New Trade – $IBB: BioShock 2?

by Enis July 15, 2014 2:18 pm • Commentary

Back in March the biotechnology sector was hard hit hard alongside social media, solar and 3d printing. Since then, most of these sectors have recovered most of their losses from that sell-off. Which brings us to today when the biotech sector was actually singled out by Janet Yellen in  Congressional testimony:

However, signs of risk-taking have increased in some asset classes.  Equity valuations of smaller firms as well as social media and biotechnology firms appear to be stretched, with ratios of prices to forward earnings remaining high relative to historical norms.

What’s especially surprising about this snippet is that Fed Chair Yellen is probably well aware that the market is going to key in on any specific sector commentary, but she decided to include biotech and social media anyways.  Putting aside the question of a historical norm for social media P/E’s, it’s clear that the Fed is attempting to reduce some of the enthusiasm for what it views as expensive areas of the stock market. Whether that’s to appease the financial stability critics, or as a new stance that it views as low-cost intervention, the Fed is taking some of the “behind the curve” criticism to heart.  

We had some thoughts on the biotech sector in a June trade post:

Looking at the headline P/E vs. earnings growth expectations for many of these stocks, the valuations don’t seem stratospheric, particularly for the big 4 at the top.  CELG is a 35 P/E stock with 20-35% earnings growth expected over the next few years.  GILD is a 20 P/E stock with 15-20% earnings growth expected.  AMGN is a 18 P/E stock with 5-10% growth expected.  BIIB is a 34 P/E with 20-30% growth expected.

The remaining names on the list are more speculative, though with higher expected growth prospects for the most part if everything goes well.  Of course, “expected earnings growth” can rapidly change, especially for biotech stocks.  Therein lies the risk for the sector in the short term, as shown by the sentiment change in March and April, when there was no major fundamental reason for the biotech swoon.

We ended up cutting the put fly for a loss after it broke our stop level, but our general bearish view on the biotech sector has not changed.  Specifically, I remain quite skeptical that the forward earnings estimates for the biotech stocks will be achieved, especially considering how large the companies have become.

Government officials have started putting a bit more pressure on the most profitable biotech drug, Gilead’s new Sovaldi treatment.  WSJ’s article from Friday:

A pricey treatment for hepatitis C is making some lawmakers sick with worry over the costs.

More than a dozen European countries are joining forces to negotiate a lower price for the Sovaldi treatment sold byGilead Sciences . And yesterday, two U.S. senators, one of whom heads the Senate Finance Committee, wrote the drug maker to ask for detailed financial information about the $11 billion deal in which Gilead acquired the drug, R&D costs and subsequent pricing forecasts.

Given high health care inflation over the past decade, biotech companies might face more and more pushback on drug pricing in the years ahead.

Given that backdrop, and Yellen’s shout-out today, I want to re-enter a short IBB position, but giving myself a bit more time for the thesis to play out, buying a September put spread:

TRADE – IBB ($253.30) Bought Sept 245/225 Put Spread for $4.73

-Bought 1 Sept 245 Put for $7.70

-Sold 1 Sept 225 Put at $2.97

Break-Even on Sept Expiration:

Profits: btwn 225 and 240.27 make up to 15.23, max gain of 15.23 at 225 or lower

Losses: btwn 240.27 and 245 lose up to 4.73, with max loss of 4.73 at 245 or higher

Rationale:  IBB recently made a lower high compared to the spring, and the subsequent selloff took the stock down into the low 200’s:

[caption id="attachment_42928" align="alignnone" width="600"]IBB daily chart, 200 day ma in yellow, Courtesy of Bloomberg IBB daily chart, 200 day ma in yellow, Courtesy of Bloomberg[/caption]

This trade is profitable on September expiry if IBB is back below $240 support, which can happen quite quickly as seen by the price action in March and April.  We will exit the trade if IBB makes a move above $265.