thinks the conjugated antibody space is "very rich for successful drug development, but there are very few remaining independent players."

Kraft is an active buyer, although he is also selling some positions that have appreciated in recent weeks to maintain his portfolio weighting.

Borho is selling biotech winners to make more binary bets in the sector and to rotate into other healthcare segments.

"I have been rotating into new catalyst stories," he said, emphasizing that he's only buying biotechs with a major transforming event in the next six months.

Borho's also is dubious about shopping for undervalued, new technology in the small- and micro-cap space, noting that "investors start looking at second- and third-tier companies typically late in a biotech market cycle."

Chaisson, however, thinks that strategy has merit. She is looking for companies with new platforms like nanotechnology in sequencing or RNAi.

"I think we're in a time period where investors might actually be willing to pay attention to new technology and stretch their time horizons. They might take on more risk or be more willing to look out into the future," she said, adding that this has to happen for small- and micro-caps to continue to run up.

Like Chaisson, Muijrers is actively buying small and mid-caps valued up to about $2 billion. He expects that there are "a number of small caps in Europe and the U.S. that are under the radar screen that will hopefully be picked up."

Fundamental investors largely agree on one point: They haven't seen a lot of generalist participation in this rally, and they don't expect any even if it continues, given the likelihood that the sector is not too far from a top.

"As far as we can tell, we don't see generalists getting involved," was a typical comment from venBio's Aghazadeh.

One exception noted by Alex Kane of Thomson Reuters is the Fidelity Magellan fund. The $15 billion mutual fund got a new manager in October who is more focused on growth: Jeffrey Feingold.

In January, he started liquidating holdings in medical products and supplies and increasing his exposure to biotech. He initiated 20 positions in January, 11 of which were in biotech. The buying continued into February and then started to slow in the back half of the month, Kane said.

Pendulum swing

Bankers expect financings to continue, if not quite at last quarter's pace. They see low stock market volatility and performance of recent offerings as key to keeping financing on track.

A closely watched volatility indicator, the Chicago Board Options Exchange Volatility Index (VIX), remained low through most of the quarter. It did creep above 20 in early March, but dropped at the end of the quarter and finished at 15.5.

Average performance for last quarter's follow-ons is barely in positive territory, at 2%. But almost one-third of the 1Q follow-ons ended the quarter with double-digit gains (see "Follow-on Performance," A7).

Ben Perkins of Ernst & Young expects to see an active biotech financing market into this quarter and perhaps all the way through 2Q, depending on the health of the broader market.

David Strupp of Rodman & Renshaw agreed. "I'm optimistic we'll continue to see a good market in the second quarter. One of the key themes we've seen since the beginning of the year has been the reduction of volatility. That removal of volatility has had a significant impact on companies' ability to finance and investor willingness to put money to work."

Still, Strupp counseled companies to finance ahead of the uncertainty associated with the Supreme Court ruling on the healthcare law and the upcoming elections.

Marina Bozilenko of William Blair had similar concerns. "I'm not as positive about the second half because of the presidential election and the possibility of significant tax changes next year - investors will want to lock in their gains," she said.

Even biotechs that don't immediately need capital are taking advantage of the financing environment, Bozilenko noted, because of concern about 2H12 and 1Q13.

Matthias Spaenle of Oppenheimer is almost entirely optimistic in his outlook. "The deals that we see get done, they're all getting done with a very modest discount," he noted. He expects a vigorous financing environment this quarter, with a 2H12 that's "a little slower."

Peter Reikes of Stifel Nicolaus Weisel agreed. "There's probably an increasing funding level with the rising tide," he said. "You couldn't do that without a compliant and accessible buyside that's interested in investing."

But Reikes recognizes the financing market will ultimately overheat.

"If there's one certainty in this market, it's that we'll overshoot the mark," he said. "The reality is this is a pendulum game. When the pendulum starts to swing, you can bet that it will eventually swing too far."

Bankers cited the difficult IPO market as a sign that biotech financings haven't overheated.

"It's still a discriminating market. That's why we haven't seen the IPO market run amok," said Reikes.

A handful of companies pulled or postponed IPOs last quarter, and biotechs that do go public need heavy insider participation and steep discounts to the price range.

Merrimack Pharmaceuticals Inc. postponed a $150 million IPO in early February. The company completed a less ambitious $100 million IPO last week. But it shed 12% in its first couple of days of trading.

