Stocks and Shares

Biotechnology: Blowing the lid off bubbletech

Pumping up the biotech bubble, or pricking it?

In my last article I talked about what we can learn from the bubbly contemporary art world. In there I mentioned that Jim Grant, the well-known investment writer, had recently highlighted a biotechnology fund with the distinctly bubbly P/E ratio of 2,000. But the P/E reported by the fund manager is “only” 42. This discrepancy, and the underlying bubble, are both worth more investigation.

Grant pointed out that the reported P/E of the biotechnology fund in question was in the 40s. But, on reading of the fund manager’s fine print, he discovered that all stocks with an actual P/E above 60 are reported as having a P/E at 60, and no more.

That’s it. In the parallel universe of fund management there is a finite upper limit on P/E ratios. Great news! Now we can only overpay up to a set limit!

(Note: this is only one of many oddities found in the fund management industry. One of my favourites is that companies that own real estate are bunched under the sector called “financial services”, which also includes banks, brokers, insurance companies and fund managers. If you’re not careful you can buy a fund with, say, 30% of funds allocated to financial services, thinking that means banks and things, when it’s mainly owners of shopping malls and rental apartments. That accidental result may be a good or bad thing, it just depends. But precisely what the shufflers of intangible money units are supposed to have in common with owners of distinctly tangible bricks and mortar constructions is left to the reader’s imagination…)

A bit of investigation reveals that the fund in question is the iShares Nasdaq Biotechnology ETF (Nasdaq:IBB). This is by far the largest exchange traded fund (ETF) in the sector, with current market capitalisation of US$5.4 billion.

IBB was launched in February 2001, 11 months after the technology bubble of that era had burst (see price graph below). The Nasdaq Composite index had peaked in March 2000, and was already down 52% by February 2001. So it’s a fair bet that had IBB been launch a year earlier the price would already have been cut in half by the actual launch date. It was only launched in a semi-bubble.

iShares Nasdaq Biotechnology ETF (Nasdaq:IBB)
iShares Nasdaq Biotechnology ETF (Nasdaq:IBB)

Despite that, the price of IBB still fell by half between launch date and mid 2002. In fact, the original investors had to wait until December 2010 to break even on their initial investment. That’s assuming any of them had the patience to hold on for the full 10 years and 10 months.

If the fund had launched a year earlier, and initially fallen in line with the Nasdaq Composite, the initial price fall could have been more like three quarters.  Those investors could still be in the red today. After all, the Nasdaq Composite index itself is still 12% below its March 2000 peak, unadjusted for inflation.

At the time of writing IBB is up 179% since launch, a period of 14 years and 4 months. That works out as an overall compound return of about 7.4% a year, although all of the profits have come in the last three and half years of the period.

That sounds like a reasonable return, if not spectacular. But it’s anything but reasonable given the extremely long waiting time to achieve it, the highly uncertain nature of biotechnology company profits, and the fact that it’s only been achieved because of a new speculative bubble in the sector’s shares.

It’s almost impossible to know when new bubbles will be inflated, much less when to get out before they pop. Investing in the hope of timing bubbles is not recommended by OfWealth.

So what is biotechnology? Put simply, and perhaps rather obviously, it’s technology based on biology. Mainly it’s applied in healthcare to combat diseases, but also has applications to increase crop yields in farming, to improve chemical manufacturing processes or to find alternative fuels to cut greenhouse gas emissions.

In other words, biotechnology involves cutting edge science, often with very admirable social or environmental aims (although just as often that’s debatable). It sounds exciting, because it’s at the forefront of human development. But that doesn’t make it a great sector to invest in. In fact that’s precisely why it’s best avoided by most investors.

Of course a small percentage of individual biotech companies’ profits, and their share prices, could go to the moon if their research leads to some new wonder product. But, as with most cutting-edge scientific endeavour, most of the investigation will result in expensive dead ends, arrived at after many years of cash burn, and big losses for investors.

In other words, from a pure investment perspective, the biotech sector is about as speculative as it gets. Investors in a very small number of companies will make a fortune, but most will lose their shirts. And anyone that’s diversified enough to prevent a wipe out will be lucky to make a modest average return on their money. That’s even assuming they get their timing perfect on when they buy and sell, which is almost impossible to achieve.

One of the big problems is that the companies themselves are extremely difficult to understand. If you can’t understand the science then you can’t understand the chances of success. And very few of us are qualified to understand the science, because it’s hugely complex and requires PhDs in chemistry or biology. I know for sure that I wouldn’t know where to start.

So biotech is definitely a sector best left to the real experts in the field, and the people with inside knowledge of the latest developments. It’s my bet that even most of those expert investors will lose money, even if a lucky few will get rich.

It pays to remember that behind every big headline about how someone became fabulously rich in technology, there are hundreds or thousands of equally talented people who didn’t get the lucky break. The chances of success are slim, to say the least.

It’s clear that biotech, although it can sound exciting, is a highly speculative sector. And it also looks like it’s currently in a bubble that’s best avoided by investors. But perhaps this story has an even more important message.

That is: you need to be very careful when you’re selecting your investments. And the more exotic the sector then the more careful you need to be.

Going back to what Jim Grant said, remember that he calculated that the IBB ETF has a P/E ratio of around 2,000. But looking at the fund’s website today the P/E disclosed by the fund manager sits at around 42 (note: this is already extremely high). This is because the small print says all individual stock P/Es above 60 are set at 60, and no more. Clearly a lot of the stocks have extremely high actual P/Es.

So, fellow OfWealthers, make sure you take the time to read the small print of all your investments. It may be boring, but it’s your money to lose if you don’t take the time. And if you don’t feel you have the ability to do it yourself then make sure you find someone you can trust who can.

Remember, fund managers and stockbrokers are in the business of selling you products to earn fees and commissions. Make sure you do your own research. Use common sense, and if in doubt walk away.

Oh, and avoid investing in bubbletech.

Stay tuned OfWealthers,

Rob Marstrand

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.