Description

After a brief sell-off earlier this year, biotechnology stocks have resumed their upward climb, and continue to exhibit the earmarks of an overheated, speculative market.  Thus, I recommend shorting shares of the SPDR S&P Biotech ETF (XBI), as XBI is the best vehicle for shorting a basket of biotechnology stocks.

Overheated, Speculative Market.  The biotechnology sector shows the typical signs of an overheated, speculative market:

• Both the NASDAQ Biotechnology Index (NBI) and the S&P Biotechnology Select Industry Index (SPSIBI) are trading at near peak multiples of price to sales and price to book.  NBI is valued at over 8x sales and over 7x book, while SPSIBI is valued at over 13x sales and over 7x book.
• There were 38 biotech IPOs in 2013, the most since the year 2000, which featured a record 63 biotech IPOs.  So far in 2014, there have been 35 biotech IPOs, which puts 2014 on pace to break the record set in 2000.  Furthermore, an increasing number of recent IPOs are for early stage companies (companies that have not yet completed phase 2 clinical trials).  Specifically, in 2013, at least 50% of the IPOs were for companies that had not completed phase 2 trials, while in 2014's first quarter, 60% of the IPOs were for such early stage companies.  This is in contrast to the comparable figures from previous years:  2010 - 33%; 2011 - 0%; and 2012 - 9%.  Putting this in perspective, according to figures published in Nature Biotechnology covering the period from 2003 to 2011, the rate of final approval for large molecule drugs was as follows:  drugs in phase 1 - 13%; drugs in phase 2 - 20%; and drugs in phase 3 - 53%.
• The recent sell-off did not remove the froth from the market.  The NBI is up nearly 13% year to date, after rising 66% in 2013, while the SPSIBI is up nearly 17% year to date, after rising 48% in 2013.

Shorting via an ETF.  One cannot profitably select individual biotechnology stocks (long or short) without a comprehensive understanding of the underlying science.  Without creating an unrealistically large basket, the same limitation applies to selecting the constituents of a short basket.  Thus, I recommend shorting biotechnology shares by shorting a biotechnology ETF with a broad spectrum of holdings.

One may reasonably ask why, if an investor does not have the requisite knowledge to select individual biotechnology stocks, the investor is justified in believing that biotechnology stocks in general are overpriced.  The answer:  (1) By relying on financial and market history and, more specifically, by relying the history of prior speculative markets, both in general and in biotechnology stocks specifically; and (2) a general understanding of economics and an appreciation for reversion to the mean.  It is theoretically possible that a thorough study by a knowledgeable investor of all the companies comprising XBI would yield the conclusion that the prospects for most (or even all) of these companies were unusually favorable and, therefore, valuations were justified.  History suggests that the odds of this are low, but they are not zero, and the position should be sized accordingly.

XBI versus Other ETFs.  Of the biotechnology ETFs, XBI is the best choice for shorting the sector.  XBI tracks the S&P Biotechnology Select Industry Index, an equal-weighted index comprised of 78 stocks.  The combination of a large number of stocks with equal weighting ensures that results won't be disproportionately dependent on just a handful of stocks.  XBI's makeup also ensures that its fortunes are not predominantly tied to the established large cap biotech firms.  A list of other biotechnology ETFs, and the reasons they were rejected, follows:

• iShares Nasdaq Biotechnology ETF (IBB).  IBB tracks the NASDAQ Biotechnology Index (NBI), a capitalization-weighted index comprised of approximately 120 stocks.  Although it includes 120 stocks, IBB's results are disproportionately affected by its top holdings.  IBB's top five holdings (CELG, AMGN, GILD, BIIB, and ALXN) represent a 38% weighting and its top ten holdings represent a 55% weighting.
• Market Vectors Biotech ETF (BBH).  BBH tracks the Market Vectors US Listed Biotech 25 Index.  The Market Vectors Index is a modified market cap weighted index that tracks the performance of the 25 largest and most liquid US-listed companies that generate at least 50% of their revenues from biotechnology.  BBH's results are disproportionately affected by its top holdings; its top four holdings (GILD, AMGN, CELG, and BIIB) represent a 45% weighting.  A decision to short BBH is, to a significant extent, a decision to short GILD, AMGN, CELG, and BIIB.
• First Trust NYSE Arca Biotechnology Index Fund (FBT).  FBT tracks the NYSE Arca Biotechnology Index, an equal weighted index of 20 companies in the biotechnology industry.  Although it is an equal-weighted index, the small number of constituents means that results can be disproportionately affected by just a few holdings.  Further, the index is heavily skewed to the established large cap biotech firms.
• PowerShares Dynamic Biotechnology & Genome Portfolio (PBE).  PBE is based on the Dynamic Biotech & Genome Intellidex Index, which is comprised of 30USbiotechnology and genome companies.  Companies are included in the index based on a variety of investment merit criteria, including price momentum, earnings momentum, quality, management action, and value.  In other words, it is actively managed.

