Biotech: After the selloff

Despite the recent tumult, our manager thinks biotech stocks may have long-term potential.

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Biotech investors have had a rough go of it in recent months. The S&P 500 Biotech Index has fallen around 20% since its high point in July of 2015, as investors have grown worried about the potential for regulatory policy changes that could affect drug pricing and valuations among stocks in the industry.

Rajiv Kaul, the manager of Fidelity® Select Biotechnology Portfolio (FBIOX), thinks that election-year rhetoric could be contributing to some of the recent volatility, but that the market may be misreading the potential impact these risks could have on biotech stocks.

It is not the first time biotech stocks have experienced a major swing in prices (see chart below). But Kaul says he still believes that biotech’s five-to-10-year investment story remains compelling and may warrant a small place in a diversified portfolio, but only for investors who can live with the potential ups and downs.

The pullback: the risks and the rhetoric

A key factor in the recent selloff has been investor concerns that new regulations could impact the prices of drugs. Kaul says while these concerns may have been exacerbated by political rhetoric connected to the presidential election, the likelihood of significant reform remains low. What’s more, the risk of any regulation to specific companies varies greatly, in a way the market does not seem to be appreciating, in Kaul’s opinion.

“There have been some high-profile cases of companies taking old generic drugs, raising prices, and cutting research and development,” says Kaul. “That business model would be very adversely impacted by pricing reform, but it is not the kind of business that I think has a long-term runway to growth or makes an attractive investment.”

Instead, Kaul has focused on the companies creating new lifesaving drugs and those that can actually help to save the health care system money, relative to existing therapies.

“In my view, the market’s not differentiating between companies with great science and tremendous innovation, and these other companies that are basically trying to engineer higher profits through higher prices,” says Kaul. “That’s where I see a great opportunity. No matter what the political outcome is in the United States during the next election cycle, there’s always going to be a need for better medicine that can cut costs for the healthcare system.”

Kaul has been using this pullback as a buying opportunity for what he believes are attractively valued stocks in the industry—some larger cap biotech stocks have free cash flow yields approaching high single-digits to low double-digits.1

The long-term outlook: Progress after decades of R&D

This is a particularly fertile time for biotech drug discovery. After decades of investment in research, the biotech industry is beginning to produce novel therapeutics for many previously unmet medical needs. More biopharmaceutical drugs were approved during the 2000–2009 period than in the 1980s and 1990s combined,2 and in 2014 the FDA approved more new “molecular entities” (chemical particles) than in any of the past 15 years.

Through its Breakthrough Therapy program, the FDA is expediting the approval process for drugs treating diseases for which there currently are few or no treatment options. In 2014, 22% of the novel drugs approved by the FDA fell into this category. Today seven of the 10 leading drugs in the world are biotechnology drugs.

Despite recent progress, treatments have yet to catch up with research. Since 1987, scientists have identified molecular causes for some 7,000 diseases, and drugs have been developed for only a small minority of them. The upshot: Biotech companies still have only scratched the surface of the industry’s growth potential.

Key investment drivers

Several themes are fueling investment opportunities in the biotech industry, including:

Personalized medicine. The combination of the Human Genome Project and the commercial application of diagnostics has created opportunities to develop more personalized and effective treatments. Excitement about the Human Genome Project began more than 15 years ago, but it has taken until recently for these genome-sequencing advances to result in therapies.

More biotech companies. The biotechnology industry continues to add start-ups rapidly, giving investors an ever-larger investment universe.

Innovation and economic insensitivity. The biotechnology industry is unusual in that it contains high-growth companies at the forefront of innovation, but is relatively insulated from the economic cycle. “The drivers in the biotech space aren’t directly tied to the economy, so the industry tends to have low correlations to the broader market,” Kaul explains. “If a biotech firm comes up with a better cure for multiple sclerosis or cancer, the stock is very likely going to work regardless of what the economy overall is doing,” says Kaul.

Favorable demographics. Older populations tend to use more pharmaceuticals and other treatments than younger ones do. Approximately 10,000 people in the United States turn 65 every day, and many other countries are also aging rapidly.

Significant headwinds

Investors should bear in mind the risks inherent in biotech. In particular, not every molecule a biotechnology firm develops will gain approval from the FDA. The possibility of failing clinical trials will always be a serious risk for biotech and pharma firms. It can take up to 15 years to bring a product to market and cost as much as $1 billion,3 and according to one estimate, just 8% of drugs make it all the way through the process and gain FDA approval.4

Another risk is reimbursement pressure, and it may become even more severe in the coming years. Even if a drug is approved by the FDA, there is no guarantee that it will be added to health insurers’ formularies or prove to be profitable.

Controlling risks

While the industry may have a bright outlook, obviously not all biotech stocks will perform equally well. To help manage risk, Kaul believes it makes sense to focus on the following elements:

Valuation. “I think of myself as a value investor,” says Kaul. “You have to make sure you’re not overpaying, based on each investment’s risk and potential reward.”

