Biotech Investing the Right Way

A friend recently asked me what I thought about a particular biotech stock. Like most biotechs, the stock had negative earnings, horrible fundamental ratios, and little to no discernible technical pattern. Essentially to invest in this company, you would be investing on the promise of future commercialization of their discoveries.

I asked my friend, why they wanted to invest in that particular stock? The answer was about some vague, heard on the street rumors. At which point, I intervened. Essentially, investing in that company is no more or less than buying a lottery ticket. Picture twenty small biotech companies lined up. In general, two of the twenty are going to make it big. The rest will most likely crash and burn. That is just the nature of this group of stocks. The skill required to pick the right two out of the bunch  is certainly beyond me, and most investors. Unless you are involved with the industry, it may be better to take a basket of these stocks, and let diversification work for you. You may give a little on the reward side, but you trade off the risk of owning a single biotech.

So if you want exposure to the hot, up and coming biotech sector because you think that there is  going to be amazing progress in the next decade, I have a better strategy. This one provides more certainty with less risk. There is still risk, but instead of losing 100% of your money if a stock crashes and burns, you might lose 40% in a bad year. This loss can be recouped quickly if one or maybe two biotechs strike gold with their discoveries. Buy a biotech ETF.

An ETF in Biotechs makes a lot of sense. It is simpler, takes less work, and you can enter the position or exit the position exactly as if it was an individual stock. There are ETFs that can give you exposure to a broad range of ETFs, and will provide a risk floor. While you can see one of the stocks soar 700%, and feel some regret that you weren’t in that individual security, you will be very happy when you read about one of the stocks failing an FDA test.

Now that you are looking at Biotech ETFs, how do you find the right one. I have some simple criteria – I want 20-30 stocks in the ETF not 100. That way, a positive piece of news will have an impact on the ETF as a whole. I want the ETF equal weighted, and this is important. Other ETFs will take larger positions in the big stocks, and small to negligible positions in the smaller stocks. I want 20 equal positions, so that I get that exposure to each company’s success.

So let’s look at the candidates:

This is from Chaikin Analytics ETF Compare screen. There are 8 choices, and none have had positive returns in the past 6 months. You can see that there are a couple of really good choices at the top BBH and FTB along with the big IBB (iShares).

BBH

Looking under the covers, there are some important factors to examine

First, the Expense Ratio. BBH charges you .34% for each year you hold the ETF. That seems pretty reasonable. There are two main fees when you buy an ETF – what your broker charges you to make the trade (similar to buying a stock), and what the ETF charges you to hold the ETF.

The next item I look at is liquidity and stability. I want to be able to trade this position without worrying about whether there is someone on the other side of the trade. I also want to be sure that the ETF doesn’t get folded in a few months due to lack of interest. In this case, BBH has $414 million under management, and it trades 23,000 shares a day. That seems adequate to ensure that it is both stable and tradeable.

Let’s compare it with FBT.

FBT

FBT is a bigger ETF with more assets under management and higher daily volume. It also seems to focus on smaller names, rather some of the big players. It does charge more from an expense ratio.

Summary:

The advantage of choosing a biotech ETF rather than a stock, is that now I have a much broader exposure. All of my eggs are not in one basket. In the case of biotechs, one piece of bad news could literally implode my stock overnight. We looked at two great candidate ETFs, and saw that there was a case to made for either.  I can take the position just as if I was buying a stock, and exit the position in the same way.

While you could get rich quick by buying one biotech stock and having it hit a home run. Far more likely though, this position will end in tears. By moving instead into an ETF, you have broadened your chances for successes at a cost of missing a 20 fold increase if you are in the right stock. Given my lack of knowledge, and my friend’s lack of knowledge in this space, this seems a far better choice!



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