October 27, 2014- A Safe Route into the Biotech Sector
Investing in biotech stocks can be a very rewarding, or a very disastrous, experience. Companies in the sector live and die by the success or failure of drug trials, and while the upside is huge when a company hits a home run… the downside can be just as large on unsuccessful trials.
Before we move deeper into our discussion about playing the biotech sector, it is important to differentiate between biotechs and pharmaceuticals. Many times investors will mistakenly assume the two are the same… but that is not the case. Big pharmaceutical companies do have their own research and development divisions, but make most of their money on the manufacture and marketing of drugs already approved.
On the other hand, research and development is the primary focus of biotech companies, which is why clinical drug trials are so important to the stocks involved. Since biotech companies tend to be smaller than the big pharmaceutical companies, they usually have just a handful of compounds in development at any given time. The costs, and the time involved, in developing a drug that makes it through the clinical trial process are tremendous, and as a result biotech companies are really only able to work on a few at a time. The risks are just too high, and the success rate too small to gamble on developing a large number of compounds at one time.
Because of the huge success that a drug trial can bring a company, the upside in biotech stocks cannot be overstated. Any time a drug trial shows promise, the stock of the company developing the drug can easily double or triple. Likewise, when the trials do not meet expectations, the stock can plummet. This leads to a lot of volatility in the sector, which some investors love, because the bigger the risk the bigger the possible reward.
This is a basic difference between biotech and pharmaceutical companies. Pharmaceutical companies are larger, and therefor tend to have more drugs in development at any given time. They have solid revenue streams from a lineup of drugs that have already been approved and are being marketed aggressively. As a result, they can tolerate poor results, much easier than biotech companies, and stock prices are far less volatile.
The question that arises is whether or not the biotech sector is too risky for the average investor. The answer to that question is not so clear-cut. As we have already discussed, the risks of investing in specific biotech companies is rather large. At any time, a company can report disappointing drug trial results and the stock could tumble. However, if you can invest in a wide range of biotech companies, you can diminish your risk. Having a basket of biotech stocks allows you to weather the storm a lot better when one particular stock runs into trouble.
So the answer is yes, even the average investor can, and probably should, consider putting a little money to work in the biotech sector. The upside potential is huge, and now is a very exciting time for the sector as a whole.
Globally, populations are not only rising, but people are living longer. As a result, the stakes have never been higher for pharmaceutical and biotech companies. As people age, they tend to run into more medical problems, requiring more prescription drugs. At the same time, technology in general is rapidly changing, opening the door for medical breakthroughs at a much faster pace. Biotech companies that can take advantage of new technologies have the potential to treat, or prevent, diseases that previously untreatable.
Biotechnology is an exciting industry, if for no other reason than the dramatic impacts it can, and does have, on millions of people worldwide. For investors who want to get into a high risk/high reward sector, few compare to biotech.
High risk is not for everyone, and I personally do not suggest putting a large percentage of your portfolio into high-risk investments. There are ways to tap into the volatility of the biotech sector while still protecting yourself the potential risks, while at the same time hedging your investment to protect from any major sell offs in the sector.
A safe way to play the biotech sector is with a trade on the exchange-traded fund iShares Nasdaq Biotechnology (IBB). IBB is designed to track the performance of the Nasdaq Biotechnology Index. The fund holds a wide range of biotech stocks, including Amgen (AMGN), Celgene (CELG), Gilead Sciences (GILD), Biogen Idec (BIIB), and Mylan (MYL).
Chart courtesy of stockcharts.com
A nice hedged trade on IBB would be the January 260/265 bull put credit spread. To set up this trade, you would sell the January 265 put while buying the same number of January 260 puts for a credit of 40 cents. The trade has a target return of 8.7%, which is 37.3% on an annualized basis (for comparison purposes only). IBB is currently trading at $287.67, providing our trade with 7.7% downside protection.