Biotech ETFs were among the best performers in 2014 and the spotlight has remained fixated on this corner of the health care market as investors continue to seek out lucrative growth opportunities. But when it comes to establishing exposure, compared to some other corners of the market, there simply hasn’t been the same level of granularity among the ETFs that are designed to provide access to this segment of the health care industry.
Luckily, innovation is a key driving force in the ETF universe, and a recent newcomer to the industry has opened up the doors like never before when it comes to investing in the biotechnology space. We recently had an opportunity to talk with Paul Yook, who is the Co-Founder of BioShares, about his firm’s entrance into the industry with two truly one-of-a-kind products.
Paul Yook (PY): We are extremely bullish on the long term prospects in the biotechnology industry. It is our impression however that many outside of the biotech industry are often scared by the space and as a result are underinvested. When you look at the growth of the healthcare sector, much of the technological innovation comes from the scientific discoveries that originated in the biotech sector, yet it is a small part of people’s investment portfolios.
Some of this is due to the lack of great biotechnology ETF options. The industry has experienced tremendous transformation since the first biotech companies went public in the early 1980s, and now there is great diversity in the types of companies that are investable – in terms of size, technology, geography and maturity. The older biotechnology ETFs each have limitations in tracking the growth of those biotechnology companies which are developing and selling new human drugs for the treatment of important diseases.
Our BioShares funds separate biotech stocks into two discrete categories – Products companies and Clinical Trials companies. These two groups of stocks are very different in almost all financial aspects – trading characteristics, volatility, cash consumption versus cash producing, business risk, size of company and perceived upside potential. It doesn’t make sense to us to put these two groups of stocks together in one fund.
ETF Database: There are nearly 30 Health & Biotech focused equity ETFs – what separates your funds from those of more established competitors? What sort of expertise does your firm bring to the table?
PY: The most comparable group is the group of 5 unlevered biotechnology ETFs that were trading before our launch. The vast majority of the Healthcare ETFs have only a small weight in biotechnology – for example (XLV ) is nearly 50% large pharma, such as Merck and Pfizer, and only 20% biotechnology, with those positions being the 7 biggest large-cap biotech stocks.
The BioShares funds have several important differences from the older biotechnology ETFs. First, our funds make a distinction between Products companies and Clinical Trials companies.
Second, our fund is comprised of only pure biotechnology companies – the other biotechnology ETFs actually have fairly significant exposures to generic drug manufacturers, specialty pharma companies, medical diagnostics and device companies and even animal product companies.
Our firm employs 20 healthcare investment professionals, including 6 members of our research team with PhDs or MDs. This, combined with our team’s healthcare experience in institutional equity sales, sell side equity research, hedge fund research and portfolio management and industry experience at pharma and biotechnology companies allows us to create indexing rules that better capture the unique dynamics of the biotech sector in our ETF structure.
ETF Database: What is the methodology behind each of your two ETFs? Please walk us through the portfolio construction and re-balancing process.
PY: Our ETFs are passively-managed index funds and our methodology is quite simple. First, we use a standard industry classification code, the ICB system, to select for US-listed biotechnology and pharmaceutical companies. We then exclude non-pure biotechnology companies, such as large cap pharma, generic drug, specialty pharma and diagnostic companies. Next, we apply minimum $250 million market cap and $2 million average daily turnover criteria.
Finally, we separate the stocks into the two baskets – Products (BBP) or Clinical Trials (BBC) – based on the stage of their “lead drug” which is typically the program that management and investors deem to be the most important.
We run these criteria twice a year, in June and December, and we equally weight the portfolios at each of those two dates. Currently there are approximately 36 stocks in BBP and 68 stocks in BBC. As of now, this number is expected to rise in both portfolios as we have had numerous IPOs (which require a 3-month waiting period before being added to our funds) and several companies in BBC have had drug approvals/launches and will therefore move to BBP.
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ETF Database: Broadly speaking, what are some of the most compelling trends you see on the horizon in the Health & Biotech space?
PY: One of the most actively debated topics today is whether biotechnology valuations are in a “bubble.” Some of this dates back to July 2014 when the Federal Reserve Chairperson commented that certain areas of the market such as biotechnology stocks and social media stocks seemed extended. Without a doubt, the biotech sector has been one of the best, if not the best performer over the past 1, 3, and 5 years.
In our view, these strong returns of biotech stocks have absolutely been warranted due to a one-two combination of strong sales growth and real technological innovation. 2014, for example, was a year of major blockbuster drug launches in the biotech sector, which beat even bullish Wall Street estimates – Sovaldi for Hepatitis C, Eyelea for AMD (a form of blindness), Tecfidera for multiple scleroris and Imbruvica for various leukemias and lymphomas, all surpassed estimates. In addition, earlier clinical trial data have shown promise in areas such as CAR-T for cancers, PCSK9 for cholesterol and gene therapy for a host of genetic diseases.
And more importantly, valuations are reasonable, certainly in the context of the broader market. (See Exhibit to the right). The largest 5 pharma companies, such as Johnson & Johnson (JNJ) and Pfizer (PFE), actually have declining 2015 sales of 4% on average, and flattish EPS, yet trade at 21x 2015 P/E. The largest 5 biotechnology companies trade at an almost identical P/E multiple but with significant, and arguably conservative, sales growth (16% estimated) and EPS growth (19% estimated).
Moving forward, we expect to these trends in biotechnology to continue – significant product sales growth and scientific breakthroughs, which in turn drive earnings and market cap growth.
The Bottom Line
The two new BioShares funds offer compelling strategies that allow investors to access the biotechnology sector like never before using the ETF wrapper. Instead of settling for a “one size fits all” approach, investors can choose to target higher volatility, more lucrative clinical stocks through BBC or lower volatility product stocks through BBP.
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Disclosure: No positions at time of writing.