Trading Biotech In Pairs: A Better Way To Hedge

by: Helix Investment Research

Biotechnology is both one of the most lucrative sectors in the market and the riskiest. The results of a single drug trial, or a single FDA decision, can dramatically alter the fortunes of a company and its stock. Investing in biotechnology stocks carries some unique risks not present in other sectors. While the sector can be seen as a defensive one, given the ever-present need for new medicines, a biotechnology company's fundamentals matter to a degree not seen in any other sector.

We think the biotechnology sector is a great sector to invest in, for a number of reasons. First, the sector has a fair amount of defensive characteristics. Secondly, there is enormous growth potential. And lastly, large pharmaceutical companies starved for growth are constantly looking to this sector to replenish their pipelines and avoid the ravages of the patent cliff. However, the risk of drug failures is ever-present. As such, it is prudent to reduce risk, while still being able to enjoy the upside the sector has to offer.

We believe that it is prudent to trade stocks in this sector in pairs. What we mean by that is pair a position in a company with a drug in development with a much larger company also developing a drug in that sector. Every drug company, from Pfizer (NYSE:PFE) down to the newest public biotechnology start-up, wants every drug in their pipeline to succeed. The difference between large and small companies here is that each drug in development means much more (or less) to each company, depending on its size. Recent developments in the prostate cancer sub-sector are a prime example of that.

On January 31, Medivation (NASDAQ:MDVN) announced that its experimental prostate cancer drug MDV3100 prolonged the lives of men with prostate cancer. The stock promptly soared 22% to an all time high. Medivation, however, is not the only company racing to treat prostate cancer. Amgen (NASDAQ:AMGN), the world's largest biotechnology company, is also working to treat the disease, using its existing Xgeva drug. But on Monday, February 6, the FDA issued some critical commentary on the drug, sending Amgen's shares down almost 3% initially. Had Medivation's drug received negative commentary, it is certain that it would have plunged sharply, just as it is certain that if the FDA had made glowing remarks about Xgeva, the stock would have risen only a few percentage points.

Our concept of pair trading is designed more for drugs that are already in the market and face competition. The reason is this: after a drug is launched, execution begins to trump the drug's medical and clinical profile in terms of what is more material to a company's success. Unless you are a company like Alexion Pharmaceuticals (NASDAQ:ALXN), which does not need to market or push its drug Soliris, due to the extraordinary rarity of the diseases it targets, execution matters much more post-launch. It does not matter that Dendreon's (NASDAQ:DNDN) Provenge was the first in a new class of therapies for prostate cancer. The company stumbled badly in its launching of the drug, allowing for the much larger Johnson & Johnson (NYSE:JNJ) to gain a foothold in the market with Zytiga. The benefits of pair trading become clear in such a situation. If Dendron stumbles in its Provenge launch, the shares tumble, because the company has nothing else to generate revenue (or profits). But Johnson & Johnson does not really need Zytiga. If the drug is successful, that is great. But if not, there is much more in the pipeline to commercialize, and the company is still solidly profitable without it.

We execute this concept by making our position in the smaller company half of the position in the larger company. This way, potential losses are minimized (but potential gains are capped as well). The logic is clear. In a competitive market for new therapies, for any disease, be it HCV or prostate cancer, whichever company can sell its drug the most is the most successful. And the drug with the strongest clinical profile is not always the best-seller. While Gilead's (NASDAQ:GILD) GS-977 may be the "leader" in the race for next-generation HCV therapies, all that really matters is that it sell. Idenix (NASDAQ:IDIX), for instance, could have better clinical data (this is merely a hypothetical example), but if it cannot successfully sell the drug, it does not matter. Gilead, by virtue of being a larger company, is simply better positioned to get its drug to market.

Covering your investment in a smaller biotechnology company with an investment in a larger drug company has some clear benefits. Below we give some potential pair trades, broken down by disease.

Trade Pairs
Disease Small Companies Large Companies
Idenix (IDIX)
Achillion (NASDAQ:ACHN)
Merck (NYSE:MRK)
Bristol-Myers (NYSE:BMY)
Gilead (GILD)
Prostate Cancer Dendreon (DNDN)
Medivation (MDVN)
Amgen (AMGN)
Johnson & Johnson (JNJ)
Diabetes Amylin (AMLN) Novo Nordisk (NYSE:NVO)
Eli Lilly (NYSE:LLY)
GlaxoSmithKline (NYSE:GSK)
AMD Regeneron (NASDAQ:REGN) Roche

While this is in no way representative of every disease targeted for treatment, the accompanying table does give a snapshot of the combinations possible with pair trading.

Minimizing risk is something that every investor wants to do. And in the biotechnology sector, that is especially true. By pairing biotechnology investments, investors can hedge their bets, protecting themselves from potential trouble at smaller companies, all while participating in the upside that a successful new treatment has to offer.

Disclosure: I am long AMLN, GILD, DNDN, REGN, MRK, VRTX, ALXN.

Additional disclosure: We are long all of these stocks through the First Trust NYSE Arca Biotechnology Index Fund, which tracks a basket of 20 biotechnology companies. In addition, we hold shares of ALXN and VRTX on their own.