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In the past three months, the average health-care mutual fund has eked out a return of only 3%, little more than half the stock market's advance. Hanging over the sector is the prospect of price controls, which the new Democratic majority in Congress made a priority in the last election.
In the same period, however, Franklin Biotechnology Discovery A (FBDIX) shot up 10.8%. First Trust Amex Biotechnology Index (FBT) did nearly as well, darting up 9.1%. Fidelity Select Biotechnology (FBIOX) managed a market-beating 5.9% return.
The sudden emergence of biotech, which was savaged along with computer stocks in the bear market of 2000-02, calls attention to a group that is relatively recession-proof, has high barriers to competition and may be immune to any legislative upheaval.
The number of new drugs being developed is growing, and the number of customers for those drugs is exploding, says Evan McCulloch, a co-manager of the Franklin fund. The baby-boom generation is approaching retirement, and 70-year-olds take eight times as many prescription drugs as 20-year-olds, on average.
Stocks for a strong stomach
Biotechnology stocks are not for the fainthearted. The Franklin fund soared 160% in the three months that ended Feb. 28, 2000, plunged 38% in the succeeding three months, then surged 58% in the three months after that.But that volatility is inspiring to traders, who can choose among two excellent exchange-traded index funds to play the group for months, weeks or even days. For long-term investors, there are three outstanding mutual funds and one ETF from which to choose when the group is cheap, as it is now.
"I think we've certainly reached a 10-year low in terms of valuations for most of the health-care sector, including pharmaceuticals and biotechnology," says Michael Sjöström, the chief investment officer of Sectoral Asset Management, an adviser to Quaker Biotech Pharma-Healthcare A (QBPAX).
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Before the bear market, health care was one of the most reliable growth sectors in the economy. It is largely immune to the business cycle; you don't stop taking your medications during a recession. Since the bear market, overall spending on health care has continued to grow in the 8% to 10% range annually, compared with 3% to 4% for the economy as a whole.
Lately, big pharmaceutical companies have taken a beating in the market because so many of them are losing patent protection on yesteryear's blockbuster medications, including cholesterol drugs such as Zocor. Generic pills sell for pennies, and health-maintenance organizations strongly pressure physicians to prescribe them.
Biotechnology is a different game. Biologically engineered pharmaceuticals are proteins, big molecules that the stomach recognizes as dinner, and digests. So nearly all of these drugs are injected. That means, McCulloch says, "there isn't any way to get a biotech generic equivalent on the market. There may never be a true biotech generic."
Prices of biological drugs are often astronomical. Under fierce pressure, Genentech (DNA, news, msgs) agreed in October to cap the total cost of its cancer drug, Avastin, at $55,000 annually, but only for needy patients. The regular price for the high dosages needed to treat certain lung cancers is more than $100,000 a year.
A thin menu of funds
Morningstar's database lists only about a dozen biotech funds, half of them exchange-traded funds, or ETFs. And that's just as well because the industry itself is tiny. Only a few companies have a substantial market capitalization; InterMune (ITMN, news, msgs), the largest holding of the First Trust fund, is barely out of small-cap range with a cap of $1.05 billion.Long-term investors will probably prefer an actively managed mutual fund to an ETF because stock selection is crucial. Only three have decent performance records: Franklin and Quaker, for load-fund investors, and Fidelity, for those who prefer no-load funds.
| Performance in % | |||
|---|---|---|---|
Mutual funds | One year | Three years | Five years |
Franklin Biotech Discovery A (FBDIX) | 4.0 | 7.6 | 1.2 |
Fidelity Select Biotechnology (FBIOX) | 2.8 | 8.4 | 0.8 |
Quaker Biotech Pharma-Health A (QBPAX) | 10.9 | 7.9 | N/A |
Exchange-traded funds | |||
N/A | N/A | N/A | |
N/A | N/A | N/A | |
-8.0 | 11.6 | 7.8 | |
Notes: Periods ended Jan. 4, 2007. Annualized for three- and five-year periods. N/A: Not applicable; fund was not available the entire period. Sources: MSN Money, Morningstar | |||
The Franklin and Quaker funds are fundamentally different in their approaches to the sector. Franklin owns about 60 stocks, including big names such as Amgen (AMGN, news, msgs) and Genentech, and has an average market cap of $4.6 billion. Turnover is a sedate 37%, suggesting an average holding period of three years.
Quaker owns only about 30 stocks and has more than half its assets in the top 10 positions. The fund leans toward small and midsize companies; the average cap is $2 billion. Trading is heavy, with an average holding period of about six months.
The Fidelity fund, which with assets of nearly $1.5 billion has half again as many assets as all other funds in the industry combined, shares attributes with each of its principal rivals. It owns about 65 names but concentrates more than 60% of assets in 10 of them, which likewise include such big names as Genentech and Gilead Sciences (GILD, news, msgs). The average market cap tops $5 billion, and turnover is a serene 34%.
3 more paths to biotech
Among the ETFs, the leading choices are between two index funds, First Trust Amex and SPDR Biotech. Neither fund has been around a full year, but their indexes have.Both indexes are equally weighted, meaning they own equal dollar amounts of their constituent stocks. The SPDR represents a basket of about 14 biotech stocks representing many of the industry's biggest and best-established players, such as Amgen and Gilead Sciences. The First Trust index constitutes 20 securities that on average are actually slightly bigger than the SPDR's holdings, but they do include a few more-obscure players.
One of them is InterMune, and that stock by itself accounts for the lion's share of recent performance. In October, the developer of treatments for hepatitis C announced a deal with Swiss-based Roche Group potentially worth half a billion dollars. The stock subsequently soared more than 80%.
Thus the First Trust fund is likely to be more volatile than the SPDR, for good or ill.
The third ETF is a very different kind of portfolio, more suited to long-term investors than short-term traders. It is Biotech HOLDRS, and its shares, or receipts, represent shares in 17 companies, and the receipts are exchangeable for those company shares. If some of them experienced big losses, for example, you could make the exchange and sell the losers for a tax deduction. You can hold onto winners as long as you want, meaning taxable distributions are never foisted on you, as mutual funds are required to do.
Biotech HOLDRS is by no means equal weighted: Nearly 64% of assets are in just two stocks, Amgen and Genentech. But the other 15 holdings could be tomorrow's big winners; weighting in Biotech HOLDRs varies with performance in the market.
Because HOLDRS receipts can be exchanged for company shares, they must be purchased in round lots of 100, which at the biotech's recent share price of $189 means increments of $18,900, plus commissions. But annual expenses are a maximum of 0.08%, a fraction of the 0.35% charged for the SPDR and the relatively huge 0.60% charged by First Trust.
Most investors avoid industry-specific funds like these because they crave diversification, and these provide the opposite. But health-care professionals, young risk takers and others willing to put money behind such a narrowly targeted investment could find biotech intriguing.
And recession-proof industries priced at a bargain could appeal to an even broader audience than that.
At the time of publication, Tim Middleton didn't own any securities mentioned in this article.
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