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Actionable news in IBB: iShares NASDAQ Biotechnology Index Fund,

IBB: Significantly Overbought - Sharp Declines Imminent

Summary

There has been a lot of speculation on the true value of the IBB ETF. It has traded range-bound, moving between 240 and 280, 3 times.

The typical chatter on social and alternate media is that the correction is going to be short lived. That the downturn presents a good opportunity to double down on shares.

So, I decided to do a deep dive on the industry and its current state – paying close attention to fundamentals.

Based on what I found, I valued the NBI, and by proxy the IBB, and arrived at a Price Target of 179 for the ETF.

I also looked ahead to what to expect over the next few years and how to best be positioned to generate outsized returns.

Investment Thesis

All does not appear right with the biotech industry. The rhetoric is that of strong fundamentals and a robust innovation cycle. However, the reality is a lot different. Net income in the sector is driven by less than 10% of companies. The rest of the firms are loss making and most will never return a profit. Similarly, major revenues are generated by an insignificant number of firms. With regard to innovation, despite record infusions of innovation capital, the rates of approvals and filings for new molecular entities are nowhere near historic highs and stem mostly from large biotech. Everyone has heard about the exponential increase in the number of biotech initial public offerings but few are aware that there has been no commiserate upturn in the number of investigational new drug applications and in mergers and acquisitions in the emerging therapeutics space (roughly 90% of the industry). Overall, pipeline productivity has decreased while the inflation adjusted cost of drug development has increased. The exponential growth in the market capitalization of the Nasdaq Biotech Index (NBI) from 2012 to 2015 was more a function of over valuation of initial public offerings and follow-on public offerings by investment bankers and sell-side analysts than driven by any material financial performance of most of the index's constituents. Based on the posturing displayed by stakeholders, it was easy to forget that this was not wealth created by biotech, but instead money invested, that belonged not only to the estates of wealthy Americans, but also was part of pension plans of ordinary citizens. Moreover, given the high fives over peak capital inflows into the industry, it appears that generating funding not profits is the predominant objective of the stakeholders. Overall, the picture emerging is not that of a mature industry, but one that is floundering - overrun by carpetbaggers and wrecked by majority loss leader companies that are guzzling capital with little return and are busy offsetting much of the success achieved by a minority few.

Considering the data surrounding the key drivers of the industry, there appears a clear dichotomy forming between the givers (NBI top 10 + few more) and the takers (the rest of the industry). The first group are the performers and the later the laggards. Therefore, to accurately estimate the current market capitalization of the NBI, it makes sense to value the two groups separately. With regard to the valuation of the NBI top 10 holdings, based on 2017 consensus earnings estimates and forward price/earnings (P/E) ratios, I reach a market capitalization of ~$483 million. Given, how the performance attributed to most of the group outside of the NBI top 10 has only worsened over time, it is reasonable to then assess this group on the basis of its valuation in the NBI in 2006. On those terms, I arrive at a market capitalization of ~$139 million for the group. Consolidating the two market capitalizations, and identifying the price when the NBI was trading at roughly the same market capitalization, I estimate a value of ~$1878 for the NBI and ~$179 for the iShares Nasdaq Biotechnology ETF (NASDAQ:IBB) by proxy. These prices are based on fundamentals. Considering technical trends, the values contract significantly.

Looking ahead over the next few years, the industry is likely to mirror its own performance in the aftermath of the genomic bubble. Although venture capital funding which reached record levels in 2015 remains relatively strong this year, moving forward, I expect weakness as sponsors react to indications that there might be potentially fewer opportunities to monetize their investments in an expected challenging IPO market. The dawning reality among non-specialist investors that biotech is extremely high-risk, if not highest-risk, combined with the risk-off mood of sector specialists will reflect in only companies with innovative technology or later-stage assets with superior data being able to go public. Some might point to the low interest rate environment as a stimulus for biotech investing, but leveraging highly risky investments is a double edged sword, which sophisticated investors are probably familiar with. Overall, there is likely to occur a considerable downturn in the funding climate (particularly due to the tightening of crossover money), leading to attrition in the market capitalization of the sector as companies lose value due to clinical trials and drug failures but front-running these losses is not possible due to an erosion in the numbers and values of initial public offerings and secondaries. Until the time company valuations are properly risk-adjusted, drug development costs reined in, and drug pricing concerns dealt with, serious investors are likely to remain disinterested. With regard to the NBI, I anticipate the twin catalysts of continued selling due to risk perception and inability of stakeholders to front-run the losses through overvalued initial public offerings and secondaries to persist and further depress the index.

