Tuesday, August 19, 2014

Picking individual stocks vs. an ETF in the healthcare sector

I’ll start by saying that the vast majority of investors should go the ETF route. The Nasdaq Biotech Index (NASDAQ: IBB) outperformed the broader markets by leaps and bounds from 2011-2014. And these stellar gains came with minimal risk because of the diversified nature of ETFs in general.

IBB Chart

Perhaps the biggest reason to forget putting together your own portfolio is the amount of work involved. At this point, I hope I’ve impressed upon you the tremendous amount of due diligence involved in picking your own stocks in this unique sector. An ETF allows investors to minimize their risk and gain exposure to most, if not all, of the biggest names in biotech/healthcare in one fell swoop.

So why go through all the hassle?
The truth of the matter is that the top performers in the sector have rarely been included in funds like IBB prior to their big moves upwards. In effect, they tend to be added after they hit certain market cap thresholds.

Most funds therefore tend to be backwards-looking investing vehicles. In other words, companies are added to a fund because of their previous success at meeting certain criteria--not necessarily because of their promise for future gains.

Complicating matters, most fund managers tend to shy away from companies without a proven track record of success. Even so, these are the companies with the highest upside potential.

To drive this point home, let’s take a look at the five best performing stocks in the healthcare sector year-to-date: IsoRay, Intercept Pharmaceuticals, Idenix Pharmaceuticals, RadNet, Inc, and InterMune, Inc. 

A quick look at this list will reveal one insightful fact: not one of these companies is presently a top holding in IBB at the time of writing this piece.

One of your main goals as a stock picker should be to identify promising companies before they begin to soar. Put simply, you want to be forward-looking when making investment choices, which is perhaps the biggest reason to take on this challenge.

Why do funds typically fail to capture the sector’s hottest stocks?
Ever since the biotech craze began in 2011, under-the-radar mid-caps have outperformed their better known and larger peers for the most part. And surprisingly enough, they have done so with comparable levels of volatility.

The underlying reason(s) why mid-caps have led the charge so to speak is because they have been the leaders on the innovation front for the most part. Companies like Seattle Genetics (NASDAQ: SGEN) have helped developed promising new therapies like antibody drug conjugates, or ADCs; Acadia Pharmaceuticals (NASDAQ: ACAD) looks like it has one of the first effective treatments for Parkinson’s disease psychosis on its hands; BioMarin (NASDAQ: BMRN) has led the way on the fight against rare diseases; and many of the new functional cures for hepatitis C hitting the market recently started out in the labs of smaller biotechs--before being scooped up by the likes of AbbVie (NYSE: ABBV) and Gilead Sciences (NASDAQ: GILD).

By contrast, nearly all of the large pharmas that inhabit healthcare funds have been dealing with an avalanche of patent issues that have hit their top line growth hard during this same time period. AstraZeneca, Merck & Co., Pfizer are just a few top names that have seen falling profits in recent quarters.

In fact, Johnson & Johnson (NYSE: JNJ) is one of the few exceptions to this trend among big healthcare companies, but a closer examination reveals some important insights worth taking to heart. Specifically, J&J’s strong top-line growth has been generated almost solely by its pharma segment lately, which has been posting double-digit sales growth.

Digging deeper into this story, we see that almost all of this growth is due to the strong commercial performance of two relatively new drugs, Olysio for hepatitis C and Zytiga for advanced prostate cancer. In short, J&J’s contrasting path compared to its peers reflects the sector-wide trend of top-line growth being driven by recent innovations in the drug business. This is a feat that has so far escaped most other big pharmas; although Amgen and Merck are pushing hard to replenish their depleted drug portfolios.

Based on the strength of biopharma compared to medical devices and consumer goods/services in healthcare of late, we’ve seen a number of companies float the idea of spinning off their pharma segments into separate entities. Baxter International and Pfizer have both stated that they will pursue this route to unlock value for shareholders, but struggling pharma giants like GlaxoSmithKline are also likely to at consider riding this wave to help boost falling share prices.

Returning to the topic of why ETFs fail to capture the best performers sector-wide, it’s important to understand that ETFs often won’t adjust their holdings based on prevailing business trends like those discussed above. Instead, an ETF, and even broader-based index funds, typically use market cap as an important factor for inclusion. Why? The reason is that larger caps are inherently less volatile and have fewer risks associated with them.

And if the truth is told, fund managers are more concerned about looking foolish to their peers than making money. As a result, they often end up sticking with time-tested names, even though they might be struggling in a given market. Remember, psychology and group-think are major factors driving market behavior. As your own investment manager, you are free to break these psychological bonds and go against the grain to generate market-beating returns.

Taking this one step further, a perfunctory analysis will show that market cap has been working against many of the former healthcare stars lately—a fact these companies are even quick to recognize by considering downsizing in order to unlock value. Even red hot companies like Celgene (NASDAQ: CELG) and Gilead appear to have run up against a market cap wall in 2014, as investors seek out more compelling valuation propositions among healthcare stocks. As a result, the IBB has started to show weakness this year, falling well off of its torrid pace a year ago.

Going the ETF route is probably a good idea for most investors in a sector as complicated as healthcare. By doing so, however, you will undoubtedly be missing out on the very best investing opportunities, given that ETFs are specifically designed to minimize risk and to keep their managers in a job! Foregoing an ETF therefore offers the chance to pursue much larger gains in a sector known for its penchant for producing a handful of multi-baggers each year.

In sum, this is a sector with a plethora of compelling investment opportunities, but the substantial levels of risk awaiting you shouldn’t be taken lightly by any stretch of the imagination. So investors willing to put in the work, leave emotion behind, and that have an iron stomach, are perhaps the only ones that should decide to take on the daunting challenge of picking their own healthcare stocks.

And if you think these risks don’t apply to you, I recommend looking into the story of Sarepta Therapeutics (NASDAQ: SRPT) before it fell over 70% in a single day in November 2013. A lot of smart people--including professional fund managers, got caught flat-footed on that stock. And this is but a single example among a sea of biopharma implosions that wiped out many brave investors. Put simply, the danger of venturing away from broad-based funds is very real indeed.  

Looking ahead, I hope to convey some of the methods that have helped me stay afloat in this turbulent sector--and to even profit! Like almost everyone else in healthcare, I have taken my fair share of single day beatings. This is all part and parcel of playing the healthcare game. And perhaps learning to deal with the gut-wrenching emotions that come with getting pummeled in the market are equally as important as doing your due diligence.

In the next chapter, I’ll delve into my overarching strategy that has served me well when putting together a healthcare portfolio and further chapters will go into the details of specific strategies and healthcare markets.