In a recent blog post ("Can The Crowd Be More Patient?"), venture capitalist Fred Wilson explained the challenge of attracting early equity investment to drug discovery:
One of the most noticeable changes to the VC business over the past decade is the movement of investment allocation from capital and time intensive sectors like biotech ... to capital efficient and fast moving sectors like Internet and mobile.
This makes total sense if you think about it
Internet and mobile product development cycles are measured in months not years. And the capital required to get a product built and into the market is less than $1mm.
Contrast that with biotech. A new drug takes $100mm in capital investment to get to market. And that process can take a decade or more.
A few days later, Financial Times columnist John Gapper echoed Wilson's point about the declining attractiveness of the sector to equity investors and quantified it ("Pharma needs an injection of financial engineering"), noting that U.S. venture investment in biotech had declined by 43% in the first quarter of this year, and R&D by drug companies declined by $1.2 billion last year. Gapper also mentioned an alternate idea for financing drug R&D: MIT finance professor Andrew Lo's proposal to use the same sort of complex debt securitization that financed the housing bubble to finance drug research - "Collateralized Drug Obligations" (Gapper quoted Professor Lo's response to the possibility that this could lead to a debacle similar to the housing bubble, "If there's a cancer bubble, I can live with that").
In response to John Gapper's column, this week a letter writer offered an elegantly simpler solution to the lack of equity investment in the sector: Extending the length of drug patents ("Extend drug patent life to rejuvenate R&D"). As the letter writer pointed out, extending patent life would increase the potential returns to R&D. In the meantime, though, declining R&D investment seems inauspicious for the future of biotech companies. With that in mind, I took a look at the current hedging costs of a handful of biotech companies on Wednesday. The table below shows the costs, as of Wednesday's close, of hedging four biotechs against greater-than-20% declines over the next several months, using optimal puts.
For comparison purposes, I've added the iShares Nasdaq Biotechnology Index ETF (IBB) to the table. First, a reminder about what optimal puts are, and a note about decline thresholds. Then, a screen capture showing the optimal puts to hedge the comparison ETF, IBB.
About Optimal Puts
Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor uses an algorithm developed by a finance Ph.D. to sort through and analyze all of the available puts for your position, scanning for the optimal ones.
In this context, "threshold" refers to the maximum decline you are willing to risk in the value of your position in a security. You can enter any percentage you like for a decline threshold when scanning for optimal puts (the higher the percentage though, the greater the chance you will find optimal puts for your position). I have used 20% decline thresholds for all of the names here.
The Optimal Puts for IBB
Below is a screen capture showing the optimal put option contract to buy to hedge 100 shares of the iShares Nasdaq Biotechnology Index ETF against a greater-than-20% drop between now and December 21st. A note about this optimal put and its cost: To be conservative, the app calculated the cost based on the ask price of the optimal put. In practice, an investor can often purchase puts for a lower price, i.e., some price between the bid and the ask (the same is true of the other names in the table below).
Hedging Costs as of Wednesday's Close
The hedging costs below are as of Wednesday's close, and are presented as percentages of position values.
|UTHR||United Therapeutics Corp.||6.33%**|
|IBB||iShares Nasdaq Biotech Index ETF||3.72%***|
*Based on optimal puts expiring in October
**Based on optimal puts expiring in November
***Based on optimal puts expiring in December
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.