We have all heard the conventional wisdom regarding the last few weeks of market turbulence, haven’t we? It is the inevitable bursting of bubbles in tech and bio-tech stocks. Bio-tech, when taken as a whole, has been hit particularly hard, with IBB, an ETF for the industry, losing around 20% in the last three weeks. As I pointed out on Friday, however, when seen in the light of a 30% increase since the start of the year or the 63% increase in 9 months that preceded the drop, it doesn’t look quite as catastrophic.
Of course, the other side of the coin is that, given that prior performance, there could be a lot further still to fall. I see two problems with this analysis, however. It lumps all bio-tech stocks in together, the good with the bad, and doesn’t allow for traders’ and investors’ knowledge and management of risk. Even if you had only become involved in the bio-tech field towards the end of last year, by which time most of the big increase was over, it doesn’t mean that you have been killed by the events of the last three weeks. With careful stock selection and decent risk management, you could have survived.
For evidence, I went back over the last five recommendations I have made in these pages for bio-tech stocks. They were: Zeltiq Aesthetics (ZLTQ) on March 27th, Nymox Pharmaceutical (NYMX) and Sophiris Bio (SPHS) on March 17th and Chelsea Therapeutics (CHTP) and Accuray (ARAY) back on December 9th last year. I emphasize, these are not cherry-picked; they are simply the last 5 bio-tech stocks that I have written about in Market Musings. Results have, as you would expect, been mixed, but overall, had you bought each stock at the closing price on the day of publication, you would have been showing a profit of around 2% at Friday’s close.
Now, I am not pretending that 2% is a fantastic return but nor is it likely to cause anybody to throw themselves out of a window. The fact is that, if losses can be limited like that following a “crash” in the sector, the possible rewards of finding a stock with potential at current depressed prices look even more attractive.
It is not without risk, of course.
As I said, this drop could have a lot further to go, so if you aren’t prepared to lose 10-20% of what you invest you should be staying well clear of the sector. Not just right now either. If that type of risk is not for you, then speculative bets on the success or failure of drugs still in the trial stage of development are not for you at all.
If, however, you have, like me, more of a trader’s attitude, then the last few weeks shouldn’t in any way put you off of looking for bio-tech stocks with upside potential. Even for those who are risk averse, however, just buying a stock you like could be like the proverbial act of attempting to catch a falling knife; foolish and dangerous. With a sensible hedge, however, it is still possible to take a measured risk on companies with potential.
The hedge that I would suggest is a simple one best illustrated by a specific example. One stock in the field that I like right now is Theravance Inc. (THRX). The play here is on some trial success for a drug known as Velusetrag for the treatment of gastroparesis.
To simplify, this is basically slow movement of food through the stomach and intestines and is often brought on by diabetes. Early trials indicate efficacy with limited side-effects and THRX already has a licensing and distribution deal for the EU, Russia, China and others that entails partner Alfa Wasserman paying for the advanced trial.
There is a complication in that Theravance is moving ahead with plans to separate into biopharma and royalty management companies, but apart from tax implications, that does little to influence the value of the stock as currently quoted. There are also concerns about sales of an existing drug, but this is simply a play on the possibility of good news regarding Velusetrag.
As you can see, the other factors, combined with the general drop in the sector, have put the stock under serious pressure. The stock specific concerns seem fully priced in, however, leaving continued negative sentiment around bio-tech in general as the biggest risk factor beyond the obvious risks with a drug in development.
Fortunately, however, this is a risk that is fairly easy to guard against. Simply shorting the industry as a whole by selling IBB or another bio-tech ETF when you buy THRX leaves you with a pure play on the relative success of the individual stock. If THRX is dragged down by continued weakness overall, then your short will compensate for that.
You could of course, get lucky and make money on both your hedge and your main holding if good news causes THRX to buck a general downward trend. Again, this is still not for the risk averse, but for those who don’t mind risk, it is a better option than being blinded to decent opportunity in individual stocks by the poor performance of the sector.
We may well be witnessing the deflation of a bubble in bio-tech, but that doesn’t mean that there aren’t opportunities in the sector. By investing in a company with something interesting in the pipeline but shorting the industry as a whole you can still make reasonable bets on those individual therapies. As some of the leaders of the recent move up have shown, the upside on these bets is big enough to make them attractive, even in a more risky market environment. Hedging that sector risk may be the answer.