PBE: Large Biotech Meets Small Biotech

by: Don Dion

The PowerShares Dynamic Biotechnology and Genome Portfolio (NYSEARCA:PBE) surged up the PowerShares Momentum Tracker ranking in August and September, reaching 21 last week after climbing 16 notches since the last week of July. The fund’s quick ascent is partially the result of solid returns: It gained 5.9% during the three months through October 1. But PBE’s rise also came about because many other funds suffered serious setbacks during recent months, making this fund’s healthy returns look positively stellar by comparison. For example, PBE’s three-month performance through September 27 beats all but three of the other funds on the PowerShares Momentum Tracker sector ranking and was well ahead of the energy and materials funds that have dominated the table’s upper echelons lately.

PBE was born in June 2005. Its history is therefore relatively brief—but its track record suggests that the fund may be a worthy vehicle for investing in this very narrow segment of the health care market. PBE’s 9.6% year-to-date return through October 1 outperformed 73% of health-care oriented funds, according to Morningstar, and beat the Standard & Poor’s biotechnology subsector by a healthy margin.

Investors should take those results with the understanding that biotech stocks are prone to wild swings. Many biotechnology companies are relatively young and untested, and their fates are often tied to a relatively small range of pharmaceutical products. As a result, the industry’s stocks frequently rise when prospects look good and investors are optimistic — and then plummet when conditions deteriorate. This fund is too young to have generated meaningful risk statistics. But the S&P biotechnology subsector produced a standard deviation of 19.2 during the five years through September—some 74% higher than that of the broad market—indicating that this fund is likely to be too volatile for more than a small slug of investors’ portfolios.

Researchers’ constant improvement in understanding the human genome allows scientists to develop new classes of better, more-targeted medicines. As a result, biotech firms are increasingly responsible for developing the drugs that combat illnesses throughout the world. Research and innovation are the keys to the biotech kingdom: Creating just one drug can require years of development, but one successful drug can result in enormous profits. Many biotechnology firms don’t make it that far: They are bought up by large pharmaceutical companies looking to capture cutting-edge research to shore up their own weak drug pipelines.

Those biotechnology firms that do remain independent often forge partnerships with drug companies, which provide “milestone payments” in exchange for the right to license the products after they’ve been developed. For example, PBE top-holding ImClone (IMCL) received FDA approval last year for a new drug designed to combat carcinoma of the head and neck; when it reached that milestone the company received a $250 million payment from its licensing partner, Bristol-Myers Squibb (NYSE:BMY). Altogether, ImClone received $900 million in milestone payments from Bristol-Myers Squibb during the life of the arrangement.

Most biotech and genome companies are small and rely heavily on a few key products. But the industry has matured to the point that its biggest players, Genentech (Private:DNA) and Amgen (NYSEMKT:MGN), have become solid large-caps with diversified revenue streams. Those firms are beginning to resemble blue chip pharmaceutical companies, especially as they take more control over the marketing, distribution and sales of their products.

PBE does own those biotechnology heavyweights, which together accounted for just over 10% of assets as of October 1. Still, the fund’s 28 stocks are predominately small fare. It recently held almost 80% of its assets in mid-cap, small-cap and micro-cap stocks, according to Morningstar. Altogether, the fund’s average market capitalization stood at $3.7 billion—squarely between the average market caps of the Russell Midcap and small-cap Russell 2000 indices.

The PowerShares Dynamic Indexing system reshuffled PBE’s top holdings in September. Most notably, ImClone—which previously had not been in the portfolio’s top 25—became the fund’s top holding at 5.60% of assets. In hindsight, the move worked out beautifully. ImClone gained 20% during the month ending October 1, after having declined over most of the summer. The reason for ImClone’s sudden surge: Positive results from a Phase III study of a new application for the company’s drug Erbitux sent investors scrambling for shares in the stock. ImClone makes almost all its profits from Erbitux sales, so good news for the drug is very good news for the company and investors. What’s more, ImClone has two more products with considerable potential in the pipeline.

During 2005 and 2006 the biotechnology industry benefited greatly from intense merger and acquisition activity. There has been much less M&A activity in 2007, but analysts think the trend may reemerge. Such activity could prove to be the trigger that sends this fund the rest of the way up the PowerShares Momentum Tracker sector ranking. Still, it’s a good idea to keep any investment in this volatile fund on the small side.