A safe way to win with biotech growth

By Michael Fowlkes,

Shutterstock photo

Michael Fowlkes 12/02/2013

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 earnings growth:

  • Gilead Science ( GILD ): 57%
  • Amgen ( AMGN ): 8%
  • Celgene Corp. ( CELG ): 27%
  • Biogen ( BIIB ): 29%
  • Alexion Pharmaceuticals ( ALXN ): 13%

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.

Chart courtesy of stockcharts.com

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.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Originally published on InvestorsObserver.com

This article appears in: Investing Options
Referenced Stocks: ALXN , AMGN , BIIB , CELG , GILD

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