Hedging Strategies in a Hot Biotech Market (Secrets of the Buy Side)

Mar 5 2014, 9:20am CST | by

For fun, go to your Bloomberg terminal and pull up a chart for Curagen (CRGN), then type in “GPO M”. This will bring up a price chart from 1998 until the company was acquired by Celldex (CLDX) in 2009. Focus on the period from 2000 to 2002.

This is everyone’s biotech bubble nightmare right now.

Is the biotech sector in a bubble? I claim no competence in gauging the wisdom – or whatever you call it – of the masses.

Is the sector “hot?” Undoubtedly.

So what do we do to prevent our portfolios from doing a Curagen?

Protecting stock gains is not as simple a process as one may think (nor is profiting from the reversal of what may be a bullish market for that matter.) You don’t want to depress the price of your stocks by selling your own position, something that portfolio managers face when they own a large position in a relatively illiquid name. Second, while tax considerations should not override fundamentals in trading decisions, they should not be ignored. The United States tax code gives us incentives to hold positions for more than one year, because the tax on capital gains is substantially less than the tax on short-term gains. Third, none of us wants to be overcautious. For those of us who invest based on fundamentals, one stock at a time, we should not overestimate our ability to predict large sector movements when that type of prediction is not a core competence.

So what do we do to prevent our portfolios from doing a Curagen?

One possibility is to ignore everything I said two paragraphs back and take a large short position in a sector index fund or exchange traded fund (ETF). This makes sense insofar as a big downward movement in the biotech or life sciences sector will be reflected in poor performance of the index or the ETF.

The problem with that strategy is that sector indices are often poor reflections of your underlying portfolio. If I were to try to hedge my portfolio, which consists of approximately 40 small and microcap names, with a sector index or ETF, I would be hedging small cap with large cap. The available indices for biotechnology are disproportionately weighted with companies like Gilead (GILD), Biogen Idec (BIIB), Celgene (CELG) and Amgen (AMGN). These stocks move in very different ways than my predominantly pre-revenue, early-stage, small-cap names. This trade could easily blow up if, whether or not the market for biotech rose or fell, a megamerger of a large pharma company and one of a large biotech companies were to occur, or if a company like Alexion (ALXN) were to be acquired. Further, the cash flow positive names that populate the indices are easy to fit into the discounted cash flow equations that analysts rely upon for price targets. This results in stock price movements that remain confined to more narrow bands than the price movements of my small cap names.

So how about choosing a portfolio of the similarly market cap weighted names that we think are fundamentally weaker, selling those names short, and moving to a more normal market neutral portfolio where our short exposure matches are long exposure?

This theoretically sound strategy, like the index hedging strategy we discussed, is much more difficult in practice than in theory.

Without naming any names, we all know companies whose weak fundamentals seem to disconnect from their share price performance. The stock market is an irrationally irrational place, and expecting engineering-type cause-and-effect relationships is an exercise in frustration. This is a particularly acute problem when identifying small company stocks to sell short. The most disastrous long position will lose 100% of its value, assuming it was bought without leverage (a rule that I feel every small cap investor should follow.) A disastrous short sale, on the other hand, is truly a house on fire.

The market can irrationally price a stock at five dollars a share, and then cruelly punish those rational value investors who, clutching their worn copies of Benjamin Graham’s “The Intelligent Investor,” short the stock at 5 and watch the market irrationally push stock price to 10, or 15 or higher. And, unlike a long position which grows less painful as it goes against you since each percentage movement in the wrong direction chips away at shrinking principle, a short position gets more and more and more painful the longer it stubbornly refuses to go by the book.

Even we fundamental investors try to avoid short squeezes.

So you want to know what to do to prevent your portfolio from doing a Curagen?

Part two to come.

(By the way, I don’t mean to pick on Curagen, which was actually founded by brilliant people and did some good for the world during its corporate life. I just needed a scary chart from a company that no longer trades.)

Source: Forbes Business

 
 

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