We’ve had a good bounce off the June 27 Brexit event. We had
placed long positions as the S&P 500 bounced off the 2000 level. One of the
sectors we moved into was large-cap biotechnology as represented by the iShares
Nasdaq Biotechnology (IBB). The sector is up 17% from the lows vs. +9% for the
S&P 500, so we are pleased with the relative performance. This sector has
had a rough go of it this year and quite honestly could not seem to get out of
its own way. It tried to bottom and rally a few times but eventually succumbed to
the bears. We are watching very closely for weakness and we may start taking
profits on our position if it appears the sector is breaking down once again.
That said we understand there remains a good possibility that this sector will offer
addition upside from here so we’re not ready to exit just yet.
Here are six items we are watching that we believe could
propel this sector even higher from here.
1 – Valuation Trends
2 – Technicals
3 – Earnings Season and Short Interest
4 – Merger & Acquisition
5 – Pipeline & Catalysts
6 – Politics
Valuation Trends
We utilize the S&P 500 Biotechnology index to derive our
fundamental data for the purposes of our screening. As seen in our dashboard
reading below the sector trades 12.5x forward eps with expected forward
earnings growth of 26%. This provides a PEG of 0.5 and offers one of the most
favorable value profiles for this sector in almost a decade. We believe if the
sector could continue to catch the bid there could be an additional 20% upside
from here. We’d of course need to see several things happen over the next
several weeks and months for this to happen and we’ll discuss each in a moment.
The chart below shows the earnings yield for the biotech
sector is at 8%. This is a very attractive yield for the space showing
significant undervaluation. The chart below that is the forward EPS value variance.
This model shows how many standard deviations the sector is trading away from
its fair value average near-term mean (two years). The sector is trading was trading two
standard deviations below the mean. It has since recaptured the one standard
deviation level but we find this momentum upward encouraging and increases the
chances of higher prices in our view.
One needs to always be concerned about the “value trap”.
Sure the sector is trading cheap for a reason. We understand the negative
sentiment that has taken form around drug prices. At one point in time we had
three presidential candidates (Trump, Clinton and Sanders) railing against the
drug industry. Daily appearances by Martin Shkreli and alleged securities
violations, Bill Ackman trying to keep Valeant Pharmaceuticals from going to
zero and the pending outcome of the Medicare Independent Payment Advisory Board
decision probably didn’t help.
One thing that we do not believe is that deteriorating
fundamentals within the space was the cause of the declines. The sell-off was
purely sentiment driven while the underlying fundamentals remained steadfast.
The following charts show revenue and earnings expectations for the sector;
profit margin for the sector; and the trend on earnings, book value and cash
flows. With the exception of a slowing in the pace of growing book value (reddish/brown
line in the third chart down) we don’t see a massive breakdown in fundamental
trends. We take that as a good sign.
What’s also encouraging is the sectors cash-to-EV ratio.
From Bloomberg research, “U.S. biotech
companies' cash-to-EV ratios suggest that the sector is firmly in a bear
market, but a silver lining is that it appears the sector is at its bottom. The
ratio of U.S.-based companies in the Nasdaq Biotech Index with cash in excess
of their EV is comparable with previous bottoms in 2009 and 2011, and it hasn't
worsened beyond that. One could argue that the market continues to hold at this
point.”
Technicals
Below is the weekly chart of IBB. I have enough scars on my
hands from trying to catch falling knives in the past but there were a few
items on the chart that enticed me to scale in from the Brexit lows. The sector
had sold off in dramatic fashion from the middle of last year but stopped dead
in its tracks at the 200 week moving average. It tested that level several
times. It broke through to the downside briefly after Brexit but quickly retook
the line and that was enough for me to get involved. We started to scale in at
that point with an average price of low $250’s (green line) and set our two
stops at key levels (two red lines) planning on selling half the position at our first stop
and closing the position below the second stop. We never reached those levels.
This isn’t an exercise in Monday morning quarterbacking, the point here is that
the valuation and the support at these levels are encouraging and support
higher prices ahead in our view. We think we have to make it through the
resistance near the $290 level and then we could see a strong breakout. We also
like the divergence between equity prices forming a base while MACD and RSI
(14) have been trending higher. This further strengthens our view towards the
sector.
We also like the weekly relative price performance chart of
biotech vs. the S&P 500. There seems to be bullish divergences in place and
leads us to the conclusion that biotech will outperform the general market in a
big way just as we have seen off the June lows.
On the IBB daily chart we had a bullish MACD cross and RSI
(14) has risen above 50. These are both good things to see when long the sector
but one needs to be weary of the overhead resistance that is now approaching.
A break above the April and June peaks and a retaking of the 200 day moving
average would be an exceptionally bullish sign and we would in all likelihood take
an even stronger position.
Short Interest
We came across this article in Seeking Alpha (Via Yahoo
Finance). The author went on to write, “According
to the NASDAQ, on the settlement of September 30, 2015, IBB short interest
surged 23.82% to 11.54 million shares, since Hillary Clinton sent out a tweet
on September 21, 2015 saying, “Price gouging like this in the specialty drug
market is outrageous. Tomorrow I’ll lay out a plan to take it on. -H “.
The tweet was in
response to then CEO of Turing Pharmaceuticals Martin Shkreli, after Turing
raised the cost of an older antibiotic drug, Daraprim, by more than 50-fold and
said the drug was still a bargain at $750. Since then, IBB’s short interest has
dropped to 5.7 million shares, as of settlement on June 15,
2016, or about 22.89%
of shares outstanding,” according to a Seeking Alpha analysis of biotech short
interest.”
