What a difference a month made.

In early September of 2008 the stock market was perched on that wobbly mesa where it had been trading in a more or less sideways corridor for the better part of the summer. Rumors about the fall of Lehman Brothers, which had been making the rounds since back in the spring, were surfacing anew and giving renewed emphasis to the downward bias that had never truly gone away since the middle of 2007 when the burgeoning toxic soup of the credit markets finally spilled messily out of the container and into full public view. Then came the day of that fateful decision – when the same government that had rushed to the aid of Bear Stearns in March to prevent a St. Patrick’s Day Massacre took a pass on Lehman and unwittingly unleashed the Panic of ’08.

Even as the stock market was starting that fall into the abyss in the second half of September – and bear in mind the vertigo-inducing freefall of 3,000-plus points on the Dow Jones Industrial Average didn’t happen in one day but over about a month into the third week of October – even as it was all falling apart your ever-optimistic author continued to assert that the case for venture capital appeared compelling. All that money piling into Treasury bonds didn’t really want to be in Treasury bonds – it was risk-seeking capital in search of a destination.

In normal times there are a handful of alternative venues to serve as that destination: the market for publicly traded stocks, real property assets, stores of value like commodities, hedge funds, and the market for privately held equity such as leveraged buyouts, specialized partnerships in areas like oil & gas exploration, venture capital, and the relatively recent phenomenon of stock market platforms for very early-stage companies that still largely depend on private investment (more about these in a forthcoming Rita blog installment).

It is unusual for all of these risk asset classes to be nearly uniformly unappealing, all at the same time, but such was the case for all the asset classes cited above save for one: venture capital. The venture capital market has almost no correlation to either stock or property markets, does not rely on the price of oil or any other commodity, and is not dependent on robust, liquid markets for speculative-grade debt capital as with the LBO market. The VC time horizon is long, meaning investors should be more comfortable about riding out the present downturn. Looking at the numbers, the National Venture Capital Association and Thomson Reuters reported that investors in VC lost 1.6% for the 12 month period ended September 30 2008 – not much to get excited about to be sure, but still preferable to the -22% return for the S&P 500 over the same period, or the -13% showing for the HFRI Hedge Fund of Funds Index.

Essentially, the attraction VC would seem to offer to risk asset-seeking investors was that it has little to do directly with the most egregiously negative forces at work in the markets and the economy, but does in fact have a relationship to the most promising ones – including that in a potential recovery scenario the most likely viable engine for growth may come from technology-intensive sectors such as alternative energy, biotechnology and broadband 3.0 solutions like intelligent energy grids. In other words a recovery in the market could favor sectors that are heavily represented in VC portfolios – and these portfolios would thus find a bevy of willing buyers to provide a market for their future IPOs and other exit vehicles.

Not that there is any guarantee this scenario will actually play out, but then risk assets are called that for a reason – because there is uncertainty and variability among potential outcomes. Also, there is a history of spectacular growth stories emerging from moribund economic times – both Apple and Microsoft, after all, came into existence during the decade of malaise and stagflation otherwise known as the 1970s. If there actually is an optimistic case to make for our economic trajectory going forward it probably involves lots of groundbreaking technology leading the way (goodness only knows it doesn’t likely involve another debt-fueled consumer binge as the path to the Promised Land). Venture capitalists are some of the most terminally optimistic people in the world, and those who invest in their funds are prone to catch this infectious spirit.

So as I ruminated over these matters back in the fall of last year the luster of this asset class seemed to get brighter and brighter, or so I thought. And that brings us to the difference a month makes.

The difference in investor sentiment between the last week of September and the end of October was a difference in magnitude - the difference between wallets being open to the possibilities of risk-seeking assets and being padlocked shut to anything that did not bear the insignia “direct obligation of the United States Treasury”. In other words, risk-seeking capital generally speaking went on sabbatical. The results show. The Barclays US Treasury 7-10 year Bond Index returned 18% to investors for 2008 – and most of that stunning gain came from the deluge of risk capital dollars flowing in during the last three months of the year. That capital is still in hibernation – but at some point it is going to want to come out of the ho-hum world of Treasury bonds and back into something interesting.

