Geological Assays, Biological Assays, Speculating Like an Ass, Hay! – Part 1

Two sectors of the equity markets that always attracts free-wheeling speculative capital like a moth to a light is early-stage biotech and junior precious metals companies. This will be a two-part posting; the first for biotech and the second for precious metals. Like I did for the “Sample ETF Portfolios”, I’ll keep separate running portfolios for the sectors against benchmark ETFs, leveraged ETFs, and stocks.

As I’ve stated in a previous post, I think biotech could end up in a huge, mega blow-off due to the M&A activity that will continue to get larger and more irrational as the equities bull market ages. Another reason M&A activity will spike is because the players who have access to easy credit to fund a debt driven shopping spree will want to get their hands on as much capital as possible before conditions tighten. Double-digit returns are obviously a whole lot easier on purchases with WACCs that are sub-4 or 5%.

I thought that biotech may be leading a potential larger market sell-off but the sector continues to show resilience. Right now IBB is consolidating and has bounced off the 50 and 100-day EMAs with ease during its ascent in 2015.

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As I said before, the conservative play is to simply buy and hold onto this bull and ride it for what it’s worth, bucking and all…but conservative isn’t fun. Yeah, yeah, I know that prudent capital allocation is not supposed to be fun. It’s about responsibly stewarding capital into intelligent investments to outperform the markets over the long term. Fine, but there isn’t a speculator, investor, or market player alive today that doesn’t get a thrill out of watching their holdings outperform the market. With that in mind let’s look at how we’ll construct a speculative portfolio of biotech stocks.

Now I’m not a biotech expert by any means. I gave up trying to cash in on the next big thing in medicine last decade in and around the time every American became an expert in real estate. For the most part, that’s been the right move but there’s always opportunity costs. In February of 2012, a friend asked for my opinion on PCYC when it was trading for a little under $20. He had shared with me some quality insight into the potential value of the company but my bias caused me to advise on passing on it. This was even after the deal with J&J. My name is Mud.

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This was a ten-bagger mistake by allowing my previous experiences to misguide. Speculating in biotech is a slippery slope, though. One can get a taste of easy, probably lucky profits and think the process can be replicated, only to have hopes and trading account balances dashed.

Which is why we’ll simply piggy-back the experts. Baker Brothers and Orbimed are two of the premier investment operations that specialize in biotech. Orbimed possesses approximately $15B in assets under management. Baker Brothers manages slightly less but has a higher profile with the public, especially after their huge billion-dollar gains in Synageva and Pharmacyclics in 2015.

It’s the old 13-F strategy made a little simpler. Instead of combing through their 13-F’s at the SEC site, I just hit the NASDAQ instead. There you’ll find the institutional portfolios, free of charge, of both Baker Bros. and Orbimed. They are updated as of Q1 2015. My logic is to simply cross-reference Q1 additions for each fund of the same companies, whether they’re a new position or an increase to an existing holding. The thesis being that if it’s good enough for both these guys then it’s good enough for me.

Bear in mind this is generally not a sound way to invest by any means. Sure there are dozens of sites dedicated to cloning professional portfolios by using 13-F filings, but blindly following a pro is just unsound. It always pays to conduct thorough due diligence. Gleaning ideas to further research is very different from blindly following a respected professional into a position. The thing about 13-Fs is that you never know how the pro is actually playing the position. How are they hedging? Are options involved? You just never know. With that being said…

The following are the stocks we’ve come up with from cross-referencing the Q1 additions.

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This will not be a real-money portfolio for me, however, I reserve the right to position as I see fit should I be so inclined. If you want to take a flyer, without putting in any work, at higher biotech returns as M&A finally supercharges the sector then this little portfolio is as good a gamble as any. We’ll run this portfolio against five other investment options for biotech exposure.

