Picking The Best Biotech Stocks, Using Intelligent Behavioral Analysis

Includes: IBB, REGN
by: Peter F. Way, CFA

Specialized knowledge in promising investment areas is regularly assembled by highly-motivated, generously-resourced, well-connected, and extensively experienced investment professionals -- the market-makers.

Biotechnology is one of the past decade's more rewarding career and investment areas. The past two years have been no exception for their stock investments, as suggested by this price performance comparison between the S&P 500 index and ETFs of Nasdaq Biotech iShares (NASDAQ:IBB) and Market Vectors Biotech (NYSEARCA:BBH), courtesy of Yahoo finance.

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But the single most important piece of investment information, for every biotech stock, is: What price may some other investor be willing to pay you, in the foreseeable future, for the stock you might buy today? -- and how likely may that be to happen?

The trick here is to stop playing the information-compiling game, and to start playing the players. That is what the market-maker does. His self-protective hedging actions to protect the employer's at-risk capital tell just how far he thinks his clients are likely to run stock prices before they bail out, or pile in. This is behavioral analysis, focused on what informed, experienced players are doing intelligently.

Here are several of the now most appealing forecasts and experiences in the Biotech segment of Medical Sector stocks, as seen through the lens of those professional market-makers, based on the most recent depressed market closing prices.

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The three right-hand columns of this table are the product of subjecting each buy candidate to our standardized investment test. It consists of a hypothetical buy of all prior forecasts at least as attractive as the current one, using the top of the forecast range as a fixed sell target and a specific holding time limit from the time of purchase if the target is not previously reached.

The proportion of profitable priors usually exceeds the odds of achieving the sell targets because the holding time limit may force a profit-taking before optimism lets it escape into decline and possible loss. It is the frugality with time that provides the frequent compounding of gains at the annual rate of return potentials indicated. Typical holding periods are about a month and a half.

The stock buy candidates are from a list of about 20 biotech companies we regularly evaluate. The last two are ETFs focused on biotechs. They illustrate the lower-risk, small drawdown exposure possibilities.

The market is constantly varying the attractiveness of specific biotech stocks, and of the group as a whole. This list of stock buy candidates is ranked by its past annual rate of return experiences following prior forecasts like the present. There is no guarantee that events of the next two or three months will evolve as they did at various times during the past 4-5 years.

Indeed, Pharmacyclics (NASDAQ:PCYC), and Ariad Pharmaceuticals (NASDAQ:ARIA) draw from forecast histories of only a year or less. Their experiences may well be an indication of exceptional management skills and product development accomplishment and product pipeline prospects. They may also be the fortunate outcomes of a brief beneficial period of time that may not persist in the next similar season, hence the red warning numbers. Market seasoning is an important element in risk assessment.

The experiences of Regeneron (NASDAQ:REGN) and Onyx Pharmaceuticals (NASDAQ:ONXX) are more soundly based across multi-year periods. In the case of REGN, the current balance being forecast between upside prospects and likely drawdown exposure is an infrequent opportunity having occurred only in 8 days of the past 4-5 years.

Those prior to REGN experiences all were profitable, averaging gains over +20% in average holding periods of three weeks and a day. We do not quantify annual rates of return in excess of three digits, which this is.

For investors favoring less active portfolio management, the goal of achieving reduced incidences of capital drawdowns, ideally of smaller magnitudes, usually comes at a price of mediocre returns over time. Instead, here we see a rare opportunity to achieve a win-win-win of 1) strong odds of 2) very competitive returns with 3) abnormally small, infrequent drawdowns. It is presented by the ETF IBB.

The histories of REGN and IBB provide an excellent opportunity to illustrate and contrast the advantages of each investment management style - the high-return, aggressive and active approach, and the low-risk, moderate return, laid-back style. We will illustrate each much as we did in our recent SA article, with extensive multi-year histories of how both have been appraised daily by market makers, and what subsequent actual price actions evolved.

The rationale for that approach and the terms used are explained in the earlier article and will not be repeated here.

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The distribution of Range Indexes in the case of REGN is fairly normal, with a median balance of upside to downside prospects at 41 instead of the 43 seen before in the ETF SPY. What is not normal is that regardless of the forecast (i.e. all the time) the odds favor higher prices in the next 3 months than at the time of the forecast.

That does not mean that a buy of REGN was never subsequently under water on cost (red line, right scale), only that such days were in the minority in every measurable 63 market-day period in the past 4-5 years.

The size of those infrequent drawdowns was independent of the forecasts, and at -8% to -11% (red line, right scale, below) was typically less than half of the average gain days (green line, right scale) of +35% to +20% when forecasts had more upside than down.

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That combination made the outcome obvious that a loss could not reasonably be expected from a series of such investments, particularly if the investments were managed following the disciplines of our standard test procedure (please see earlier article). Note that in the picture below, the net odds-weighted results only go negative at the least promising forecasts.

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The vertical orange bar indicates the current balance between forecast upsides and downsides (on the horizontal Range Index scale at bottom), and its rarity is evident in the size of the adjacent blue bars.

The typical simple (not annualized) percent gains of prior like forecasts on an odds-weighted net-of-losses basis are indicated by the green line (right hand scale) at the intersection of the orange column.

If the future outcome of the market-makers' judgment about REGN is like their past experiences, it is time to pounce on REGN.

Now, if the following comparison with the ETF IBB were for an either/or outcome, this would be an unfair fight.

But the proposition was to illustrate two different styles of investment management, and it turns out that IBB has as much or more going for it in the low-maintenance, low-risk arena as does REGN in the opposite style.

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Does this look familiar? Just like with REGN, the odds of more drawdowns than gains never occurs at any forecast level. Once again the odds deck is stacked in the investor's favor. How about payoffs? Will the actual upside price moves again overwhelm modest drawdowns?

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Yep. Gains of +5% to +10% across the forecast board, compared to drawdowns of -3% to -7%. So at no level of forecasts does the net of odds-weighted payoffs turn negative. That's not the way it worked for either SPY or DRN in the earlier article. Nor is it the way most investments are appraised by the folks that talk regularly with the guys in control of the capital that inevitably moves markets.

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So here is the intersection of odds-weighted net payoffs with the current forecast for IBB. While the proposition is that a purchase of IBB likely may have a longer holding period than might be desirable for REGN, starting off the position at a probable larger gain is much better than what has occurred at the median (average) forecasts.

Also comforting is the knowledge that the implied periodic reinvestment of the position, due to its longer-term holding, is unlikely to be faced with any serious untimely recommitment. It is a condition that strengthens with repetition, as long as the ETF's future behavior is similar to its past.

Of course, there is no guarantee that it will. Which is why active attention to all investments periodically always outperforms the "strategy' of buy-and-forget.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.