Diversifying Your Portfolio With Biotechnology Stocks

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 |  Includes: AMGN, IMUC, JAZZ, LLY, MITI
by: Brian Nichols

The best way to diversify your portfolio remains a very questionable debate. The answer typically depends upon your assessment of risk/reward. However, one belief that almost everyone can agree upon is that diversifying a portfolio with various investments is the smartest, and safest, way to invest. Last year I wrote a five-part series entitled "Building The Perfect Portfolio." The series challenged the conventional wisdom of diversification and focused more on individual goals and the idea that each investment serves a purpose within a portfolio. Over the next couple months I will be writing a number of articles that discuss industries and or sectors and how each can be used within a portfolio to serve a purpose, and the first to be discussed is biotechnology/major drugs.

I am beginning with the biotechnology/major drug industries because I believe it's the single best collection of value-presenting investments within the market. Stocks within this industry can serve a variety of purposes within a portfolio: there are stocks that offer safety and security, along with growth and potential for large returns, and even speculative companies with the potential for retirement like returns. It simply offers everything an investor could want, in fact, I believe an investor could purchase exclusively in this field and return gains over a period of several years that more than double the performance of the market, if done correctly.

The valuation of the biotechnology/major drug industries is why I believe it presents so much upside over the next several years. During the last five years the major drugs industry has lost 15% of its value and biotechnology has lost 13% while the S&P 500 (NYSEARCA:SPY) has only lost 7% of its value. However, earnings and revenue for the majority of these companies have increased, which means that both industries are trading with lower valuations and better ratios.

Biotechnology is a large component of my portfolio, and I diversify biotech investments in three categories: high-yield strong growth, aggressive growth and undervalued, speculative biotech with significant value. I believe it's important to have all three categories within a portfolio, and if done correctly it can return very large gains. To better explain I have included a few examples of each category, which I consider to be the best.

High-Yield Strong Growth

This category consists of the largest and most stable of biotechnology companies. Approximately 35% of my biotechnology holdings fall under this category, depending on your risk assessment it should be between 30% and 50% of biotech holdings. In my opinion, it's the best time to purchase this category of stocks because of low valuations, strong growth, and the high yields associated with the stocks in this category. And because of valuations being so low there are numerous stocks that would make great investments, however one of my favorites is Eli Lilly & Company (LLY).

My reasons for being bullish on LLY are plentiful. The company has four years of considerable growth in revenue and earnings-per-share while decreasing its debt-to-assets ratio during the same period. Yet despite its growth, the stock is trading with a five-year loss of 27%, following the recession, and is trading at just 10.12x earnings with a yield of 5%. The company's earnings are, once again, expected to rise as the stock trades at just 9.45x future earnings.

The concerns surrounding LLY are patent expirations and future regulations that could affect sales. These concerns have allowed for its low valuation despite high sales. Back in September, I wrote an article in which I covered the company's patent expiring drugs. My belief is that the only expiring drugs will be those that the company wishes to expire. I compared the company's current situation to that of Reckitt Benckiser and its drug Suboxone. Basically, Reckitt Benckiser was facing a patent expiration with its drug Suboxone, the incredibly fast growing drug that treats the addiction of opiates, but the company was able to change the technology of the drug's delivery and its patent was extended. I believe that if LLY wishes to extend its patents it will simply change the delivery, since several of its patents consist of drugs that could offer various delivery technologies.

Eli Lilly creates drugs that treat a variety of conditions, but its primary focus is in diabetes, Parkinson's Disease, and cancer; which are all very profitable fields of treatment. The company has 70 clinical phase compounds with 33 being in either phase II or phase III. This includes a drug device that treats Parkinson's disease and another recently approved drug that treats type 2 diabetes, that many believe will challenge the sales of Metformin. I believe that because of the company's innovation in drug delivery technology, its incredible pipeline, and its already approved product line, that LLY will return large gains along with its great yield for many years to come.

Aggressive Growth & Undervalued

As of late I've spent a significant amount of time writing about the distinction of market valuations in biotechnology. There are companies without an approved drug that trade with multi-billion dollar valuations while some of the fastest-growing biotech companies in the market are valued much lower, despite high revenue and earnings. This category consists of 40% of my biotechnology holdings; mainly because there are so many companies that fall within this category. My top two are Spectrum Pharmaceuticals (NASDAQ:SPPI) and Jazz Pharmaceuticals (NASDAQ:JAZZ). But since I always discuss SPPI I will talk about JAZZ, which would make an equally good investment.

