Strategies For Uncertain Times: biotechnology strategy update

Yesterday Bespoke Investment Group put out a blog post about the strength of health care stocks as of late. The title of their post is “Health Care ETFs Catch Fire” and the link is here: http://www.bespokeinvest.com/bespoke/2009/12/health-care-etfs-catch-fire.html

They attribute the sector’s strength to the Senate’s actions re: the proposed health care bill. I don’t disagree. They note, for example, the strength in XLV (Health Care Select Sector SPDR).

Examining HQH (H&Q Healthcare Investors), their portfolios share a few of their top 15 holdings (3 to be exact), although that’s not a terribly high number and the allocations to each security are not even close.

Between 9/15 and 12/5 (a 3 month period) XLV has returned 10.7% including at 13c dividend paid. During the same period HQH has returned 3% and it’s discount vs. NAV shrunk very slightly to 20.57% from 21.79% (it has not made any distributions). During the same period the PBE PowerShares biotech index has declined 2%.

So… this raises an interesting question: Should we either assume that 1) biotech lags overall health care sector price movements and will catch-up, or 2) does biotech trade independently with a low correlation versus even its parents sector overall, or 3) does biotech have unique challenges that have presented new reasons for investors to be cautious over the last 3 months?

I hypothesize that the correlation is actually pretty low (I keep screwing around with various beta calculations and get something between 0.5-0.6 between HQH and XLV, but these are not concrete numbers). Furthermore, if I examine the holdings of the XLV portfolio and other health care portfolios that have been rocking and rolling as of late, it’s clear that the parent industry portfolios have larger concentrations in the big cap pharma, services, and insurance names (closer direct impact to proposed health care legislation). That said, there is some overlap but the biotech names are smaller and less widely owned. Perhaps they are the less-desirable short-term trading vehicle?

The bottom line is that I don’t have the answer, but I do know that the CEF discount for HQH is still well above its historical average, and as their distribution was already cut a while back, I don’t see much downside in holding shares of the fund. However, the combination of not much downside and an uncorrelated investment makes HQH attractive in my eyes as a piece of an larger portfolio with a overall perspective of Strategies For Uncertain Times.

Strategies For Uncertain Times: Biotechnology

Overview: Biotech funds typically hold mostly equities of listed biotech companies, although some have private company stakes as well. Biotech stock returns have a relatively low correlation with overall equity markets (if you cure cancer, who cares what the S&P or the US economy might do next year).

Biotech/Healthcare

Overview: Low correlation with S&P, should get boost post government healthcare policy announcement. Valuations are below historical averages. Large cash balances at mega-cap pharma co’s should lead to M&A activity. Low current income/dividends means probably best to hold in a taxable account if you plan on holding for longer than one year period. Uncertainty regarding potential government policy/regulation has created an opportunity via unusually large CEF discounts.

• Open-end mutual funds:
  • PHLAX: Jennison Health Sciences
    • Jennison is outstanding in the healthcare space
  • FSMEX: Fidelity Medical Equipment & Systems
• CEFs:
  • HQH: H&Q Healthcare Investors
    • Has 0.77 beta w/ S&P
    • More service/distrib names than HQL, later-stage than HQL, larger cap
    • More liquid trading than HQL
    • Higher short interest than HQL, funds are adding to existing positions
    • Have about 15% of funds in private co’s via restricted stock/convertibles
    • Spoke w/ PM of both H&Q funds: Dan Olmstead – there since 2001
    • PM believes discount partially due to healthcare reform uncertainty = catalyst
    • PM believes suspension of distributions widened discount
    • PM believes share buyback will close discount, can buyback up to 10% of fund
      • Buyback was announced on 10/9/09
  • HQL: H&Q Life Sciences Investors
    • Earlier-stage than HQH, more biotech oriented
    • Smaller cap than HQH
  • BME: BlackRock Health Sciences
    • Great track record but doesn’t have the discount of HQH
• ETFs:
  • PBE: Very diverse
  • IBB: Midcaps, 120 holdings, low fee
  • XBI: Only 28 holdings but not concentrated, low fee
  • PBTQ: 43 holdings, 20% foreign, low volume, high fee
  • DBR: Wisdomtree INTERNATIONAL healthcare ETF, weighted by dividends paid
    • This makes it a good LT holding but not necessarily a ST strategy

Other Notes:

• Slowing growth rates for the mega-firms will spur acquisitions of smaller firms to inorganically boost growth rates and to buy pipeline/technologies instead of self-funding internal R&D.
• Biotech stocks have historically traded around 20x PEs and are now in the 14-15x range.
• BUY BEFORE THE HEALTHCARE DEAL IS ANNOUNCED. SHOULD BE A SELL THE RUMOR, BUY THE FACT RALLY.

