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Biotech Roundup: Generalists Flee From Biotech


Money flow and not fundamentals may determine biotech performance in 2008.


It was big doings in San Francisco this week with JP Morgan's (JPM) big healthcare conference. This used to be the place where biotech strutted its stuff, but JPM has mostly relegated biotech to the sidelines in favor of biopharma, specialty pharma, healthcare companies, and insurers. That doesn't decrease the draw of this event, as I swear everyone involved in biotech makes their way to the area around and in San Francisco for meetings, meals, and drinks – lots of drinks.

My friend Adam Feuerstein blogged that he thought the meeting was the busiest he has ever seen. I admittedly did not spend as much time in the St. Francis (the conference hotel) this year, but the rooms I was in were almost empty. I think the difference was he focused on the biopharma names and I, as always, am more interested in the biotech names.

Medarex's (MEDX) room was 25% full, for instance, and maybe a dozen people came to the breakout. While its second line melanoma trial failed, this will still be one of the big stories of 2008 as Medarex and partner Bristol Myers (BMY) insists it will file a BLA anyway.

This was the tale of two conferences, really: large market cap companies had lots of attendance while small biotechs had not much. There were exceptions to that, of course. On my list of sessions both ZymoGenetics (ZGEN) and Seattle Genetics (SGEN) were full rooms, with SGEN hosting a standing room only presentation.

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I will say I think there was more action outside the conference than in any of the four years I have attended. The other hotels around Union Square do bang-up business this week as companies and investors grab suites and host one-on-one meetings from breakfast through dinner and beyond.

These one-on-ones are arguably more informative anyway, which is why the heart of the JPM "experience" is as much outside the conference as inside. Most licensing and acquisition deals have some connection to this conference. My firm always finds one or two new companies at each event that end up on our coverage list. This year is no exception as I came back with a list of four interesting stories I get to dive into and see if they can pass through the due diligence process.

Even more valuable to me is the ability to talk to clients and non-client hedge funds at the evening events or over breakfast. I'm telling you, folks, it's ugly out there. I've never seen professionals simultaneously so sure of their position fundamentals and so clueless about how that will translate into profits for their funds.

The fundamental issue is money is flowing out of the sector. Let me trace what I think is happening:

Generalists and individual investors were whipsawed in much of 2006-07, meaning most of them are fleeing what they see as a capricious and inexplicable sector. Blame much of this on the FDA, but bad clinical trial design decisions by management teams bear significant blame as well.

Funds of funds (FOFs) are also withdrawing money from biotech funds. It appears the withdrawal is driven by more than just poor performance, and centers on three concepts.

The first is comparative risk. FOFs have decided that biotech and emerging markets carry similar risk profiles. It is the rare biotech hedge fund that has been able to post back-to-back-to-back 50% years, but you could throw a dart at a list of emerging market ETFs to find that sort of performance. On a competitive basis within the FOF allocation "basket" for higher risk investments, biotech just is not able to compete on performance.

The second is closely related. European FOFs dropped a great deal of new, long-term money into biotech and healthcare in the last 12-18 months. The dropping dollar made that decision less attractive, even though all recipient funds employed currency hedges to blunt this impact. While we haven't found anyone who has stories of those hedges failing, the EU FOFs seem to suffer psychologically and have moved their money elsewhere.

The third is fallout from the CDO market. FOFs often placed these backed security investments into the "medium" or "low" risk asset allocation baskets. The implosion in these markets has firmly stuffed these investments into the same high-risk basket as biotech. Since, reportedly, these investments are still locked down and not redeemable in some instances, FOFs who made this mistake had no choice but to sell everything else in the high-risk basket in an attempt to rebalance their asset allocations.

I've known for a number of months that biotech hedge funds were going out of business right and left. Many were blown out by some 1H-2007 positive news events, with the big hurt for many of these funds being the move in Dendreon (DNDN) from $4 to $25. When fund redemptions and failures continued beyond the "resolution" of the Dendreon story in May, I started casting around for more information. That's when I landed on the three items above.

Net-net, money is fleeing the sector. Those of us biotech specialists who remain are, as Toddo likes to say, standing around in a circle shooting at each other. That's endlessly entertaining in terms of boasting over beers at conferences like JPM, but doesn't do much for the performance numbers so many are beholden to.

With few generalists and individuals to run stocks up on good news, great early fundamental analysis by biotech specialists doesn't mean as much as it used to. Many of us in biotech are getting all too used to being right on the fundamentals, only to be greeted by less than expected returns.

The response to this is a shift in how to position funds along the development timeline for biotech, a process that is not exactly going to happen overnight. What biotech specialists are hoping for is more deals like the Isis (ISIS) deal. The thought, which I completely agree with, is that it will bring generalists back to the sector – or at least have pharma deal dollars replace the capital flowing out of the sector.

At the end of the year, my firm forecasted that biotech would outperform the overall markets. The caveat was that we could not depend on the overall market to be positive so "outperformance" could simply mean losing less money. That's the investor equivalent of kissing your sister.

It is worth noting we are seeing money flow into the sector in a traditional "flight to safety" reaction where unstable markets tend to shift dollars to healthcare. That has my Model Portfolio up about 3%, the NASDAQ Biotech Index up 2.75%, and the AMEX Biotech Index up 2.54% -- compared to over six percent declines in the NASDAQ and Russell 2000.

Setting aside the doom and gloom I outlined above, the minxy market has decided she'll let me be right about the outperformance of biotech for the first few days of the year, anyway. This "flight to safety" has clearly counteracted the flight of capital out of the sector for the time being. How biotech goes from here depends much on whether good data, more approvals, and deal flow can take the ball the rest of the way across the goal line.

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Positions in DNDN, ZGEN, SGEN

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