Martin Shkreli can take part of the blame for a massive recent rout in biotech stocks. The CEO of Turing Pharmaceuticals had decided to boost the price of Daraprim, a drug that treats parasitic infections, by a whopping 5,000%. Soon thereafter, presidential candidate Hillary Clinton tweeted “price gouging in the specialty drug market is outrageous,” and she eventually laid out a campaign promise to enact sharp price controls for such drugs if she’s elected.
All of this drama came as the markets were convulsed in tumult, with biotech stocks being especially hard-hit. The iShares Biotechnology ETF (IBB), for example, has slid from $400 in late July to nearly $310 today. Many other biotech stocks and ETFs have fared even worse.
Should investors take caution with an industry that may soon come under deeper governmental pricing regulation? Or is this just a periodic scare that will eventually blow over?
Goldman Sachs’ Terence Flynn suggests a cautious stance. “While it will be very difficult to affect near term change in U.S. [drug] pricing, the set-up creates greater uncertainty into year end,” he wrote in a September 29 note to clients.
Geoff Meacham, who follows the biotech sector for Barclays, dismisses such concerns. “While election-related rhetoric on specialty drug pricing may continue, the impact on the sector going forward may be more muted given the difficulties of actual implementation in Washington,” he recently wrote, noting that most efforts to radically pare back drug prices have rarely moved into legislation.
Meacham’s key take-away is that he believes the aggressive sell-off has created good valuation entry points, particularly for large-cap biotechs.
Of course there is a more prosaic reason to own biotech stocks and funds––namely, demographics. The global population is rapidly aging, leading to steadily growing demand for specialty drugs. Indeed, analysts expect aggregated revenues for the top 15 biotech companies to grow at least 20 percent in 2015 and again in 2016.
Investors looking for large-cap biotech exposure should consider the above-mentioned iShares Biotechnology ETF, which carries a 0.48 percent expense ratio. With roughly $8 billion in assets, it’s larger than the next 14 biotech ETFs combined.
The fund’s modified market-weighted approach provides a clear bias towards large-cap holdings. The top five holdings––Celgene, Amgen, Gilead Sciences, Biogen and Regeneron Pharma––account for more than 40 percent of the portfolio. The large-cap bias means that the “IBB [fund] has been less volatile during the past five years than any other biotech ETF and any other major actively managed biotech mutual fund,” according to Morningstar.
The recent sharp pullback in biotech stocks should be placed in context. The IBB fund, for example, is still generating a 15.6 percent annualized return over the past decade. That means that sector prices are now merely reasonable, but not dirt-cheap. The average portfolio holding trades for around 22 times forward earnings, which is a fair price to pay in light of the sector’s expected robust growth in 2015 and 2016.
Investors seeking exposure to small- and mid-cap biotech stocks should consider the SPDR S&P Biotech ETF (XBI), which owns a balanced mix of companies that already have FDA-approved drugs on the market and companies which are still in clinical trials. This fund, which carries a 0.35 percent expense ratio, was launched nearly 10 years ago.
For now Morningstar can only cite its five-year annualized performance of 26.6 percent, which slightly lags the IBB fund. Moreover, the XBK find also produces greater volatility, so it’s performance starts to lag on a risk-adjusted basis.
Perhaps the best approach is to consider both the IBB fund for stable returns and a smaller ETF that focuses on high-risk/high-reward development-stage biotechs. These smaller firms have been hit especially hard in the recent sector sell-off.
The BioShares Biotechnology Clinical Trials ETF (BBC), which has slipped roughly 23 percent in the past three months, highlights the risk and reward in the small-cap space. During down markets, investors tend to aggressively dump small-cap biotechs. These are the kinds of companies that need to periodically re-load their balance sheet with fresh cash, and a down market often leads to a shutdown in capital markets (i.e., fund-raising) activity.