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Biotech investor's macro market conundrum


Can't they make up their minds?

When the stock market is going to heck in a hand basket, a flight to healthcare stocks is often seen. The theory behind this is even in situations where the economy or other macro situations may be not having the best time of it, people still get sick.

Theoretically, biotechnology stocks are healthcare stocks. So why shouldn't money flow into biotech stocks during times when the rest of the market is going into the proverbial hand basket? That is a good question.

The obvious answer is because macro disasters rarely encourage people to invest in high-risk stocks like biotechs. People flee into healthcare stocks precisely because of the impression (impression) they are low-risk, safe havens. No sane person mistakes biotechs for low-risk or safe.

Therein lies a conundrum for long-term biotech investors. The fact is, these stocks become healthcare stocks if they are successful. That transformation does not occur overnight, but the first giant leap towards that end comes from big news releases of the type I have discussed before.

If indeed the market will crash down around our ears as more than a few are now predicting, what should the savvy biotech investor do? We know these stocks have immense promise. We also know they'll bear more than their share of any macro market decline. Sell and shift to lower risk stocks or add more as they decline, "knowing" their ultimate value will be realized when they are successful?

Unfortunately, I'm not sure I have a good answer. We were fortunate (lucky) enough to tell people to raise cash throughout much of 2002 and start plowing cash back into biotechs in October 2002. I take no real pride in the last part of that call as it was pretty obvious biotechs would not continue to trade at 1x cash or less and we didn't load up as much as we should.

Perhaps the best thing for me to do is remind you of the five rules I shared shortly after I first joined the 'Ville. Here are the two I find most appropriate when I am faced with a macro market meltdown:

Rule 2: Polygamy is your friend
Diversification is the difference between living to invest another day and financial ruin in biotech investing. You must spread out your risk capital over a wide number of biotech stocks to protect yourself when (not "if") bad news arrives.

When valuations in this sector are going down, I use it as an opportunity to diversify. I do this in small batches, though, respectful of the overall market decline. My first buys are usually the worst as I am rarely smart enough to diversify at the bottom.

Rule 4: Reward good data, punish bad data
Because so many people break Rule 1
[never fall in love with a stock], combined with the broadly misunderstood concept of dollar cost averaging, the tendency of biotech investors is to buy more stock on a price decline after bad or mixed news from a clinical trial.

Biotech is not a sector where dollar cost averaging is a winning investment strategy. While Rule 4 speaks to avoiding adding more stock on bad news, the same can be said for adding on general market declines. You are better off letting good clinical results dictate buying of names you already own.

I need to offer one caveat to all of this: If you are buying on margin, the rules change dramatically. I cannot stress how catastrophically dangerous buying biotechs on margin can be. For every one time it works out, the next nine result in bone-crushing margin calls. If you own your biotechs on margin, please do whatever you can to fix that situation in a hurry. Not only might terrible market conditions cause you to have unplanned sales, but one implosion combined with terrible market conditions could spell disaster for you and your family.

I am less bearish than many of my fellow professors, but I can tell you this is not a time in the market when you want to be heavily invested on margin.
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