Betting On Biotech | Seeking Alpha

By Garrett Baldwin, Tim Melvin

Sick people need medicine no matter how the economy is faring, which keeps pharmaceutical stocks defensive and makes them likely to outperform in this year’s shaky financial scene.

Besides, the sector is loaded with large-cap stocks capable of paying big dividends and passing inflationary price increases through to consumers via insurance companies.

Passive investors seeking a defensive position might just purchase the VanEck Pharmaceutical ETF (PPH) and call it a year.

But trading will be more complex for active investors looking to beat the market by a wide margin while adjusting to the ups and downs of sentiment driven by the Federal Reserve’s policies.

Niche clinical biotech strategies have worked well during long stretches of the 2010s bull market. So, let’s study the recent history of some popular ones and determine their viability for the year ahead.

Insider buying

Over the last decade, one of the top-performing and least-understood strategies in biotech centered on tracking insider purchases. That’s when C-suite executives-those who tend to have the word “chief” in their job title-buy stock in the companies where they work.

The C-suite includes the chief executive officer, chief operating officer, chief financial officer, chief marketing officer, corporate director, board members and any entity owning more than 10% of the company.

The portfolio strategy consists of buying the four most recent open market biotech stock purchases within three days, each held at 25% of the portfolio and each sold at 30 days.

From 2009 to 2018, the first 10 years of the long bull market, the strategy averaged a return of 40.6%, outperforming the S&P 500 by an average of 27%, according to WhaleWisdom, a platform offering data on moves by fund managers. It was one of the best-kept secrets of several biotech trading blogs.

In 2022, as the Federal Reserve raised interest rates and as valuation compression accelerated, this strategy drastically underperformed the market. It declined by 45% last year, trailing the S&P 500 total return of -18.1%. However, the downtrend for this strategy started a few years ago. Since 2019, the performance has underperformed the S&P 500 three times by at least 26.88%.

Deep value to cash?

When interest rates don’t matter, investors might fall back on the idea that biotech companies tend to hold a bit of cash. But consider the state of the sector today, with 156 companies trading for less than the value of their cash. It means the company’s market capitalization is lower than the net cash on the balance sheet.

The valuation suggests these companies burn through cash while conducting drug trials. They may be cutting back on expenditures, but investors have largely abandoned them based on the expectation they’ll fail to produce new drugs or find an acquirer.

As interest rates rise, the cost of capital increases, placing pressure on the balance sheets of biotech companies trading below their price-to-cash value.

In a rational world, such companies would shut down operations, return the cash to investors and retain the intellectual property. But that’s not how the biotech sector operates.

Instead, companies approaching the end of their cash runways hold onto the hope that a larger company might fund further trials. That expends a lot of capital quickly, and investors lose money because they think they’ve found a deeply undervalued stock.

Torpedo warning

For further evidence of why it’s best to avoid stocks trading under the value of the cash, consider the work of students at the Ross Business School at the University of Michigan.

Rising interest rates and cuts to the Fed’s balance sheet will likely pull earnings multiples lower and reflect broadly on companies already struggling for profitability.

That’s why investors could use some help identifying stocks to avoid or to sell short. One of the better tools for determining what stocks face serious earnings challenges comes from those students at Ross.

Each month, they compile a list of 100 stocks with characteristics they dub “earnings torpedoes.” Specifically, these companies face the increased possibility of “a rapid and precipitous decline in a richly priced growth stock that is triggered by revised information about fundamentals underlying the stock,” a university report says.

To create the list, the student analysts assess value, quality, momentum, and expectations for growth and profitability. When students add a company, it joins a notorious club-like the Black Book banning some gamblers from Las Vegas casinos.

For perspective, note that the list includes some of the worst-performing, most unprofitable companies of 2022, including Blink Charging (BLNK), Upstart Holdings (UPST), Peloton Interactive (PTON), Roku (ROKU) and ChargePoint Holdings (CHPT).

But digging into the list at the start of this year, observers see several healthcare and biotech companies. In fact, it carried 45 names from system-specific biopharmaceutical delivery and logistics services, diagnostics and drug delivery devices, general medical devices, healthcare support services, miscellaneous healthcare, and non-system-specific biopharmaceuticals. (See chart: Damn the torpedoes.)

As expected, the biotech players are spending lots of cash, and few have any discernible path toward profitability. The biotech names on the list look like promising shorts.

Cheap cash flow

The lesson of 2022 and 2023 hinges on profitability and proper management of cash flow. Pharmaceutical giants and other healthcare players with strong margins that kick off cash are primed for an extensive recovery in 2024 and beyond.

After a strict dive into backtesting over 20 years, a top strategy uses two simple metrics: Investors can tap into stocks trading less than 15 times cash flow with 12 trailing months of net income. The strategy has provided an annualized return of 22.3% since 1998, according to Portfolio123, a stock screener providing extensive data.

That said, the strategy is off roughly 12% over the past year but has still improved markedly over the 19% drop in the S&P 500.

To streamline the opportunity, investors can narrow their consideration to these 10 companies with positive net income and maintain the lowest price-to-free-cash-flow.

Insiders are selling Moderna

Although stock in Moderna (MRNA) has been a darling of the COVID-19 era, corporate insiders have aggressively sold their holdings at every opportunity in the last two years.

In fact, they’ve sold a stunning $2.825 billion in stock while buying back none.

The insider selloff could be linked to incentives for corporate officers, who might have been awarded shares as part of their agreements, thus reducing the need to purchase stock.

What Buffett sees in DaVita

DaVita Healthcare (DVA) ranks 10th on the list of stocks trading cheap compared to their cash flow and 12th among the largest holdings in Warren Buffett’s portfolio-with a stake worth $2.88 billion, according to Securities and Exchange Commission filings.

The company’s shares started the year up more than 8% as healthcare equites rebounded. However, Tipranks analysts have panned the stock, and it has an average price target of just $75.60. So what does Buffett see that Wall Street analysts are missing?

He often invests in companies with monopoly power, and DaVita controls a stunning 92% of the U.S. kidney dialysis industry, a wide moat for a niche sector.

Plus, it’s not the only dominant player in Buffett’s portfolio. He owns stock in companies with significant market share in mining, soft drinks, credit cards, credit rating, domain names and rail transportation.