While 2017 was a strong year for the markets — especially technology stocks — biotech and health care stocks in general were only able to keep pace. The iShares Nasdaq Biotech ETF (NASDAQ: IBB) was only up about 21% in 2017, just slightly above the S&P 500. However as we start 2018, Merrill Lynch believes that this could be the year biotechs break out.

Merrill Lynch previewed the 2018 biotech industry trend and the key catalysts for its covered stocks. In 2018, the firm believes the need for growth, positive impact from tax reform and a boost in M&A can drive sector outperformance. Specifically, Merrill Lynch has a few picks, bad and good, that it believes will play a big role in the coming year.

The brokerage firm detailed the growing pains of the biotech industry saying:

The biotech stocks sported a comeback in 2017 out of the penalty box in 2016 with the Nasdaq Biotechnology Index (NBI) up 21%. Despite giving back part of its gain (peaked at 29%), NBI managed to outperform S&P500 (up 19%) during 2017. Coming into 2018, most investors find biotech less exciting than FAANG in the tech world. Long considered a hyper growth sector with high risk/high reward, biotech is experiencing growing pains. With aging product line-up, fewer blockbuster launches, large revenue bases and thinning pipeline, the large cap biotech companies increasingly look like their major pharma peers. As a result, investors are penalizing large cap biotech with lower P/E multiples than the major pharma group. Admittedly slower growth is a function of much larger revenue base and biotech stock performance is a victim of its own success with 8 large caps in S&P500 index.

At the same time, considering the scarcity of pipeline assets, strong balance sheets and cash repatriation from tax reform, Merrill Lynch is not surprised by the high expectation from investors on uptick in M&A activity in 2018. The two biggest biotech companies Amgen Inc. (NASDAQ: AMGN) and Gilead Sciences, Inc. (NASDAQ: GILD) had $39 billion and $32 billion, respectively, in ex-U.S. cash at end of the third quarter. The firm subscribes to the popular view that “stars are aligned” for M&A transactions in the biopharma universe.

In terms of its single stock picks, Merrill Lynch has selected Vertex Pharmaceuticals Inc. (NASDAQ: VRTX) and Esperion Therapeutics Inc. (NASDAQ: ESPR) as its top picks, while downgrading Celgene Corp. (NASDAQ: CELG) and Ironwood Pharmaceuticals Inc. (NASDAQ: IRWD). In the report, Merrill Lynch detailed:

We are upgrading Vertex and Esperion from Neutral to Buy with updated PO of $180 and $76, respectively. We see Vertex as a winner on both the clinical and commercial fronts with an anticipated strong launch of Tez/Iva and positive Phase 2/3 data in cystic fibrosis. Vertex enjoys enviable monopoly and pricing power as well as a commanding lead in the clinic. Esperion could see upside with positive Phase 3 results in 2018 and positive read-through from Regeneron/Sanofi’s Praluent outcome trial. We are downgrading Celgene from Buy to Neutral and Ironwood from Buy to Underperform on lack of significant catalysts and lower expectations on product sales (PO updated to $120 and $15, respectively.).

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