Under Trump And Gottlieb, Small- And Mid-Cap Biotechs Are A Better Bet Than Large Caps

Includes: BBH, IBB, XBI
by: Andrew Roberts

SPDR S&P Biotech ETF consists of more small and mid-cap companies, making it a more attractive investment than other leading Biotech ETFS weighted heavily in the biggest biotechs.

Scott Gottlieb, Chief of the FDA, is adamantly against monopolistic practices used by big pharmaceutical companies to extend drug exclusivity.

The less arduous drug approval process means less expenses for cash hungry biotech companies, and thus more competition for market heavyweights reliant on older drugs.

The push for development of more generic drugs means more competition for industry heavyweights whose revenues rely heavily on older drugs.

Scott Gottlieb, the 23rd and current commissioner of the FDA, has a wide range of experience in the pharmaceutical industry. Gottlieb worked as a physician before assuming the role of Deputy Commissioner for Medical and Scientific Affairs for the FDA in 2005. To list a few of his subsequent positions: Gottlieb worked as an adviser to the National Coalition for Cancer Survivorship, a member of the Public Policy Committee to the Society of Hospital Medicine, served as a director for Tolero Pharmaceuticals and Daiichi Sankyo, and worked on the product investment board for GlaxoSmithKline. His extensive experience in the industry affords him valuable insight to the necessary reconstructing of the pharmaceutical industry in the United States.

One of Gottlieb's biggest moves thus far has been the Drug Competition Action Plan (DCAP) implemented on June 27th, 2017. According to the FDA, the plan has three main purposes:

... reducing gaming by branded companies that can delay generic drug entry; resolving scientific and regulatory obstacles that can make it difficult to win approval of generic versions of certain complex drugs; and improving the efficiency and predictability of the FDA’s generic review process to reduce the time it takes to get a new generic drug approved and lessen the number of review cycles undergone by generic applications before they can be approved.

Initially, the DCAP featured two major components, neither of which major pharmaceutical companies were happy about. First, the FDA provided a list of branded drugs that are no longer subject to patent or exclusivity restrictions that do not yet have approved generics with the intent of fueling supply competition to achieve lower drug prices. Under the DCAP, the FDA also implemented a new policy regarding expedition of the drug approval process, namely for generic and orphan drugs. The agency supplemented the DCAP earlier this month with two documents which aim to optimize the Abbreviated New Drug Application (ANDA) process, which is used for generic drugs. The first, titled "Good ANDA Submission Practices", focuses on common mistakes and deficiencies in ANDAs received by the FDA and concisely explains requirements for companies looking to submit an ANDA. The second document is a Manual of Policies and Procedures entitled "Good ANDA Assessment Practices", which will be used by FDA staff to help transition into the new streamlined review process. Gottlieb is showing no mercy in his quest to demonopolize a large portion of the pharmaceutical industry.

Prescription opioids are another colossal issue which both Trump and Gottlieb have promised to fight. In the US in 2016, a reported 116 deaths were caused by opioid-related overdoses every day, and a staggering 11,500,000 people misused prescription opioids. The economic impact of the opioid epidemic was estimated to be $504 billion for 2016.

Gottlieb has promised to take "intrusive" action to rectify the growing opioid epidemic. In fact, the FDA recently forced Endo Pharmaceuticals to discontinue marketing Opana ER after receiving word of the severity of the drug's abuse. Such an action has never been attempted by the FDA. Major opioid producers include Depomed, Johnson&Johnson, Mylan, Insys, Purdue, and Allergan.

These major opioid producers have faced heavy scrutiny and litigation in the past year. Johnson&Johnson, Teva, Allergan, Endo, and Purdue Pharma were sued by the state of Ohio for their apparent role in creating the opioid epidemic. In December, several hospitals in Mississippi and Alabama filed class-action federal lawsuits against over a dozen pharmaceutical companies for reportedly fraudulent marking and sales of opioids. In March, a Senate committee launched an investigation into Purdue, Johnson&Johnson, Insys, Mylan, and Depomed, demanding marketing and sales materials relevant to their opioid production. All of the 5 companies' stocks were red the following day.

It seems small and mid-cap biotech companies stand to gain the most from the ongoing changes in the FDA. Going forward, more drugs will be available to be developed by lower market cap biotech companies as top pharmaceutical companies are hindered from blocking generic entry into the respective market. Reduced trial expenses due to the expedited drug approval process will likely afford monetary relief to developing biotechs.

I speculate that there will likely be a few large & mega-cap pharmaceutical/biopharm names that the changes have little effect on, which will actually benefit from the Trump administration due to tax cuts. In 2016, Pfizer, Merck, and Johnson&Johnson alone held over $200 billion overseas to avoid the excessive corporate tax rate of 35%. With the Trump Administration's new 21% rate, these major companies may find it prudent to bring the offshore funds home effectively increasing free cash flows & allowing for more company acquisitions, which saw a steep decline this year.

In order to find a sound investment in the extremely volatile world of small & mid-cap biotechs, diversification is essential. Let us look at three major biotech ETFs:

iShares Nasdaq Biotechnology (IBB)

IBB is a market cap weighted ETF, meaning the companies comprising the fund are weighted based on their respective relative market cap. Because of this, the top 10 largest market cap holdings in the fund account for nearly 54% of the fund. These 10 holdings are Gilead, Amgen, Biogen, Celgene, Regeneron, Vertex, Illumina, Alexion, Mylan, and Incyte. The fund has 198 total holdings with a weighted average market cap of $39.97 billion, and expense ratio of 0.47%. IBB has realized a 29% annual return in the last year, and a dividend yield of 0.28% in the trailing 12 months.

VanEck Vectors Biotech (BBH)

Similar to IBB, BBH is a market cap weighted ETF with collective top 10 largest holdings accounting for nearly 69% of the fund. These 10 holdings include Amgen, Gilead, Celgene, Biogen, Allergan, Vertex, Shire, Illumina, Alexion, and IQVIA. The fund has 25 total holdings with a weighted average market cap of $55.51 billion, and expense ratio of 0.35%. BBH has realized a 19% annual return in the last year, and a dividend yield of 0.31% in the trailing 12 months.


XBI is my choice ETF for diversified small to mid-cap biotech holdings going forward. XBI is an equal-weighted ETF, meaning individual holdings in the fund represent a near equal relative portion of the total fund. The fund currently has 108 total holdings with a weighted average market cap of $12.85 billion, and an expense ratio of 0.35%. XBI has realized a 53% annual gain in the last year, and a dividend yield of 0.21% in the trailing 12 months.

The FDA is driving the development of generic drugs rapidly. This poses an immediate issue for major pharmaceutical companies whose revenues are largely comprised of older drugs with no available generics yet. For small to mid-cap biotechs, this is good news for a vast majority. In all likelihood, there will be biotech companies with novel drugs that end up losing revenues to generics, too. But the cumulative benefit to smaller-mid size biotech companies in being able to market generics quicker while spending less on trial costs greatly outweighs the detriment to the few who will lose out on competitor generics.

Moreover, top opioid producers are being sued by state governments, investigated by the federal government, and receiving criticism from all fronts. Many feel the opioid fallout will be detrimental to Big Pharma.

For the time being, it seems the safe play in the biopharm industries is a diversified, low- to mid-market-cap ETF. I'm going with XBI.

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