Jazz Pharmaceuticals has a market cap of $2 billion -- and has returned 5,000% over the last 3 years --yet trades at just 11.5x future earnings. The company's growth is remarkable, yet despite its market-leading gains over the last three years, some believe 2012 will be the company's breakout year with the takeover of Azur Pharma, which will create new revenue and allow for an international platform. Prior to the takeover of Azur the company had two approved drugs and a significantly large pipeline of candidates with strong growth potential.

The majority of Jazz's success is a result of its fast-growing drug Xyrem, which treats Narcolepsy. During its most recent quarter the company returned $62.5 million from Xyrem, or a 68% year-over-year gain. In addition, Luvox, which treats OCD, returned $9.6 million, which is a 46% year-over-year gain. The potential for these two drugs is gaining momentum, and because of its pipeline and its new international platform I believe its growth could reach an entirely new level in 2012. JAZZ has returned very large gains over the last few years, but overall, it's possible that with its growth and a solid pipeline it could become the next Eli Lilly, 10 years down the road, making it a great investment in this category.

Speculative Biotech With Value:

The opinions surrounding speculative biotech are always quite high and since there are a number of companies with candidates that are potentially transcendent the number of value presenting companies is quite high as well. Last week, I wrote an article that discussed valuations in speculative biotech, and identified companies worth billions and others that trade with valuations under $100 million, despite similar technology. In my opinion, the smaller companies in clinical trials are a much better investment because of its upside potential if awarded an approval for its candidate. There are several great companies presenting value, with encouraging clinical trials, treating major conditions that could become the next JAZZ. I invest 25% of my biotech holdings in speculative biotech, and I believe there are several companies with low enough valuations and good enough products to return very large gains in an industry that is loaded with potential.

As I mentioned in a previous article, which covered Galena Biopharma (NASDAQ:GALE), I own several of these small companies, and one of them is ImmunoCellular Therapeutics (NYSEMKT:IMUC). The company is working on a next-generation immunotherapy that targets cancer stem cells, and the results of its initial testing have been remarkable, which makes its $47 million valuation very attractive.

The initial results from the company's phase I trial of ICT-107 were incredible, yet it still trades with a modest valuation. The company's candidate treats glioblastoma, which is the most common and most aggressive brain tumor with a survival rate that is measured in months, 14.6 months on average. However, phase I results show that 100% of the patients survived past the first year of treatment, with ICT-107. Furthermore, the study showed that 40% of the patients were disease free in three years compared with the average of only 6% being disease free without ICT-107, which I believe is a remarkable statistic that puts a major price tag on this drug if its phase II trials show similar data. As I said, I'm not a big fan of billion dollar companies in clinical trials, but IMUC has the potential to trade quite high with a drug that's successfully extending the life of those with the most aggressive of brain tumors.

It doesn't matter how you feel about immunotherapy companies or cancer treating drugs, the point is that you are looking for companies with significant upside that are presenting value. I like to compare similar companies to identify the best value within a specific industry; and when comparing IMUC you will see how much cheaper it's priced compared with other companies with similar technology. Look at both Micromet (NASDAQ:MITI) and Biovex. Toth companies, with immunotherapy treatments, were recently acquired by Amgen (NASDAQ:AMGN) for $1 and $1.2 billion, which could reflect both the value of IMUC and its potential interest if phase II trials continue to show promising data. However, the most significant proof of value is evident in shares of Verastem, which is 3-5 years behind IMUC with a similar technology but trades with a market cap of $225 million, after its recent IPO. These examples show the separation of value within the industry, and more specifically IMUC compared with other immunotherapy companies, despite IMUC's drug having arguably the best results.

It's important to do your homework and find the best value in a company that you believe has a promising future. I like immunotherapy and believe the treatments show very encouraging data, especially IMUC, which just so happens to be the cheapest. Its initial trials have been very enticing and it is already enrolling patients ahead of schedule for its phase II trial. The company is the cheapest in terms of valuation but some would argue that it provided the best initial data with the most upside, which is exactly what you are seeking in speculative biotech companies.

Conclusion

Biotechnology investments have the ability to return remarkable gains while still presenting value. The industry's valuation for large pharma is trading considerably lower over the last few years with higher revenue, better earnings, and large pipelines. There are also several aggressive growth companies with $1-$2 billion valuations that are just scratching the surface of growth with several great drugs and diversified pipelines. The goal of this category is to find companies that could become large pharma in the next 5-10 years, such as JAZZ. And lastly, there are a number of speculative biotechnology companies that are presenting incredible value with results that insinuate a future approval and large returns for many years to come. Overall, the biotechnology/major drug industries are showing the potential for aggressive growth, and if invested correctly, can provide the perfect balance of security and growth to return the highest possible gains, unlike any other portfolio strategy.

Disclosure: I am long JAZZ, LLY, GALE.