Biotech (NYSE:XBI) was easily the best-performing sector in 2013, rising by an incredible 48%. That performance put the sector almost 20% ahead of S&P 500, which rose by 29.6%.

biotech companies

It is fair to say that not even the bullish of biotech bulls predicted this kind of relative performance. But cheap valuations, the promise of strong drug pipelines and a stellar year for biotech IPOs all came together in a perfect year for the sector.

The question for those holding biotech now, and for those considering adding exposure, is whether or not this extreme rise means biotech has become too hot for its own good. After all, it has been the best performing sector now for three straight years.

The many attributes that made biotech so compelling in the beginning of 2013 – attractive valuations, robust pipelines and the defensive nature of the industry – are not all present today, especially since valuations are a bit stretched.

At the beginning of 2013, the sector was trading at a 20% premium to the S&P 500 based on 2013 estimated earnings. Now, biotech is trading at a 40% premium to the S&P 500 based on 2014 estimated earnings.

In order to meet the expectations that premium implies, the biotech sector will have to fulfill its promise and deliver both margin and earnings growth.

I think the answer to the “is biotech too rich” question lies beyond the sector’s relative valuation, however. While that 40% premium to the S&P 500 snatches my breath for a second, I start breathing again when I look at growth prospects for individual companies.

Many look to have considerable upside when we factor earnings growth into the equation. I suggest Celgene (NASDAQ:CELG), Biogen (NASDAQ:BIIB) and Gilead (NASDAQ:GILD) as three large-cap examples. Analysts at firms, including Credit Suisse, believe these stocks have 25% to 50% upside before they are fairly valued.

We must remember that new blockbuster drugs deliver EPS growth for years, not just quarters. And those robust drug pipelines I talked about earlier are starting to deliver; a number of new drugs are set to hit the market in 2014 and 2015.

Currently, my largest biotech holding is Gilead (NASDAQ:GILD). This is largely a result of a sizeable position in the Fidelity Advisor Biotechnology (FBTAX) mutual fund, as well as some exposure outside of the fund.

I like GILD because of the potential of the company’s hepatitis C drug, sofosbuvir, which gained FDA approval in December 2013. Hepatitis C is a blood-borne disease that causes liver damage. Between 3 million and 4 million people in the U.S. suffer from the disease, and it is blamed for 15,000 deaths a year.

Current treatments cure around three-quarters of patients, and can take up to a year of treatment. The FDA said GILD’s sofosbuvir cured 90% of patients with the most common form of the virus in just 12 weeks; that’s a high percentage in a much shorter period of time.

The company’s single-dose pill is reported to cost $84,000 for the 12 months of treatment that most patients require. While that price has raised some eyebrows, I expect sales will be strong right off the bat. Within the next five years, it is entirely possible that GILD could double revenues.

The drug should hit the market in mid-to-late 2014, and it’s one of the reasons why you should own GILD right now.

Even though biotech had a good run last year, I still see a lot of potential in several biotech stocks. My best advice for the first quarter of 2014 is to consider holding shares of funds like FBTAX (if you currently hold them, as I do) and add exposure to select companies that should benefit over the next five years from new drugs, like Gilead.

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