Feb 2, 2009 
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.
