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Walking Through a Trade

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biotech, particularly smaller biotech, will broadly outperform the market in 2006

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For those who are not familiar with our research model, we maintain a model portfolio to allow our clients to track our performance. It also allows our clients to see how we view the 25 companies currently in our coverage universe in comparison to each other. The model portfolio is a subset of our coverage universe, as not every company we cover deserves investment capital.

In October of last year, we added the IBB to our model portfolio. This may seem a little odd given the model is comprised solely of development-stage biotech companies, but there was a method to our madness.

We were convinced the biotech sector, particularly the smaller cap stocks that populate the IBB, would begin to significantly outperform the market into the first half of 2006. We were unsure whether we could add new coverage fast enough to catch this move, so we used the admittedly ham-handed tool of the IBB as a stop-gap until we could add "weight" via new companies under coverage.

I say "ham handed" because, as you are likely aware, the IBB is heavily biased towards larger biopharmaceutical companies like Amgen (AMGN). It is a decidedly imperfect tool for our task.

Earlier this week we closed the position added last October. My apologies for burying the lead here, but this move is what I'd like to discuss.

Any reader of the commentary on this site is made aware of all the good reasons to not buy stocks. Nevertheless, there are many of us in the market for whom policy or temperament makes shorting not an option. We must dodge the obvious steamrollers so eloquently described by my fellow professors in order to make money for our clients and/or ourselves.

Balancing the macroeconomic concerns with the nearer-term requirement of actually making money from the long side is more art than science. It requires understanding when these macroeconomic issues will matter to the broader market and to what degree they will matter. When market psychology depresses these concerns (rationally or irrationally, it doesn't matter), then it's time to increase exposure. When the psychology begins to integrate these concerns into portfolio decisions (rationally or irrationally), then it is time to decrease or eliminate exposure.

We still believe biotech, particularly smaller biotech, will broadly outperform the market in 2006. Our decision to let go of the IBB piece added last October has nothing to do with the fundamentals.

Two issues caused us to let go of the position, both equally persuasive: (1) We've added six new companies to coverage since October, five of which went on the model portfolio; and (2) I sense my fellow market participants might be entering a period where the macroeconomic picture matters in terms of portfolio decisions.

Recall why we added the IBB position in the first place. We were afraid the market would run before we could increase our exposure. It did, to the tune that the IBB position gained 12% from October to now. No regrets on that call, obviously. We've also added 5 new companies to the model portfolio and increased the position size on several more. While we still have several companies we wish to add before mid-year, we've crossed over the threshold of feeling underweighted – at least for now.

As far as the macro market is concerned, we do not like what we see in the very short term. Technicals are usually mixed, but the current mix feels much more bearish than I normally like. The macroeconomic situation continually gets bleaker. While that's no surprise given the fiscal habits of our "leaders," it just feels like these issues are beginning to matter to Wall Street – for a while anyway, until they find something else to worry about.

I wrote a long piece over a year ago about how the negative macroeconomic issues written about with such frequency on this site were not actionable in and of themselves, but must always be factored into one's risk/reward calculations. If billowing budget deficits, global unrest, large money supply, a Fed head with something to prove, etc. did not exist, then we would not have closed the October IBB position. Sure, there is always something to worry about on Wall Street, but these are not your garden-variety issues. Any significant flare in any of them could really hurt a long-only portfolio.

The trick is to respect, but not to defer to the macroeconomic bear case.

In October, I demonstrated respect for the bear case by not being too aggressive with the position size of the IBB. If I had deferred to the macroeconomic bear case, as I mistakenly did in August 2004, I would have never added the position in the first place.

This week, I respected the macroeconomic bear case by closing the October IBB position while maintaining an overall portfolio strategy that still has us significantly exposed long to the sector. If I deferred to the bear case, then we would have dumped more than the IBB.

Hopefully working through this thought process is helpful for Minyans. I don't know if the call will be profitable or not, but I do know it was the right call for our overall strategy and our overall outlook on the sector.


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No positions in stocks mentioned.

The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

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