A Few Thoughts on Biotechnology

Biotechnology has been the topic of intense interest over the past week.  Through the close of the market on Friday, the NASDAQ biotechnology index had lost over 13 percent on the month.  Nearly half of those losses have come in the last week, and over 2 percent on Friday.

I have received a number of calls from members questioning the biotechnology sector and the explanation behind the sell-off. Without a doubt, the sector has historically been one of the more volatile portions of the market.  The companies create cutting edge medical treatments and if clinical trials do not meet expectations, the stock price can plummet within only a few hours.  Alternatively, the results of successful testing can move the stock upwards 30, 40 or 50 percent or more almost immediately.  In fact, Intermune (IMTN) jumped over 170 percent a few weeks ago due to positive results for its lung disease drug.  Such rapid price changes can also have a contagion effect upon other firms in the sector.  If a panic occurs, not only will one company suffer, but often spreads to other firms within the sector.

For biotechnology mutual funds and ETFs, the impact of a few companies can have a dramatic impact on the fund.  These funds often have a low number of holdings.  Market Vectors Biotech ETF (BBH) has 25 positions and SPDR S&P Biotech (XBI) has only 82 holdings.  Fidelity Select Biotechnology (FBIOX) has 163 positions but the top 5 holdings comprise nearly 40 percent of the portfolio.  Similarly, iShares NASDAQ Biotech (IBB) has 123 holdings, with the top 5 stocks making up 39 percent of the fund. If you are seeking broad diversification, biotechnology is not the sector you should be looking at.

Given the hefty weightings of a just a few firms in these funds, any change in their business can have a dramatic impact.   FBIOX’s largest holding is Gilead Sciences (GILD) and is nearly 15 percent of the fund.  For IBB, GILD is the fourth largest holding, with a 7.6 percent allocation.  BBH has GILD and it is the largest holding with a 12.12 percent allocation.  Gilead is not alone – Amgen (AMGN), Biogen (BIIB) and Celgene (CELG) are also companies that have significant exposure across the same funds.

Gilead has been one of the leading drivers behind the sector moving higher and now moving lower.  On February 25th, Gilead closed at $83.95.  This past Friday, the stock closed at $68.55, a decline of over 18 percent.

By most accounts, Gilead is a solid company with innovative drug treatments for HIV and hepatitis.  In fact, its hepatitis C drug, Sovaldi, has been shown to provide a 90 percent cure rate in Phase 3 trials.  With over 3 million people infected with hepatitis C, Solvadi may prove to be a revolutionary drug that has a sweeping positive benefit.

A 12-week treatment program costs $84,000.  With such high potential demand, the financial prospects for Gilead look promising.  A problem surfaced earlier last week: it was publicized that the House Committee on Energy and Commerce sent a letter to Gilead questing the pricing structure of the drug.  The stock dropped, pulling other biotech companies down with it.

To summarize – this is a solid company which has created an innovative drug needed by over 3 million people in the United States alone.  Globally, the demand will be even higher.  Analysts widely view Gilead’s prospects positively, with some indicating the stock could move up to $95 a share.  Actively managed FBIOX clearly favors the firm as it has a 14 percent weighting.

What has occurred should provide an important reminder to investors.  Sometimes a stock price can be influenced by more than the fundamental strength of the company.  It may have sound financial practices, innovative products and strong management.  In this case, a letter sent last week had a massive impact on Gilead and the broader biotechnology sector.  If the pricing inquiry doesn’t gain momentum, there is absolutely no reason why the sector can’t rebound by 10 percent or more over the next week or two.

Certainly, biotechnology has been on a great run and a correction was inevitable.  Unfortunately, a correction can be started or exacerbated by seemingly minor events.   This is the nature of volatile sectors – speculation can cause dramatic swings.  As biotech has been a market leader, your positions may have become a significantly larger percentage of your overall portfolio.  It may make sense to take some profits and rebalance your holdings so you do not have oversized exposure to aggressive areas of the market.

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