The first option will be IBB, the all-weather biotech ETF with the most assets under management that has extensive coverage and great liquidity. IBB will be the benchmark. The next option will be LABU, which is the Direxion Daily 3x leveraged ETF of the S&P Biotech Select sub-index. This is our leveraged play without the margin. It’s very new; less than a month old. Trendy ETF creations that hop aboard trains which have already left the station have had a fairly consistent tendency to signal that the destination may soon be reached. As noted countless times though, “soon” is a relative term.

The third and fourth biotech investment options are the BioShares ETF offerings from LifeSci Index Partners. Paul Yook is the co-founder and portfolio manager for LifeSci. He came from Galleon as a portfolio manager and analyst. Despite the downfall of Galleon’s founder, it was still one of the more powerful hedge funds during its prime. You can garner some additional knowledge via this May ETF Reference interview with Yook. The thing that is nice about these two particular ETFs is that LifeSci offers two levels of risk. They offer BBC which takes positions in biotechs at the clinical trials level and has the potential for higher reward. Then there is BBP which only “invests in biotechnology companies with lead drugs already having received FDA approval.” In theory, BBP should reduce some of the risk and volatility compared to BBC.

The final investment option will be Ligand (LGND). They are basically the only publicly traded royalty play in biotech. They’re essentially modeled after the natural resources royalty players. Think Franco Nevada or BP Prudhoe Royalty Trust but with a wide-ranging portfolio of medicinal therapies at varying levels of clinical stages. LGND possesses a portfolio of over 120 partnered programs with biotech players ranging from the highly speculative to the most established in pharma. A position in Ligand is a bet on management’s competence to expose investors to some of the best profit generating opportunities in biotech while de-risking the investment, so to speak.

Be warned though, LGND has seen its share of volatility. Yes, it has treated shareholders exceptionally well for those who have been able to buy and hold over the last 5 years, but it hasn’t exactly been a one-way ticket to Profitsville. There’s been a few stops to Correctionville along the way including a recent 45% haircut through most of 2014.

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None the less, as the only royalty option in the biotech sector I still want to track it against our speculative portfolio, volatility-warts and all.

I’ll post portfolio updates once a month. You’ll see a new link on the Marginrich.com home page around the beginning of next month. The tracking page will maintain nominal dollar gains and percentage gains as well. They’ll look exactly like I what used before with the Sample ETFs.

So there you have it; multiple ways in which to capitalize on what could be an explosive rise in biotech as M&A potentially rages out of control. If you’ve missed this several hundred percent move off the 2009 lows, then here is a perfect opportunity to get positioned for the final blow-off which should come just as it always does for every biotech boom. I don’t think this blow-off is imminent so please don’t misunderstand what has been written. I just feel very strongly that biotech M&A will catapult returns in the sector based on what we’ve seen in every other boom over the last 15 years. The timetable, as with all speculation, is the real question. This portfolio will be tracked indefinitely until we see signs of a legitimate trend-ending correction. Come back often to track the results.

One final note before signing off. For the truly conservative investors out there who visit this site, I just wanted to offer a quick update on one of the funds that I highlighted in my post regarding the emergency fund. It would appear that now may be an opportune time to position into the muni-bond closed-end funds. My preference happens to be NEA but there are a multitude available. Most of them happen to be at their 52-week lows in regards to their respective discounts to NAV. The 10-year Treasury yield is bumping up into what appears to be stiff resistance while at the same time hitting a 61.8% retracement off the Dec. 2013 highs to the Jan. 2015 lows. Additionally, NEA has retraced 38.2% off of its Dec. 2013 lows to Jan. 2015 highs while currently trading in a price range where it has tended to bounce off of. Three out of the last 5 times we saw the price action dip like this to the $12ish range we saw a relatively quick bounce back up into the $14ish area. The two times NEA went lower than $12 and took longer than normal to bounce back up over $14 were aberrant situations like the GFC of 2008 and the huge muni-selloff of 2013. It looks like a good time to take advantage of some great tax equivalent yield with the potential for some decent share price gains.

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