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03/26/15 05:00:20 PM
FUND STRATEGIES

BIOTECH HAS ROOM TO RUN

Biotechnology has been one of the best performing industries in the stock market over the past several years. According to S&P Capital IQ, there were numerous catalysts, for this substantial stock outperformance, including several blockbuster drug approvals that drove significant sales and earnings growth. Yet, we think the industry's drivers, including a robust pipeline, remain intact and have a positive fundamental outlook.

S&P Capital IQ equity analyst Jeff Loo notes that expects approximately a dozen drugs to be approved and launched in 2015 with the potential to achieve blockbuster sales levels of more than $1 billion annually by their fifth year after launch (2020). Total sales for the seven biotech companies in the S&P 500 rose 41.5 % in 2014, driven by new drug approvals, and aided by Gilead Sciences (GILD 100 *****) sales growth of 122%. In 2015, our forecasted rate of increase moderates to 13.2%, nonetheless, an impressive rate, in our view. Loo projects gross margin for those seven S&P 500 constituents, which also includes Celgene (CELG 117 *****), to widen to 89.8% in 2015, from 88.6% in 2014.

From January 1, 2011 to December 31, 2014, the S&P 1500 Biotechnology stock index rose 288.5% compared with the 63.6% rise for the S&P Composite 1500. As such, the S&P 1500 biotech industry's valuation has expanded significantly from 12X forward 12-month EPS in 2011 to 18X in 2014. However, in spite of the significant multiple expansion, biotech's current 19.1 multiple is equal the health care sector's PE multiple of forward 12-months EPS and only slightly higher than the broader S&P 1500's PE multiple of 18X, despite much stronger growth.

Loo notes that in March 2015, the FDA approved the first biosimilar, Zarxio, manufactured by Sandoz , as a substitute for Amgen's Neupogen. Although we see price competition and erosion, we do not anticipate the same level of price erosion that chemically based pharmaceuticals face when a generic hits the market. We see biosimilars being priced at about a 30% discount compared with the 90%-95% discount that is typical for generics.

Investors have increasingly utilized ETFs in a tactical manner to gain exposure to industries, while benefitting from the ability to make intra-day trades and benefit from their low-cost, passive nature. In 2014, $41 billion was added to all sector ETFs, with nearly $6.4 billion in health care securities. In the first two months of 2015, health care products added an additional $3.0 billion of fresh money.

iShares Nasdaq Biotechnology (IBB 346 Overweight), First Trust NYSE Arca Biotechnology (FBT 346 Overweight) and SPDR S&P Biotech (XBI 217 NR) , the three largest most direct ways to gain exposure to the biotech industry, experienced combined net inflows of more than $1.6 billion in 2014. However, in the first two months, the trio had already added a collective $1.2 billion of inflows. While IBB and FBT primarily provide exposure to larger- cap biotechs, IBB is more concentrated. Top-10 assets comprised 56% of assets compared to 34% for FBT.

IBB is a market cap weighted ETF, meaning the largest companies, including Amgen (AMGN 163 ****), Biogen (BIIB 433 ****), CELG and GILD, tend to dominate the portfolio. S&P Capital IQ views all four of the stocks as undervalued on both a qualitative and quantitative basis and not surprisingly the ETF ranks favorably from both a STARS and Fair Value perspective.

Meanwhile, FBT holds just 30 stocks compared to 153 for IBB, but is equally weighted and rebalanced four times a year (the next time in mid-April). As such, the ETF has more exposure currently to Intercept Pharmaceuticals (ICPT 262 NR), a $6.5 billion biotech company, as it does to AMGN, BIIB, CELG and GILD. FBT ranks favorably from a STARS perspective, but is neutral from a Fair Value perspective.

Both of these ETFs also provide exposure to pharmaceutical and life sciences stocks. Meanwhile, XBI holds just biotechnology stocks yet has more exposure to smaller-caps. Indeed, XBI's weighted average market cap was $8 billion, compared to IBB's $44 billion and FBT's $24 billion.

Like FBT, the ETF is equally weighted and rebalanced quarterly, but holds 88 stocks. Top-10 holdings comprised 17% of assets, including ICPT and Foundation Medicine (FMI 47 NR), a stock that doubled in value in January 2015, after Roche Holdings acquired a majority stake.

In 2014, FBT climbed 48%, outperforming the otherwise impressive 45% and 34% for XBI and IBB, respectively. Year to date through March 25, XBI was the stronger performer of the trio. However, past performance is not necessarily indicative of future results.

We think XBI's inclusion of smaller-caps contributed to its higher standard deviation relative to FBT and IBB. However, with a 0.35% expense ratio, XBI has the cheapest of the three. S&P Capital IQ has various risk consideration and cost factors to support investor analysis, but we do not rank enough stocks in the ETF with a STARS or Fair Value to enable us to establish an overall ranking.

S&P Capital IQ believes industry ETFs can incur elevated risk that investors may not want. As such investors who agree that the fundamentals for biotech are positive may want to consider some more diversified health care ETFs. Health Care Select Sector SPDR (XLV 73 Overweight) and Vanguard Health Care (VHT 135 Overweight) have approximately 20% of assets in biotechnology, second only to pharmaceuticals.

To learn more about these five ETFs or various biotech stocks please refer to the S&P Capital IQ reports.

 

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