Cashing In on the Biotech Bear Market

The three-day rally in the market took a pause on Thursday, although equities held up well considering the large gains in recent sessions. I would be more than happy to see a flat day Friday so the market can digest this upsurge and investors can enjoy a rare up week. I have deployed almost two-thirds of the 30% cash allocation I built up in my portfolio before the start of 2016 back into equities, on the substantial decline to begin the year. A lot of that cash has gone into cheap stocks paying large dividends, such as General Motors (GM) or lodging REIT Chatham Lodging Trust (CLDT). An increasing portion has also found its way into the biotech sector, especially in large-cap growth plays like Amgen (AMGN), as these stocks are selling at their lowest valuations since 2011. Biotechs are in the midst of their biggest bear market since the financial crisis. However, the sector has had a nice bounce over the last week off oversold levels. Hopefully this is a start of a long overdue rally. Outside the large stocks in the sector, I am going a bit further out on the risk scale as many smaller caps have been taken out and beaten like a rented mule over the past six months. There are some great values, but this area is not for the faint of heart. It is helpful to look at the sector in tiers varying by risk. Tier 1 stocks are large-cap growth stocks, such as Amgen or Gilead Sciences (GILD), that have great balance sheets, deep product portfolios and pipelines, and are trading at attractive valuations based on their long-term and established earnings growth. My rule of thumb is one should have 50% to 75% of overall holdings in this volatile sector in these large-cap core positions, depending on one's risk preferences. Tier 2 stocks in this sector are small-caps that have real earnings and revenue growth across a diversified product portfolio but less financial strength than their larger-cap brethren. Biopharma ANI Pharmaceuticals (ANIP) is a good example of a cheap stock in this tier. Tier 3 stocks in the space are companies with recently approved drugs that are just getting started in the commercialization phase of their development. Revenue growth and real earnings are right around the corner, which takes a lot of pipeline risk out of the equation -- one that is prevalent in the small biotech and biopharma space. Pernix Therapeutics (PTX) and Relypsa (RLYP) are two attractive plays in this category I own right now. Finally, Tier 4 stocks are developmental concerns with no recurring revenues as yet, whose main attraction is their pipelines. I like to de-risk further this area, especially given the big bear market in the sector. In this tier, I am only adding to stakes in firms with recently approved drugs or that on their way to having them by the end of the year. Merrimack Pharmaceuticals (MACK), which had its primary drug candidate MM-398 approved by the FDA late in 2015, is a good example. Another is Dynavax Technologies (DVAX), which should file a New Drug Application (NDA) for its hepatitis B vaccine HEPLISAV-B by the end of the quarter. By breaking biotech into tiers one can put more focus on risk management and make better decisions on how to deploy capital matching one's risk profile. Currently, I am allocating roughly 70% of new money in the sector to Tier 1 names, 15% to Tier 2, 10% to Tier 3 and 5% to Tier 4. Once a bottom in biotech is confirmed I will likely move to a more risk on stance with new money I deploy into the space.

Cashing In on the Biotech Bear Market

My 4-Tier approach to deploying new capital in the sector.

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