In fact that is already happening to a certain extent. Technology indexes in the public stock markets are significantly higher than broader market averages, as I wrote about in a previous entry on the biotechnology sector. The Dow Jones Industrial Average is down more than 10% for the year to date, while the technology-weighted Nasdaq Composite is about flat. Growth-oriented technology stocks across the range of market capitalizations are outperforming so-called value stocks, mostly because the latter category is chock full of those banking and consumer-related names that are in the swamp along with other poorly-performing sectors like energy and industrial materials.

So the climate seems like it could be right again for VC. But over the past couple months I have started to wonder if that is really going to be the case. Not because the VC case isn’t compelling – I truly believe that it is – but rather because I believe the psychological scars from the last four months may last for some time to come and may alter the nature of the whole risk paradigm. Venture capital requires a greater degree of commitment than other investments – the time horizon is longer, the fund managers have to instill confidence (and many track records are looking rather sparse these days) and there are various and sundry legal, tax and other issues for prospective investors to countenance.

Are there alternative avenues for investors who want exposure to a particular breed of risk asset with low correlation to other investment markets that offer enticing prospects for growth at commensurate levels of risk? In our previous installment on this blog we looked at technology sector plays in the publicly traded marketplace – a good destination for more traditional investors who require the daily liquidity of traded equities. There is another vehicle, though, that provides a space somewhere between the very liquid public markets and the illiquid world of institutional world of venture capital. This is the market for listed early stage companies – and although it has been around for some time in one form or another the market has recently evolved. In forthcoming entries to this blog we will be looking at this market in more detail.

Flat is the new up: Biotech steady in a sea of collapsing sectors

The stock market remains a forbidding place to be these days. Coming on the heels of the worst year for US equities since 1931, the broader market indexes quickly tossed aside an embryonic rally over the New Year transition and reasserted the downward trend. Both the Dow Jones Industrial Average and the S&P 500 Index finished the month of January down more than 8% year-to-date, continuing last fall’s miserable performance as the economic data find new ways to disappoint investors with each passing day.

At times like this two sentiments can emerge. The bears – both those by natural temperament and by the pain of recent experience – will survey the bleak landscape and retreat back into their dens for the rest of the winter. The never-say-die optimists and the iconoclastic contrarians will go bargain hunting and value fishing. The bears’ sentiment is understandable – there is not a whole lot out there about which to get excited. Peace be with you.

For those ready to do some venturing down Wall Street’s mean streets, beware, for in the words of fearless voyagers in times past, there be monsters. However there would be many worse places to voyage than the biotech sector. In fact the Nasdaq Biotechnology Index finished the month of January just about flat, at -0.11% for the year to date, well ahead not only of the broader markets but also the broader healthcare sector: the S&P Global Healthcare Index returned -3.80% while the Dow Jones Select US Pharmaceutical Index was off -2.84% for the same period. The Nasdaq Composite Index, widely used as a broad gauge for the hodgepodge of technologies that make up the so-called “tech sector”, was down a bit over 6% at month end.

Risk as seen through the looking-glass

Biotech is unquestionably a highly risky investment sector, and intelligent investing in biotech companies requires a level of knowledge that relatively few possess in an adequate level of detail (and those who do possess it can be wrong as often as right). True enough, but “risk” in investment markets is not a static concept – it appears in different guises at different times. In more stable times, when equities are doing what they should be doing (i.e. outperforming bonds), biotech is considered to be significantly out there towards the edge of the risk spectrum, while traditional “blue chip” mature, large cap names constitute the core of prudent investment portfolios.