Therefore, over the next couple of years, shorting the IBB and investing in the ProShares UltraShort Nasdaq Biotech ETF (NASDAQ:BIS) as well as undervalued commercial companies that offer substantial potential growth appears strategic. Overall, in a sector wherein less than 10% of drugs undergoing clinical trials ever secure regulatory consent, it makes little sense to invest in individual non-commercial companies, unless you are a sector specialist who has a grasp on the science and the clinical/regulatory environment associated with drug development. Given that greater than 90% of investigated drugs fail to get approved, attempting to identify potential drug successes and companies linked to them is like trying to find a needle in a haystack. Counting on the opinions of sell-side analysts is futile, as they've historically almost always been unsuccessful in predicting drug development and regulatory failures. Therefore, a lower-risk trade in biotech is not to invest in multiple high-risk clinical-stage enterprises but instead to buy shares of newly commercial companies on their journey upwards. Recollect that Regeneron (NASDAQ:REGN) did not turn into an eleven-digit company overnight. Even after Eyelea's outstanding success, the stock traded below $100 for some time.

RISKS

Ignoring the long-term time horizon associated with the investments. The price objective linked to the IBB might take multiple years to be achieved.

How Has the NBI Performed Historically?

The NBI is a Poster Child for Boom Bust Cycles. Between October 2011 and July 2015, the market value of the NBI appreciated dramatically going from a lowly ~1152 to a record breaking ~4166 representing a gain of ~261%. Comparatively, the genomic era NBI did slightly better registering an absolute return of ~313% before falling 75% to the bottom. Following that period, from July 2002 to October 2011, a period of 9 years, the value of the NBI increased by a paltry 748 points.

Nasdaq Biotech Index (NBI) Market Value (1993-Present)


Source: Yahoo Finance; Seamist Capital Presentation June 2016 (Updated in July)

Since July 2015, the value of the NBI has declined. After falling ~39% to a low of ~2572 from a high of ~4166, the index has recovered somewhat and for the most part trades range-bound between ~2500 and ~3000.

When and What Popped the Biotech Bubble?

Descent Began Ahead of Hillary Clinton's Tweet. Many lay the blame for the flight of capital and downtrend in the NBI on Hillary Clinton's tweet on drug pricing. However, the contention is inaccurate. The descent in biotech started much before that. Hillary Clinton's tweet just added an additional concern, broke the camel's back, and dramatically accelerated the process.

The NBI Reached a Trillion Dollars in July Before Starting its Descent on August 6, Much Ahead of Hillary Clinton's Tweet on September 21


Source: Nasdaq Biotech Index (NBI) Database; Seamist Capital Presentation June 2016

The sell-off was driven more by a dawning among non-specialist investors on the reality of biotech investing. A reality that most of their biotech investments are likely to result in negative returns.

Hillary Clinton's Tweet on Drug Pricing Dated September 21, 2015


Source: Twitter; Seamist Capital Presentation June 2016

The response from industry stakeholders has been that the pullback in biotech is directly correlated to typical presidential election cycle politics about drug pricing. They argue that industry fundamentals are strong, the innovation cycle robust, and the correction temporary. However, analysis of key data surrounding the major drivers of the industry unfolds a different story.

How Has the Biotech Industry Performed Over the Years?

I evaluated financial data from the entire industry, the NBI top 10 holdings, the commercial leaders, the emerging therapeutics firms (~90% of the sector), and the rest of the industry (comprising companies aside from the top 10 holdings in the NBI and the commercial leaders). Overall, the investigation revealed that an extremely small minority of firms in the industry accounted for most of the revenues and net income while the rest of the...


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