The biotech industry is showing signs of life after a months-long struggle. Except this time, investors are holding companies to a higher standard.

No more disappointment, please

The past year has been described as “the most extreme period of stress in the modern history of biotech” — as miserable market conditions, diminishing investor interest, and rising lab and research costs (thanks inflation) impacted the biotech industry.

But the sector is finally showing promising moves.

• Comeback: The S&P 500 Biotechnology Select Industry Index is up 15% from its 52-week low on March 14 — after falling over 30% in the past year.
• Bank’s blessing: Wells Fargo analysts upgraded their outlook on the healthcare industry to “favorable” last week on strong industry demand and reasonable valuations.

Wells Fargo sees the industry performing better during an uncertain market environment with rising interest rates. JPMorgan has also taken a more optimistic view in recent weeks (BBG).

Biotech won’t be treated the same this time

Despite the rebound, smaller biotech companies — at the mercy of FDA approvals and limited cash reserves — have fallen harder compared to larger companies with stable cash flows.

Larger biotech and healthcare stocks — whose sales remain stable and predictable during market downturns — are seen as “defensive” sectors.

• The iShares Biotechnology ETF (NASDAQ:IBB) — which prioritizes large-cap companies — is down 13% in 2022.
• The SPDR S&P Biotech ETF (NASDAQ:XBI) — which has an equal weighting of large and small biotech companies — is down 19% in 2022.

Despite the bloodbath, several large-cap healthcare stocks are breaking all-time highs —  i.e., McKesson Corp (NYSE:MCK) up 26% and Abbvie (NYSE:ABBV) up 25% in 2022.

Despite their move, valuations are still lower than the S&P 500 — and Goldman strategists expect these stocks to move higher towards historical averages, with biotech valuations below-median averages.

Investors: Going big or small?

Large-cap stocks outperforming small stocks could lead to a more significant upside in smaller biotech stocks. On the flip side, larger ones could provide more stability during uncertain market environments:

• Choosing stability: High-quality companies with “some element of a business structure/revenue generation” are recommended by Oppenheimer strategist Jared Holz.
• Example: Apellis Pharmaceuticals (NASDAQ:APLS), Horizon Therapeutics (NASDAQ:HZNP) and Vertex Pharmaceuticals (NASDAQ:VRTX) — picks recommended by Oppenheimer and JPMorgan strategists.

On watch: Investors will closely watch the US midterm elections at the end of this year. Historically, Republicans are more relaxed on capping drug prices and favor speeding up drug approval processes.