Strategies For Uncertain Times: THE OVERVIEW

I believe that tremendous uncertainty supports the adoption of hedge fund replication strategies.

At the end of 2008 I felt very certain that, given the oversold levels of various equity markets around the world, a basket of China, India, and LatAm (Brazil) were extremely likely to experience very solid price appreciation. Multiples for their respective indexes were lower than they were in the US (which is rare) and I knew that emerging market economies will precede the US coming out of the trough of the macro cycle. Additionally, their macroeconomic situations were comparatively healthy versus the US. In retrospect, it was a no-brainer and a huge winner. I nearly bottom-ticked those equity markets and ended up doing extremely well on a percentage/relative basis as their TTM performance has been stellar.

This year I have the entirely opposite mindset: I have ZERO idea what will happen to equities over the next two years and I think anyone who says they do is selling a theory that they can’t realistically support as actually PROBABLE. Hence, I’ve put together a list of strategies/asset classes that, in aggregate, satisfy my desire to make money over the next year or two. Some ideas are targeted at generating current income, some ideas are targeted at capturing potential equity market appreciation, and some ideas are just uncorrelated strategies or asset classes that offer non-equity means of potentially increasing in value (income plus price appreciation).

Some people refer to compiling these strategies and/or adding non-equity  asset classes  as “hedge fund replication” whereas I just call it considering your alternatives (zing). I believe that, while unlikely to repeat the huge outperformance of my portfolio this over past 12 months, this strategy should produce sold tax-managed returns with favorable volatility over the next one to two years. This is really just a study I prepared for myself (AKA The Dan-Don’t-Be-Broke-Portfolio), but you might find some interesting info for yourself.

There is a considerable amount of disagreement about the definition of the term “hedge fund replication” but, to me at least, it means any combination of three things: 1) not being exclusively long equities (long only), 2) maintaining short exposure as a hedge against bearish moves in equities or the economy overall, and 3) looking at various asset classes and strategies that seek to generate uncorrelated or low-correlation returns with equities.

Clearly 2008 demonstrated that many “hedge funds” were not appropriately hedged, if at all. If the S&P was down 30%+ in 2008 and hedge fund XYZ was down roughly the same amount, then they did not come close to producing returns for their investors that were either 1) positive on an absolute basis (greater value at end-of-period than at beginning-of-period), or 2) positive on a relative basis (lost less value on a percentage basis than the S&P, which is admirable but still fails to increase investor wealth), and 3) most likely generated a return that was highly correlated with the performance of the S&P, which is not acceptable given that investors pay high fees to hedge funds in the expectation that they do NOT produce results similar to what the overall equity market does.

This list is not inherently “fully hedged” or “market neutral” but the list (when aggregated as a portfolio) has a correlation with the S&P of less than 1.0 and potentially has the ability to increase in value even if the S&P falls.  Obviously, my allocation to each of these strategies will vary greatly depending on changes in value, and I might not even currently employ any one of them at all.

Non equity asset classes:

-Commodities

-Debt (emerging market)

-Debt (floating or variable corporate)

-Muni bonds

-Closed end fund (CEFs) arbitrage

-Private equity and/or venture capital (PE and VC)

-Currencies

-Convertible bond arbitrage

Equity-based strategies:

-Merger arbitrage and special situations

-Closed end fund Fund-of-Funds (CEF FoF)

-Biotechnology

-Stock buyback funds

Covered call funds (buy-write strategy)

Real estate (US and/or international)

Long/short equity (partially hedged or market neutral equity)

Managed futures (this can mean several things)

—————————-

I have prepared my own investment guide that spans all of these strategies. You can download it by clicking here.

Strategies For Uncertain Times

I prepared it awhile back, so it may not reflect current market conditions, valuations, or discounts. It is based on my own financial situation, goals and objectives, risk profile, and tax considerations. My picks/selections are bolded, there may be two per strategy/asset class. In many cases I prefer closed-end mutual funds (CEFs) b/c they trade on an exchange like stocks, and frequently trade at discounts to their “net assets” per-share, which occasionally creates a built-in margin of safety. I will continue to hold a good portion of emerging market equities, which I trade in and out of depending on valuation on price changes. I hold HAO for China, GML for Latin America, RSX for Russia, and EPI for India. I just typed up my handwritten notes, so there are plenty of abbreviations, typos, and short-hand notes. The format isn’t meant to be anything more than acceptable, so just call me if you have a question about what something means or what I’m thinking.