Many investors (including myself) regularly watch or listen to the show "Mad Money" by Jim Cramer on CNBC. As with any celebrity, Mr. Cramer tends to be polarizing, with some loving him and some reveling in pointing out when he is wrong. Rather than focusing on his individual stock picks, I listen more to learn about companies and also for strategies in investing.
One of the regular segments on the show is called "Am I Diversified?" In this segment, viewers call in and give a 5-stock portfolio which Cramer either blesses as diversified or recommends substitution for better diversification. While some find this segment somewhat repetitive (if not predictable), it does effectively emphasize the value of portfolio diversification. Cramer emphasizes not only sector diversification, but also some diversification in market cap and risk. He typically recommends having no more than one speculative pick out of the five stocks. He generally seems to like multiple large caps to be included, but is often positive when there is one mid-cap and one small or micro cap out of the five (assuming the sectors are diversified).
For an overall portfolio, I believe having diversification as Cramer recommends should certainly be the standard. However, many, if not most, investors tend to gravitate towards one sector. This is often a sector that they feel like they study or know better than the others. For me, that is biotech stocks (and more specifically, biotechs that include neuroscience products). In a larger portfolio in particular, there is likely some room for being overweighted in a sector that the investor more heavily researches. I personally try to never have over 50% of my portfolio in one sector (and many, including Cramer, would argue that even this is too high), with the remainder of my portfolio much more significantly diversified. I chose to do this knowing the risks involved if the pharma/biotech sector were to significantly collapse (and ready to respond if that began to happen). However, I also have employed a diversification strategy within the pharma/biotech sector, and that is the primary subject of this article. Simply: How does one build as diversified of a portfolio as possible within this one (very large) sector? Others could probably build a similar strategy for diversification within other large sectors, such as financials, oil/gas, technology, retail, etc.
The following is key "Levels" within pharma/biotech upon which to build a portfolio within the sector.
Established Companies with Diversity (Level A)
These are the large pharma companies with diverse portfolios. They generally have many currently marketed products, several products where they sell brands that now have generic competition, and several products at each stage of their pipeline. Most offer a regular dividend. They generally have at least one of the following as well: a generic division/subsidiary, an OTC division, non-pharmaceutical products, and/or a biomedical devices unit. My current favorite example here is Johnson & Johnson (NYSE:JNJ), but most of the well-known pharmaceutical companies fit here.
In an ideal, well-diversified pharma/biotech portfolio, I'd recommend about 20-30% of holdings be from Level A stocks. This is the one level where it is most acceptable to have this be all in one stock from the level, but I'd ideally split it between two or three Level A stocks.
Profitable Companies with a Strong Pipeline (Level B)
These companies are not quite as diversified as Level A stocks but have at least two approved products and several others in their pipeline. They have at least 3-5 years of consistent profitability and no major concerns that they will fall from profitability in the next 8-10 years. They can be large-cap or mid-cap stocks. Most of these companies will not offer a regular dividend, but a few might. One example of a company that falls into this level is Alexion Pharmaceuticals (NASDAQ:ALXN). My current favorite here is one that is just moving into this level, Supernus Pharmaceuticals (NASDAQ:SUPN).
In an ideal, well-diversified pharma/biotech portfolio, I'd recommend about 15-25% of holdings be from Level B stocks. This should be split among at least 2 different stocks from the level, but ideally 3 or 4 of them.
Newly Profitable or Near-Profit Companies with a Maturing Pipeline (Level C)
These companies may only have one or two approved products, and they often have been approved within the last 2-4 years. There are no major concerns that they will not be able to maintain profitability for the next 6-8 years (or 8-10 years once they are profitable for a near-profit company). They have other products in their portfolio in Phase 3 research or multiple in Phase 2b. They are often exploring additional indications for their currently marketed products. There is a clear vision for the companies that will keep them from being the biotech equivalent of a "one-hit wonder." These companies are generally mid-cap stocks, but occasionally are on the smaller side of large caps or are small caps (if their approved drugs are limited in scope). An example of a company that falls in this level is Exelixis (NASDAQ:EXEL). An example of a company that is on the cusp of reaching Level C is one that I have written about several times, Neos Therapeutics (NASDAQ:NEOS).
In an ideal, well-diversified pharma/biotech portfolio, I'd recommend about 15-20% of holdings be from Level C stocks. This should be split among at least 2 different stocks from the level, but ideally 3 to 4 of them.
