4Q14 Financial Markets Preview: 'Perfect world' - for now

4Q biotech stocks: Large cap recovery points to smaller cap cherry picking

Even as the major biotech indices creep toward new all-time highs, buysiders are hard-pressed to identify any major risks that could cause a downturn in the fourth quarter. At the same time, there are few major milestones before year end, leading investors to scout ahead for catalysts in 2015.

The recovery of the biotech indices from their spring swoon was driven almost entirely by the large cap names. Buysiders will therefore look to add to returns before year end by cherry-picking in the small- and mid-cap space, where prices have continued to drift.

The fourth quarter will bring plenty of data to chew on, but few major clinical milestones and, importantly, no binary events that carry significant negative risk for the sector.

A flurry of cancer conferences will bring more data for cancer immunotherapy, while the American Association for the Study of Liver Diseases (AASLD) meeting in November will be closely watched for updates in non-alcoholic steatohepatitis (NASH) and new HCV regimens that could challenge combo regimens from Gilead Sciences Inc., AbbVie Inc. and Bristol-Myers Squibb Co. that are expected to receive approval this quarter (see "Commercial Race in HCV," page 8).

The pace of IPOs is expected to pick up through year end, with a few banner names expected to make their debuts. Rational pricing will remain the name of the game as it has for two quarters. In addition, a few investors think the increasing ranks of IPOs taking haircuts and then trading down could constitute the first bad news for the window.

Although 3Q14 saw a drastic drop in follow-ons, most investors attributed the falloff to the fact that most companies are well financed. Indeed, in the past three years, the amount of money raised by public biotechs exceeds the total raised during the entire six-year bull run of 2003-08.

With the sector well capitalized and FDA approving new drugs at a steady rate, buysiders said the only major risks for biotech - high drug prices and rising interest rates - are likely 2015 story lines.

Driven by large caps

The BioCentury 100 and NASDAQ Biotechnology indices surpassed their February highs in mid-September and late August, respectively, finishing the quarter up 10% and 6%. The indices are up 23% and up 21%, respectively, on the year. But large caps were the only segment in the black last quarter, up 9.2% for 3Q14 and up 20.7% year to date.

In contrast, mid-caps between $1-$5 billion were down 3.1% last quarter and roughly flat for 2014. Small caps in the $500-$999 million range were off 8.1% for the third quarter and are the worst hit YTD, down 15.1%.

The hardest hit market segment in 3Q14 were small caps between $200-$499 million, which were off 13.6% for the quarter and down 6.4% YTD.

Investors think a key ingredient for continued sector performance will be large caps maintaining the momentum of new product launches into the fourth quarter.

"I think the key

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