Likelihood of success. As an active manager, Kaul tends to pick and choose the companies he thinks have the best chance at success. “Our team quantifies what we think is the probability that each company in the biotech universe will deliver on its potential. We only want to invest in the companies with the highest probability of positive outcomes.”

Diversification. “I want to ensure that no one company will make or break the fund,” says Kaul, whose portfolio holds more than 200 names. He has typically invested in a combination of large and early-stage companies. “Historically we have held between 65 and 70 percent of assets in shares of larger, more established firms, with the balance of the fund's assets trying to capture greater upside from the newer, more innovative names.”

The bottom line

Stocks in the biotech industry have a history of volatility, and no one knows what will happen in the short term. But the industry is experiencing a wave of innovation, and companies that discover drugs that improve and extend patients’ lives could potentially deliver attractive returns to investors. Of course, the first priority is to ensure that your investing strategy appropriately reflects your time horizon, financial circumstances, and emotional capacity for volatility. Within this context, it may make sense for some long-term investors to consider how biotech stocks may fit into their portfolio, and it may pay to take a diversified approach to the industry.

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Before investing, consider the investment objectives, risks, charges, and expenses of the fund, exchange-traded fund, or annuity and its investment options. Call or write to Fidelity or visit Fidelity.com for a free prospectus and, if available for the options, a prospectus or summary prospectus containing this information. Read it carefully.
Stocks in the biotech industry have a history of volatility, and no one knows what will happen in the short term. But the industry is experiencing a wave of innovation, and companies that discover drugs that improve and extend patients’ lives could potentially deliver investors attractive returns. So it may make sense for long-term investors to consider a diversified approach to the industry for a small part of their portfolio.
1. Free cash flow yield attempts to measure the amount of money a company generates after paying all expenses, including capital expenditures. The value is expressed in relation to the market value of the total company.
2. “Novel New Drugs 2014 Summary,” January 2015, U.S. Food and Drug Administration, Center for Drug Evaluation and Research.
3. “The FDA Approval Process,” BrightFocus Foundation.
4. “The Drug Development and Approval Process,” The Independent Institute.
Views expressed are as of the date indicated and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the speaker or author, as applicable, and not necessarily those of Fidelity Investments.
Any such views are subject to change at any time based on market or other conditions, and Fidelity disclaims any responsibility to update such views. These views should not be relied on as investment advice and, because investment decisions for a Fidelity fund are based on numerous factors, may not be relied on as an indication of trading intent on behalf of any Fidelity fund. Neither Fidelity nor the speaker can be held responsible for any direct or incidental loss incurred by applying any of the information offered. Please consult your tax or financial adviser for additional information concerning your specific situation.
Past performance is no guarantee of future results.
Investment decisions should be based on an individual’s own goals, time horizon, and tolerance for risk.
Rajiv Kaul manages Fidelity Select Biotechnology Portfolio, which invests in some of the stocks mentioned in this article. As of June 30, 2015 the fund held shares of Gilead Sciences Inc. equal to 6.7% of assets, and shares of Biogen, Inc. equal to 6.3% of assets.
Diversification and asset allocation do not ensure a profit or guarantee against loss.
Keep in mind that investing involves risk. The value of your investment will fluctuate over time, and you may gain or lose money.
The biotechnology industry can be significantly affected by patent considerations, intense competition, rapid technological change and obsolescence, and government regulation. The fund may have additional volatility because it can invest a significant portion of assets in securities of a small number of individual issuers.
Stock markets, especially foreign markets, are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. Sector funds can be more volatile because of their narrow concentration in a specific industry.
The S&P 500® Index, a market capitalization–weighted index of common stocks, is a registered service mark of The McGraw-Hill Companies, Inc., and has been licensed for use by Fidelity Distributors Corporation. The S&P 500 Biotech Index is a float-adjusted market cap-weighted index that comprised of stocks in the S&P 500 Index that are classified in the GICS biotechnology sub-industry.
The MSCI U.S. IM Biotechnology 25/50 Index is a modified capitalization-weighted index of stocks designed to measure the performance of biotechnology companies in the MSCI U.S. Investable Market 2500 Index. The MSCI U.S. Investable Market 2500 Index is the aggregation of the MSCI U.S. Large Cap 300, Mid Cap 450, and Small Cap 1750 indexes.
The NASDAQ Biotechnology Index includes securities of Nasdaq-listed companies classified according to the Industry Classification Benchmark as either Biotechnology or Pharmaceuticals with market capitalization of at least $200 million and daily trading volume of at least 100,000 shares.
The MSCI® U.S. Investable Market Biotechnology Index is a market capitalization–weighted index of stocks designed to measure the performance of Biotechnology companies in the MSCI U.S. Investable Market 2500 Index.
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