Safely playing the biotech sector

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Michael Fowlkes 02/03/2014

Earnings season continues to roll along, and the most recent sector to take the spotlight was healthcare, in particular several biotechnology companies. Many of the biggest biotech companies have now reported their recent quarterly results, giving us a slightly better insight into the sector.

By all accounts, last year was a great year for healthcare stocks. There are multiple reasons why Wall Street was so bullish on the overall sector. One is the Affordable Care Act, and a second is the aging U.S. population.

The Affordable Care Act has gotten off to a rough start, but as the wrinkles of the program get ironed out, a large number of previously uninsured Americans will finally obtain some level of health insurance. Since insured people are more likely to visit the doctor, the result should be higher patient counts, as well as an increase in prescription drug sales.

Along the same lines, the aging of the U.S. population should have the same effect. The baby boomer generation is hitting retirement age at a rapid rate, with around 10,000 currently hitting retirement age each and every day. It is easy to see how this will lead to higher prescription drug sales for years to come.

As a result, healthcare stocks were strong in 2013. To get a clearer picture of how strong the sector performed last year, we simply need to look at a chart of IYH, the iShares US Healthcare exchange traded fund.

You can see a steady upward trend, but also may note that the ETF started trending lower over the last few weeks. The main reason for this is just healthcare stocks trading lower as the overall market has pulled back.


Chart courtesy of Stockcharts.com

With the entire market trading in the red so far in 2014, to get a better view on the sector, we need to look at a few recent earnings reports, and unfortunately, the results have sent out mixed messages.

Take for example Biogen ( BIIB ), which reported its fourth quarter results on January 29. The company posted better than expected earnings and revenues, but issued weaker than expected guidance. Looking forward, the company forecast 2014 earnings in a range of $11.00 to $11.20 a share, shy of the $11.50 analysts had forecast. Wall Street ignored the weaker than expected forecast, and the stock has traded higher following the report.

Pfizer ( PFE ) reported its fourth quarter results January 28, reporting earnings of $0.56 per share, easily topping the $0.52 analysts had forecast. Revenues were also slightly higher than expected. The stock has traded higher following the report.

Another big name to report is Celgene ( CELG ). Higher research and development costs pushed its fourth quarter profit down 19%, but revenues were up 21%. The company reported a 54% increase in its total research and development costs. The stock has traded lower since its report.

Another disappointment came from Eli Lilly ( LLY ). The drug maker topped analyst estimates for profit and revenue, but Wall Street was disappointed with its 12% dip in profit, and 2% decline in sales. The stock has traded lower following its earnings report.

It is hard to get a good grasp on the sector. There are clearly reasons to be bullish, but the recent string of earnings reports does raise some red flags.

Personally, I remain bullish on the sector. I believe the long-term positive impacts from the Affordable Care Act and the aging U.S. population will keep strength in the biotech sector, but in light of the mixed earnings reports I would prefer to play any investment in the sector safely.

In order to make a safe play, you need to do two things, diversify and hedge. We can set up a trade on IYH that accomplishes both.

IYH holds a wide range of healthcare stocks, so it is clearly a diversified play on the sector. Among its top holdings include Johnson & Johnson ( JNJ ), Pfizer ( PFE ), Merck (MRK) and Gilead Sciences (GILD).

A nice hedged trade on IYH would be the April 103/108 bull put credit spread. In this trade, you would sell the April 108 put while buying the same number of April 103 puts for a credit of 35 cents. This trade has a target return of 8.6%, which is 35.2% on an annualized basis (for comparison purposes only). IYH is currently trading at $118.54, so this trade has 8.6% downside protection.



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

Originally published on InvestorsObserver.com


This article appears in: Investing , Options

Referenced Stocks: BIIB , CELG , JNJ , LLY , PFE

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