Merrill Lynch biotechnology report: small cap ideas for a near-term rally

By Lisa Kerner

Charlotte, N.C., Aug. 21 - Look for a near-term biotech rally, particularly in small caps, according to a report by Merrill Lynch analyst Eric Ende, who said Merrill's BIO-I Score rose to +2 from +1 due to improved small cap valuations.

This reflects a positive reversal of fund flows at the end of July and potential seasonal strength during August.

According to Ende, while a tradable rally is expected as odds increase that the federal government is done raising rates, upside could be capped due to massive potential stock supply, near an all-time high of $10 billion. Plus, the sector's downtrend could last another 18 to 24 months.

Small cap valuations have improved, with 23% of biotech companies trading at less than 2x cash, signaling that investors have possibly moved away from lower-quality stocks.

Money flow into biotech/health care funds turned positive at the end of July and remained positive through the first two weeks of August.

Ende said the Nasdaq Biotech Index (NBI) generally trades well in August and September, with an average monthly return of 3%, and a 1% return during the last 13 years.

A break out above 747 in the NBI would signal the completion of a two- to three-month bottom and also suggests a move toward 800, noted the analyst.

Ende recommends investors take a basket approach in order to diversify, suggesting Alexion Pharmaceuticals Inc., BioMarin Pharmaceutical Inc., Cubist Pharmaceuticals Inc., Keryx Biopharmaceuticals Inc., MGI Pharma Inc., New River Pharmaceuticals Inc., Nektar Therapeutics Inc., OSI Pharmaceuticals Inc. and Theravance Inc.

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