Also last week, allergy company DBV Technologies raised €40.5 million ($53.6 million) in an IPO on Euronext. The money should be enough to get to a 2016 approval for lead product Viaskin Peanut, a patch that delivers proteins epicutaneously to treat peanut allergy in children and adults, DBV board member Rafaele Tordjman of Sofinnova Partners told BioCentury.

The plan is not to raise money again, she added. Rather, this financing also should get DBV to a regional partnership for Viaskin Peanut, or a partnership for another program such as Viaskin Milk.

Including Merrimack and DBV, seven IPOs got out in 1Q. Two were in double-digit positive territory by the end of the quarter. Two more ticked up in the high single-digits (see "IPO Performance," A6).

Still, many investors aren't seeing the IPO performance they would like.

"Most have a portfolio of newer companies that haven't performed that well," Burrill noted. "The appetite for new issues is relatively low and selective."

Michael Brinkman of Jefferies is critical of IPOs that don't raise enough to get to substantial value creation. He advocates being creative to ensure that a company has enough money to reach crucial milestones with the IPO. Otherwise, the stock will languish as investors wait for a follow-on everyone knows is coming.

Bankers said a handful of companies are expected to jump into the IPO queue this quarter, including dermatology company Kythera Biopharmaceuticals Inc.

Acquiring success

Brinkman sees the tone of pharma M&A activity as conservative and driven by fear of blow-ups, despite the obvious need for acquisitions to fill pipelines.

Nevertheless, Tim Opler of Torreya Partners expects Japanese pharmas to continue to actively acquire biotechs outside Japan, citing that country's biennial mandatory price reductions. "If they don't diversify out of Japan, if you look at how draconian these reductions are, they will be out of business in 10 years," he said.

The 2012 price cuts were 6% on average, Opler noted.

Opler also expects to see acquisitions by public Chinese companies with market caps over $1 billion, like Simcere Pharmaceutical Group.

Matt Geller of Geller Biopharma thinks otherwise. "China isn't playing out quite as fast as people think. There's some interest from Chinese companies, but there's not a lot of money up front or help with development in partnering," he said.

Opler also thinks there will be another pharma-pharma acquisition this year. He noted that pharma is still much less consolidated than other industries, with the largest company having less than 10% of revenue share.

"There's been a large pharma-pharma deal once a year for the last 10 years. Last year was the first time in a long time we didn't see one," Opler said.

Opler also expects more activity from specialty pharma consolidators such as Valeant Pharmaceuticals International Inc., Jazz Pharmaceuticals plc, Meda AB and Shire plc.

"Emerging consolidators, not big pharma, have driven the market in the last few years," Opler noted.

He added: "We're in a bit of a barbell world. We have emerging consolidators that are all about finding cash flow and making companies more efficient. On the other hand, look at pharma: It's all about finding game-changing innovation."

Opler noted that the four therapeutic areas with the most high-priced acquisitions in the last five years are oncology, HCV, fibrosis and renal disease. "In these four disease areas, this is where the science is on the move, and there is innovation that is truly game-changing and makes patients better off."

COMPANIES AND INSTITUTIONS MENTIONED

Alexion Pharmaceuticals Inc. (NASDAQ:ALXN), Cheshire, Conn.

Amgen Inc. (NASDAQ:AMGN), Thousand Oaks, Calif.

Biogen Idec Inc. (NASDAQ:BIIB), Weston, Mass.

Celgene Corp. (NASDAQ:CELG), Summit, N.J.

DBV Technologies (Euronext:DBV), Paris, France

Dendreon Corp. (NASDAQ:DNDN), Seattle, Wash.

Gilead Sciences Inc. (NASDAQ:GILD), Foster City, Calif.

Human Genome Sciences Inc. (NASDAQ:HGSI), Rockville, Md.

Jazz Pharmaceuticals plc (NASDAQ:JAZZ), Dublin, Ireland

Kythera Biopharmaceuticals Inc., Calabasas, Calif.

Meda AB (SSE:MEDAA), Solna, Sweden

Merrimack Pharmaceuticals Inc. (NASDAQ:MACK), Cambridge, Mass.

Regeneron Pharmaceuticals Inc. (NASDAQ:REGN), Tarrytown, N.Y.

Shire plc (LSE:SHP; NASDAQ:SHPGY), Dublin, Ireland

Simcere Pharmaceutical Group (NYSE:SCR), Nanjing, China

Valeant Pharmaceuticals International Inc. (TSX:VRX; NYSE:VRX), Mississauga, Ontario

Vertex Pharmaceuticals Inc. (NASDAQ:VRTX), Cambridge, Mass.