Right now, though, times are not stable and risk relationships in general are as upside down as the Red Queen in Alice in Wonderland. Both US and global equities have lagged every other liquid, publicly tradable investment category over the course of this decade through the end of 2008: bonds, commodity futures and real estate investment trusts (REITs) have all outgained equities over this period. I would argue that the riskiest place to be in the stock market is in anything that is highly correlated to…uh well, the broad stock market…and particularly the financial sector that has been the broader market’s primary engine of growth for more than a quarter century.

Low correlation: vive la difference

Cue in biotechnology. The Nasdaq Biotechnology Index currently exhibits a correlation of about 0.63 with the S&P 500 and 0.58 with the Dow Jones US Financial Services Index. A level of 1.0 indicates perfect positive correlation while 0.0 indicates no discernable correlation. The correlation coefficient is one of the most important indicators in portfolio management alongside mean return and dispersion around the mean (standard deviation) – it tells us the level of likelihood (or not) that very bad things will affect all assets the same way at the same time.

The comparatively weak correlation of biotech to the broader market is a function of a number of different factors. The Nasdaq Biotech Index is a potpourri of over 130 biotech stocks ranging from industry giants like Amgen (AMGN) and Celgene (CELG) to microcap offerings like Vanda Pharmaceuticals (VNDA) and CombinatorX (CRXX). Each of these stocks has its own unique value proposition – and those in many ways tend to have rather less to do with each other than is the case in many other industries – but as a group they are relatively less directly affected than other industry sectors by the two key interrelated economic forces responsible for the broader malaise: dysfunctional credit markets and the sharp retreat in consumer income and spending power. Naturally there is some correlation here, but health care spending decisions historically do not exhibit high demand elasticity; i.e., where prevailing economic trends exert high influence over the responsiveness of household or business spending to changes in price for any given product or service.

Save time: buy in bulk

Because business risk is such a determining variable in biotech – pipelines can take years to win approval for breakthrough drugs and technologies that in turn may or may not become commercial blockbusters – having one or two biotech stocks in a portfolio (even ones with proven products and revenue streams) is not a recommended strategy for the uninitiated. A better strategy is to take on exposure at the sector level, i.e. to profit (or not) from microeconomic trends in the biotech sector relative to the macroeconomy as a whole. This can be accomplished with one simple trade using the increasingly popular vehicle of exchange traded funds (ETFs).

For example one can obtain proxy exposure to the Nasdaq Biotechnology Index through an ETF operated by iShares, a fund management entity owned by Barclays Global Investors N.A. The ETF trades under a ticker (IBB) just like any stock, and buying shares will incur similar transaction fees, commissions, etc., just as with any other stock (actual fees and expenses will depend on the particulars of one’s own brokerage or financial advisory relationships). ETFs also generally do not come with some of the baggage of traditional mutual funds like front-end sales charges, redemption fees or confusing multiple share classes. IBB, which at present has 137 holdings across a range of sub-sectors from biomedical drugs to therapies, diagnostics and drug delivery systems, is constructed to mimic the trading patterns of the NBI index that it tracks (indexes themselves are not directly investable).

The weather outside is frightful, but…

The debt- and consumer-driven economic freefall will no doubt bottom out at some point, though a fairly dismal consensus seems to have formed around the idea that the economy will bounce along dully in that trough for awhile before something – and nobody seems to know exactly what – will start to revive animal spirits again. The worst may or may not be over for the stock market yet, and anyone venturing into these unhappy grounds would be well advised to proceed cautiously. Still, investing in equities is never without risk, and there are as many plausible cases to make that a true market bottom may not be that far away. What is going to power the growth when market strength does return? The best way to answer that question is probably with negatives: not the financial sector and not the consumer discretionary sector. Such growth as may happen in this next cycle is more likely to come from a sprinkling of tech sectors, and biotech has a better than average chance of being in that mix. To which end the type of broad sector exposure attainable through an ETF like IBB may be a very sensible play now.