XBI and SPSIBI - Inclusion and Removal Criteria.  XBI tracks the S&P Biotechnology Select Industry Index (SPSIBI).  SPSIBI is an equal weighted market cap index representing the biotechnology industry group (based on GICS classification) of the S&P Total Market Index.  The Total Market Index tracks all U.S. common stocks listed on the NYSE (including NYSE Arca and NYSE Amex), the NASDAQ Global Select Market, the NASDAQ Select Market and the NASDAQ Capital Market.

SPSIBI is rebalanced quarterly, with rebalancing occurring on the third Friday of the quarter-ending month (March, June, September, December).

The market capitalization criteria for inclusion in, and removal from, the SPSIBI are as follows:

• Market capitalization above $500 million, subject to defined liquidity criteria.
• Market capitalization above $400 million, subject to more stringently defined liquidity criteria.
• Existing index constituents are removed at the quarterly rebalancing if their market capitalization falls below $300 million or if they fail to meet defined liquidity criteria.

XBI and SPSIBI - Constituent Company Characteristics, Valuation Characteristics.

• The index was rebalanced on June 20, 2014 and consists of 78 constituent companies, down from 82 after the last rebalancing.  However, the number of constituent companies has dramatically increased over the past three years, from 30 companies at the end of 2010, to 49 companies at the end of 2012, to 78 companies today.  This significant increase in the number of constituents, many of which are development stage companies, is itself another indication of a speculative market.
• Of the 78 companies, over 40% do not have a single drug approved.  Although most of the companies in this group are either in phase 3 trials or have filed applications for approval, 10% of the index constituents are, at best, in phase 2 trials.
• Of the 78 companies, 22 have annual revenue of less than $10m (8 have zero revenues), and only 14 constituent companies showed a profit over the past twelve months.
• The index trades at over 7x book, near its all-time high of 7.7x in 2009, and well in excess of its historic average.
• The index trades at over 13x sales which is, by a significant margin, its highest multiple since 2001.
• Since July 1, 2012, XBI has shown a slight positive tracking error, because securities lending revenue (from lending shares to short sellers) has exceeded the cost of advisory fees.  Currently, over 20% of XBI's shares are out on loan (the fund has a cap of 33%).

Borrow.  I had no problem shorting XBI shares, and the shares are not currently listed as "hard to borrow" by my broker (Fidelity).

Conclusion.  XBI, with its large number of equally weighted holdings, and its significant exposure to development stage companies, is the best vehicle for shorting the overheated, speculative biotech sector.

Risks:

New paradigm.  It is conceivable that recent technological advances have resulted in more productive R&D, yielding higher drug approval rates.  This, if true, when combined with favorable demographics for the health care industry generally, could mean that current valuations, especially for development stage companies, are justified.  I am skeptical, but this possibility can't be ruled out completely.

M&A.  A short position is vulnerable to acquisitions of index constituents at large premiums.  Idenix (IDIX) illustrates the point.  On June 9, Merck announced that it had agreed to acquire IDIX for $24.50 per share in cash, representing a 200%+ premium over IDIX's previous closing price.  The acquisition is noteworthy for two reasons.  First, the index jumped 6% on the day of the announcement, primarily as a consequence of the increase in IDIX's share price.  Second, IDIX is revenue-free, and is only in phase 2 in its drug development cycle.

Structure of the Index.  The combination of equal weighting and quarterly rebalancing will reduce the impact of failing companies on the investment result.  Failing companies will be kicked out of the index after falling below market cap thresholds, so losers won't be ridden down to zero.  I suspect a static index comprised of the current 78 constituents would yield better results.

Speculative Market Risk.  The risk of shorting any speculative market - now that XBI and IBB, etc. have resumed their ascent, they could continue to go higher before they go lower.

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