Companies with Newly Approved Drugs or Strongly Positive Phase 3 Studies (Level D)
These companies have recently had their first drug approval or are likely on the cusp of their first approval due to strong Phase 3 studies. They can vary significantly in market cap from micro caps up to mid-caps, but are most often small caps. They can have drugs that vary from being potential blockbusters to also-rans with modest sales potential, but have a clear path towards profitability. These companies should have at least two other significant drugs in their pipeline that have reached at least Phase 2. My current favorite examples for this level are Dynavax Technologies (NASDAQ:DVAX) and KemPharm (NASDAQ:KMPH).
In an ideal, well-diversified pharma/biotech portfolio, I'd recommend that about 15-20% of holdings be from Level D stocks. This should be split among at least 3 different stocks from the level, but ideally 4 or 5 of them.
Companies with Late-Stage Pipelines (Level E)
These are the companies that biotech investors are often the most excited about, and it is easy to over-allocate here. These companies have at least one product that is completing a large Phase 2b study or in a Phase 3 study. They generally have at least one other Phase 2 compound. Almost all of these companies are small caps, with a few of them being micro caps. They have a very high risk/reward profile with large binary events when there are drug results. My current favorite stock within this group is Cytokinetics (NASDAQ:CYTK).
In an ideal, well-diversified pharma/biotech portfolio, I'd recommend that about 10-20% of holdings be from Level E stocks. This should be split among at least 3 different stocks from the level, but ideally 4 or 5 of them. Bret Jensen has an excellent article about picking what he calls "Tier 4 Stocks." His Tier 4 is roughly the same as my Levels E and F combined.
Companies with Early-Stage Pipelines (Level F)
These companies are often fresh off of IPOs and do not have Phase 3 drugs in their pipeline. They have often recently started Phase 2 studies. They generally have at least one other compound in Phase 1b/2a and will also more often mention the preclinical compounds in their drug portfolio. The vast majority of these stocks are micro-caps or on the smaller side of small caps. Long term, these companies often don't make it and are highly speculative. One stock that I own in this level is BioLineRx (NASDAQ:BLRX).
In an ideal, well-diversified pharma/biotech portfolio, I'd recommend only having 0-10% of holdings from Level F stocks. This is the one category that I would recommend that less experienced investors avoid. If an investor does have holdings from this level, then I would recommend that they be split among 4 or 5, with no one stock ever being over 5% of the biotech portion of the portfolio. Ideally, no one stock in this level should be over 2-3% of the biotech portion of a portfolio.
Summary and Conclusions
By diversifying within the pharma/biotech sector, an investor can better withstand sector corrections. Each investor can modify within the allocation ranges presented above. More conservative investors wanting less risk should use the higher numbers in Levels A-C and the lower numbers in Levels D-F. Investors willing and able to take more risk (in addition to the risk of being overweight in any one overall sector) could consider using the lower numbers in Levels A-C and the higher numbers in Levels D-F. The allocation within each level should roughly be as follows:
|Level ||Allocation ||Minimum # ||Guideline # ||Maximum # ||Max allocation |
for 1 stock
Over time, companies will occasionally "graduate" from one level to a higher one due to pipeline advancement, drug approval, or profitability. There will also be companies that drop in level due to drug trial failure or loss of revenue. Adjustments to an individual's portfolio should be made as necessary with these events - particularly if the move causes the investor to be outside of these guidelines for one level or the other.
In the near future, I will begin to offer additional examples of stocks in each tier and begin to build a model portfolio based on the above.
Author's note: Thank you for reading my article. Please follow me for additional articles covering the biotech space with an emphasis on neuroscience. As always, I will disclose below which drug companies I have mentioned in the article for which I am the recipient of direct marketing. My articles include my personal opinions and are neither financial nor medical advice. They are solely intended to show my perspective and due diligence on a given subject. Please consult with the proper professional if you are looking for specific advice for your situation.
Disclosure: I am/we are long BLRX, CYTK, DVAX, JNJ, KMPH, SUPN. 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.
Additional disclosure: I have had ~6 marketing lunches provided to my office in the last year by Neos. Prior to the last year, I have had marketing lunches provided by JNJ. I anticipate that several of these companies may provide additional lunches in the future. I have never been paid by any of the above companies for speaking or writing articles.