Veteran investors will remember the first boom in biotechnology shares in the late Nineties. Prices crashed and brave backers vowed never to go there again.

But biotech is hard to ignore given the incredible gains of the past decade, driven by an ageing population and demands for better health care. Leading the charge has been the Biotech Growth investment trust. It has been run by Geoffrey Hsu of OrbiMed Capital since 2005. He also runs theWorldwide Healthcare Trust.

At its peak in July, Biotech Growth’s returns equated to more than 20pc a year over a decade. Even after falling hard since then, the five-year return still stands at 282pc, turning £1,000 into £3,820.

Have biotech shares become overvalued?

There are some pockets of overpriced stocks in emerging biotech but big biotech still has compelling valuations.

The sell-off we have seen since the start of the year really can’t be justified. It’s to do with the slowdown in China and the falling oil price. Biotech has no exposure to any of that.

Our chart (see below) shows that previously when the big biotechs have been cheaper, on price-to-earnings ratios, than the S&P 500 index it has turned out to be a good time to buy, which is the case now.

We believe the possibility of mergers provides a “valuation floor” for biotech. Single-product companies valued at $5bn to $10bn are in the sweet spot. We saw in 2015 that companies were still being bought at huge premiums of up to 140pc.

David Fuller's view

Here is a PDF of The Telegraph article.

The bubble for the Nasdaq Biotech Index has certainly burst, so what happens next?

There is currently no evidence that NBI has bottomed but it is somewhat oversold and at a much more interesting level for perspective investors.  Also, valuations for many of the more successful big-cap shares in this Index are more reasonably priced, as Eoin has often pointed out. 

A relevant question is: for how long will this previously top-performing sector underperform now that its bubble has burst?  No one knows but we do have some historic precedent from other burst bubbles.  They are followed by bear markets from either the lengthy medium term (1 to 3 years) or much longer, usually depending on the sectors’ earnings and overall stock market performance.

NBI has already experienced a not insignificant bear trend of just over 35 percent from its peak on July 20^th 2015.  It will probably go somewhat lower but the big companies with earnings, in which leading funds invest, should outperform especially as prospects for their earnings growth are generally favourable. For this assessment I will take a cautious view on the market outlook and rate it as neutral, but I hope to be pleasantly surprised over the next three years.

Against this background I would commence nibbling at the Biotech Growth Trust which currently sells at a discount to NAV of -7.92%, adding to this position on weakness.  I would regard this as a long-term investment, which may underperform while you are acquiring most of your position.