Biotech: Q3 Market Update

by: R. Scott Raynovich

In Q3 2009, life science and biotech stocks kept pace with market sectors that offer comparable risk and performance such as small-cap growth, science and technology, and midcap growth.

The Rayno Report (raynoreport), in conjunction with our contributing partner Raygent Associates (raygentassociates), tracks the biotech market and a model portfolio. The broadly diversified biotech ETF -- IBB -- was up 16%, moving from 70 to 81 in the three-month period. About 50% of the IBB holdings are large cap companies such as Amgen (NASDAQ:AMGN), Celgene (NASDAQ:CELG), Genzyme (GENZ), Gilead (NASDAQ:GILD) and Teva (NASDAQ:TEVA). The IBB was flat for the year as of July 1, so all the gains came in Q3.

The Fidelity Select Biotech Fund was up 9.4% YTD and underperformed due to overweighting in large caps such as Cephalon (NASDAQ:CEPH), Genzyme, and Gilead. The fund was underweight in tools and diagnostics, where a lot of upside performance was found.

The key drivers to biotech performance have not changed over the past few years, but M&A activity has come to the forefront as several acquisitions have sparked the sector:

* Abbott (NYSE:ABT) announced a play to buy Solvay (OTC:SVYSY) for $6.6B.

* Bristol Myers (NYSE:BMY) completed the acquisition of Medarex (MEDX) for $2.4B

* JNJ bought Cougar (CGRB) for $1B, 18% of Crucell (NASDAQ:CRXL) for $441M, and 18% of Elan (NYSE:ELN) for $885M.

* Sanofi (NYSE:SNY) bought Merial for $4B

The vaccine area was almost entirely abandoned by large pharmaceutical companies in the 1980s, but now that area accounts for many of the deals. New immunotherapy technologies and a greater market need for disease prevention against new infectious agents such as swine flu has brought vaccines to the forefront.

Building a long-term product pipeline has always been an arduous process for large-cap pharma companies, as it requires a development process of 7-10 years with costs in the range of $1B per drug and a high risk of failure. The acquisition route has become more attractive because of good technology value. The deal-making is helped by the fact that there is a shortage of capital for smaller biotech companies in the current post-meltdown market environment.

Over the past few weeks, several analysts have rushed to put out their biotech acquisition lists spurring rallies across the screen. Another factor mentioned is that biotech products may be less affected by healthcare reform than more mature drugs.

The Portfolio that we track -- The Rayno Life Science portfolio -- was up 13% YTD and higher for Q3.With higher weighting of selected stocks as we recommended, it could be up as high as 15%. For more details go here.

The big winners in the portfolio with Sep 30 prices and in order of stock appreciation YTD:

Targacept (TRGT): up 700% at 21.3

Abaxis (NASDAQ:ABAX) up 65% at 26.75

Inverness (IMA) up 58% at 38.75

Illumina (NASDAQ:ILMN) up 55% at 42.50

United Therapeutics (NASDAQ:UTHR) up 45.5% at 49

Among the losers in the portfolio were Array BioPharma (NASDAQ:ARRY), Celera (NASDAQ:CRA), Cephalon, Cubist (CBST), Gilead, and Viropharma (VPHM). Cubist, Gilead, and Viropharma are now recovering.

The results from life science stock performance YTD illustrate the following principles of biotech portfolio management:

1.) It is important to overweight large caps to protect losses due to events and volatility.

2.) Tools and Diagnostics companies provide good returns and excellent diversification without binary clinical trial risk. Some of these companies including Illumina, Abaxis, and Inverness. Those looking for speculative plays on beaten down tools stocks should look at taking profits in Illumina and buying Helicos (HLCS) and Sequenom (NASDAQ:SQNM).

3.) Stock picking can be difficult with the smaller caps due to clinical trial risk so if you are going to invest in small caps, a larger pool of stocks is necessary.

If the small-cap growth market holds up and we continue to get good news on clinical trials, the M&A backdrop should support higher biotechnology valuations.

Disclosure: Contributing Analyst Rod Raynovich is the Principal of Raygent Associates, a biotech research and business development firm. Raygent Associates may be long or short stocks in the Rayno Life Science portfolio from time to time and as of this writing we are long CBST, GILD and VPHM.