““From a technical
viewpoint, IBB bounced off the $240 support level, or the February low, and
broke back into the symmetrical triangle chart pattern. There are three major
resistances at $280, $285 and $290, respectively, as the IBB continues to move
higher. Closing and staying above the 200-day moving average will trigger a
short squeeze,” adds Seeking Alpha.”
I checked the latest numbers from Bloomberg and as of
6/30/16 there were $5.7mm shares outstanding which represents 2.4x average
trading volume. These figures are slightly elevated but for the most part not
at extremes. This is something we will continue watching.
Should there be a short squeeze coming, surely the earnings
report by Biogen rattled a few cages. There are many biotech stocks that have
retaken their 200 DMA and are breaking out. Amgen, Inc. (AMGN), Celgene
Corporation (CELG) and Biogen (BIIB) are all large weightings in the S&P
500 biotech sector and large holdings in IBB. It looks like we broke the neckline of a reverse head-and-shoulders formation on CELG.
M&A Activity
We’ve already had several high profile Merger &
Acquisition activity this year and given prolonged accommodative monetary
policy and cheap access to cash along with the low valuation within the sector
we could see that pace of M&A activity continue through the remainder of
the year and into next year. This would be a net bullish event for the entire
sector in our view.
Recent headlines from Bloomberg Research:
“M&A in the
biotech sector may be poised for a comeback after a relatively lackluster start
to the year. A sustained period of active M&A came to a halt in 1Q, as
valuations crashed and dealmakers avoided the volatility. Still, the need
exists, especially for companies such as Gilead, Biogen and some large pharmas,
where the right deal could ease concern that key assets have reached their
growth ceilings. The pronounced change of tone suggests M&A discussions may
be back on the radar.”
“Smaller biotech
companies may be forced to the deal table, given the slowdown in secondary
financing. Market volatility in the last 12 months will have probably made
further public offerings unattractive, corroborated by the slowdown in IPOs.
Smaller biotechs typically don't finance via debt, so if the markets aren't
ripe for further equity offerings, these companies --particularly those with
less than two years of cash in the bank -- may have issues funding R&D and
day-to-day operations.”
“Recent commentary
from biotech buyers suggest broadly increasing comfort with the valuations of
potential targets. While some comments were also made that there could be room
for a bit more of a price correction, this may be posturing, and overall
sentiment appears to be in stark contrast to that at the beginning of the year.
Biotech is typically purchased by large pharma and big biotech companies
seeking new potential growth engines, technology, or pipeline fillers.”
“Among big biotech
companies, Gilead, Biogen and Amgen are more likely to be seriously evaluating
M&A options to bolster their pipelines in 2016. Gilead and Biogen have
openly hinted at this on earnings calls, and the Financial Times reported Amgen
is hunting for a potential deal of up to $10 billion. Celgene is by nature
deal-centric, though typically resorts to licensing. Gilead has commented that
a large merger is possible, which may help challenge consensus expectations of
slowing revenue.”
“Pharma industry
access to cheap cash amid loose monetary policy may be prolonged with the
U.K.'s Brexit vote. U.S. and European large pharma companies have more than
$170 billion in debt capacity to deploy for M&A, assuming leverage of 2.5x.”
Pipeline &
Catalysts
According to recent statistics derived from Bloomberg
research, it would appear that the pipeline for clinical and regulatory
catalysts is the most robust it has been in the past five years. Much of these
anticipated announcements are expected towards the latter part of this year and
that could be an added bullish factor to send stock prices higher (assuming a
majority of the news-flow is positive). With the bulk of catalysts happening in
4Q16, this could continue to shift positive sentiment within the sector.
Politics
We’ve managed to get through the RNC without direct mention
of drug pricing controls. We’ll see this week if the drug industry is demonized
at the DNC. Given the choice of the two V.P. picks by each of the candidates,
it appears there will now be a shift towards the center to try to appeal to the
independent and swing voters. Recent polling shows that economic concerns and
the fight against terrorism is still the predominate concerns of the country.
Given the recent wave of global violence, Trumps “law and Order” candidacy and
the aggressive tactics of the Republican base against Secretary Clinton, we
would guess that she has enough to address and drug pricing will take a much
more subdued role in her massage than when she was battling Bernie Sanders in
the primaries. The chart below is the World
Conflict Index from BBVA Research. As can be seen, it has been edging
higher recently and will be a focal point of the coming election season in our
view.
We believe this could be a positive for the sector that has
been at the forefront of controversial political concerns. The decision to
stall and delay the Medicare Independent Payment Advisory Board should also be
seen as a net benefit for biotech sentiment. Based on political articles that
we read, it also appears more likely the House and more importantly the Senate should
remain in Republican control. We also believe this to be a net benefit for the
sector.
Bottom Line: We are
long the biotech sector through the purchase of IBB. The sector has been basing
for a while and we believe it could be on the verge of a breakout for the
reasons cited above. If we do breakout above the 200 week moving average to the
upside and retest to hold that level, we will be increasing our exposure to the
sector as we believe there is much upside to be garnered. If the sector breaks
down, we will lessen our long exposure with a willingness to re-enter should
the support of the past continue to hold.
Be wary of potential
market weakness coming in August through October. We’ll be tightening our stops
up here.
Email: joe@squaredconcept.net
Twitter: @jskalinowski
Facebook: https://www.facebook.com/JoeKalinowskiCFA/
Blog: http://squaredconcept.blogspot.com/
Web Site: http://www.squaredconcept.net/
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