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To continue the series we started this week on strategy, we will look at ways to mitigate risk while capitalizing on some possible rewards with a focus on a sector that I don’t think has gotten its due respect, the Biotechs. With roughly almost 200 stocks in this sector that trade on the major US exchanges, how do you approach picking a winner or winners? Often, your selection will be the result of your own research or that of someone you trust. But we have seen many times, that our research and due diligence aren’t always manifested in the performances of our stocks. With that in mind, I have become increasingly interested in biotech ETF or (exchange traded fund). The benefit of this is twofold. I will get the diversification of an index fund as well as the ability to sell short, buy on margin and I will be able to buy as little as one share if I so chose.

Another advantage is that the expense ratios for most ETFs are lower than those of the average mutual fund. But with each transaction, you have to pay the same commission to your broker that you'd pay on any regular order. What’s not to like? In the end, the reward-to-risk ratio becomes more attractive for the average investor who either does not have the research capabilities to pick an individual biotech stock or prefers less risk.

Many experts will tell you that the most difficult sector to attempt to pick a stock that will beat the market without taking on unnecessary risk is (you guessed it) the biotechs. This is partly because their successes and failures often hinge on one or two drugs that either wins FDA approval or gets rejected. The “thumbs up or thumbs down” response can often make or break a biotech company. The most astute investors know this. Let’s look at XenoPort (XNPT) as a prime example. In one trading day on February 17th of 2010, the stock lost two-thirds of its value. This came after the company released a statement that the FDA had delayed an approval of one of their drugs.


(Click to enlarge)

The graphic above shows just how volatile biotech stocks can be. On February 17th, the stock closed at $19.60, and then upon the company announcing that the FDA had rejected a key drug, the stock closed at $6.67 on the next session.

Since then it has been several ups and downs for the company over the past year. But as I mentioned earlier in this article, where there is high risk, there are high rewards. This week proved to be one of the rewarding times for XenoPort. The stock surged today (4/7) by 62%. The company and partner GlaxoSmithKline (GSK) won U.S. approval to sell a new drug, Horizant, prescribe for restless legs syndrome.

How to avoid the volatility

Not many investors can stomach the type of volatility that I have just highlighted above. For these investors there are several biotech ETFs that will allow you to minimize your exposure to the individual stock while also being able to reap some rewards. The two most heavily traded ETFs are the SPDR S&P Biotech ETF (XBI) and the iShares NASDAQ Biotech ETF (IBB). Both of these ETFs have had varying degrees of success. This is due to the mixture of stocks that they contain, thus their performance will mirror that difference.

There are however several individual biotech stocks that are worthy of consideration. This is for the investors whom are willing to take the additional risk. The first one is Amgen (AMGN) - One of the handful of large-cap biotech stocks available for investors. AMGN has been a bit of a laggard versus its peers lately. The stock is attractive to investors because it will not come with the extreme volatility; however, it also gives up the upside potential. With a basket of top selling drugs and more in the pipeline, the stock offers investors an avenue into the world of biotech without the single-drug risk. AMGN is the top holding of IBB, making up nearly 10% of the ETF.

The other stock is Dendreon (DNDN) - If you can stomach the volatility, you might want to consider DNDN. The junior biotech stock hit a high of $25.25 in 2007 before hitting a low of $2.55 in March 2009. In the eleven months since the low the stock has gained more than 10-fold and is now trading at $38 per share after having reached an all time high of 57 last May.

Summary

One of the keys to successful investing is identifying and managing one’s portfolio. Doing this is even more challenging where there is constant volatility. If investing in the biotech sector is something that you desire, ETFs can prove to be the safest entry into the sector. But if you opt for individual stocks within biotechs, understanding the risks can be the difference between financial sickness and health.

Disclosure: I have no position in any of the companies mentioned

Source: Time to Consider Xenoport Among Biotech Strategies for Your Portfolio