There is no crystal ball for spotting tomorrow's strongest
stocks. But while there is no way to predict which stocks will
outperform the market moving forward, one way to spot tomorrow's
winners is by looking at forecast earnings growth.
As companies grow their earnings, Wall Street pushes up the
stock price in order to maintain the price to earnings ratio that
has been established on the stock. For example, if stock XYZ
historically trades with a price to earnings ratio of 15, and
enjoys strong earnings growth, the stock will have to move higher
in order to bring the P/E ratio back in line.
If you are looking for earnings growth, one sector worth looking
at is the biotech sector, as a lot of biotech companies are
forecast to grow earnings handsomely.
There are several reasons why the biotech industry is expected
to be strong in the upcoming years, not the least of which is The
Affordable Care Act, or Obamacare.
Obamacare got off to a rocky start, and despite early glitches
and low initial enrollment numbers, it will ultimately result in
a much larger percentage of the U.S. population having health
insurance. This leads to higher patient numbers, and therefore
increased sales for biotech companies.
Another catalyst for future earnings growth is an aging U.S.
population. By nature, older people require more healthcare
services and prescription medicine. The baby boom generation
started retiring at the beginning of 2011, and now there are
around 10,000 baby boomers retiring each day. The aging
population will create steady demand for prescription drugs for
years to come.
Biotech companies can also expect to grow earnings due to
rising incomes in emerging nations. Rising incomes will boost
demand for prescription drugs since more people will be able to
afford regular doctor visits.
Let's look at a couple biotech stocks and their forecast 2014
- Gilead Science (
- Amgen (
- Celgene Corp. (
- Biogen (
- Alexion Pharmaceuticals (
What these five stocks have in common is that they are all
included in the Market Vectors Biotech ETF (BBH). In fact, they
are the top five holdings of the exchange-traded fund.
While I like the outlook for biotech, it can also prove to be
a fairly risky sector for investors. The risks include (
but are not limited to
) blockbuster drugs losing their patent, drugs coming down the
pipeline failing a clinical trial, or even worse a current drug
on the market can start showing harmful effects on patients.
Any of these things can happen quickly, and send stocks into a
tailspin, which is why I prefer to take a more guarded approach
to the sector. Yes, the predicted growth makes me want to play
the sector, but I believe a diversified and hedged play makes
sense when dealing with biotech stocks.
BBH holds the biggest names in the sector, so a trade on BBH
provides enough diversity to overcome any hiccups that one or two
of the stocks encounter, and you can give yourself even more
protection with a hedged trade.
A nice hedged trade on BBH would be the March 77/81 bull put
credit spread. In this trade, you would sell the March 81 put,
while at the same time buying the same number of March 77 puts
for a credit of 65 cents. This trade has a target return of
19.4%, which is 61.1% on an annualized basis (for comparison
purposes only). With BBH currently trading at $87.53 this trade
has 6.7% downside protection.