Biotech stocks are once again making headlines as the fight against COVID-19, commonly dubbed the "Wuhan Coronavirus," is well underway. Investors are suddenly searching for attractive opportunities in this sector in the hopes that a successful solution to curb the spreading of the virus will lead to eye-popping capital gains.
While there's no reason to deny such a possibility, picking the right companies to bet on can be both tricky and complicated. To avoid the many pitfalls of thematic investing based on a temporary development such as a pandemic, a thorough understanding of all the important factors involved is important.
History teaches valuable lessons
This is not the first time an epidemic threatened to disrupt the performance of global capital markets. Even though the new coronavirus seems to be spreading at an alarming rate that has never been seen before (perhaps partially due to the improvement of information and diagnoisis technology), the Ebola and SARS outbreaks can be used for comparison purposes to identify trends in the biotech sector.
In January of 2015, Daniel Ward, CFA, a popular biotech analyst, prepared a table ranking the performance of all biotech companies that had announced plans to develop a vaccine to fight Ebola. The mean return for this basket of stocks was negative, suggesting that an average investor would have lost money if equal amounts were invested in each of these companies.
Source: Daniel Ward, CFA
While this might discourage contrarian investors, the stellar performance of a few stocks is proof that some investors won big. Even though there's no guarantee that history will repeat itself, a few more conclusions can be drawn through an analysis of the past.
A deeper dive into the size of the biotech companies listed above reveals that most of the losers were small in scale and that stocks of large companies delivered acceptable returns.
Companies with a market capitalization of $100 million or more
Companies with a market capitalization of less than $100 million
Investing in small companies has often proven to be lucrative in the long term. However, when it comes to tactically allocating assets to benefit from something short-term like an epidemic, it seems best to go with the leaders of the industry. This makes sense as government authorities would naturally be inclined to provide funding and approve fast-track clinical trials for renowned companies that have proven their ability to develop high-class medicine.
These companies are at it
Many companies have already announced their plans to find a solution for the rapidly spreading COVID-19 virus. Notably, all these companies are billion-dollar pharmaceutical giants, which falls in line with the discoveries of this analysis. Below is a list of companies that have made some progress so far.
On Feb. 24, the company announced a collaboration with a Chinese biotech firm, Clover Biopharmaceuticals, to develop a vaccine to fight the virus.
Gilead Sciences (NASDAQ:GILD)
The World Health Organization said on Monday that Gilead's drug remdesivir is showing signs that it may help treat the virus. The company, in a statement made the same day, confirmed that clinical trials involving humans are currently underway and that results can be expected within a few weeks.
On Feb. 18, the company announced a partnership with the U.S. government to find a solution to curb the spreading of the virus.
Johnson & Johnson (NYSE:JNJ)
The world's largest drugmaker is working with the Biomedical Advanced Research and Development Authority to find a cure.
The company is developing a vaccine and the drug will be tested on humans within two and a half months, according to a statement released by the company on Feb. 24.
Investors might be tempted to bet on these companies. However, there's a better way to do the same thing as well.
One fund to capture the potential upside
There's a simple way to gain exposure to a basket of biotech companies with attractive prospects. Investing in not one but many companies provides diversification benefits and can protect a porfolio from a severe downturn of a single stock. The iShares Nasdaq Biotechnology ETF (NASDAQ:IBB) primarily invests in large-cap health care stocks, which ensures that many of the companies that are actively seeking for a vaccine or a cure to fight COVID-19 are holdings of this exchange-traded fund.
As evident from the above illustration of the top-10 holdings of the fund, the primary focus is on listed biotech stocks with billion-dollar market capitalizations. The below table from Morningstar confirms this.
As discussed in the previous segment, an investor wanting to pick biotech companies that would ideally rise in value as a result of developing a successful vaccine to control the spread of the new virus should ideally focus on large-scale companies. Investing in this iShares fund is an easy way to do this.
Another measure to mitigate the risks
Even though investing in a basket of billion-dollar biotech stocks could lead to very attractive returns once the spread of the virus is contained, things might still go wrong for investors. Making the right decisions does not always lead to the desired results. Such is the nature of investing in equity markets. While systematic risk, or market risk, cannot be mitigated, one can reduce the chances of ending up on the wrong side of the bargain by taking appropriate actions and being diligent.
In the context of the subject matter of this discussion, the most appropriate due diligence measure that investors should execute is to evaluate the pipeline of the companies before investing. This can be done either by visiting the Food and Drug Administration (FDA) website or by going through the quarter-end investor information published by the respective companies.
The big name-holdings of the iShares Biotechnology fund have strong pipelines with many trials in the late stage. Also, all of these behemoths can certainly survive in the long term even if they fail to develop a vaccine to fight the new coronavirus. This provides a hedge against a significant collapse of the share price if things go south in the next couple of months.
Takeaway: high rewards for prudent investors
No one can predict the performance of capital markets with any degree of precision. However, at the same time, calculated risks need to be taken to generate alpha returns consistently.
Biotech companies are in a race, with the support of government authorities, to find a solution for the COVID-19 virus. In the most likely scenario, a few companies will emerge victorious, rewarding investors with eye-catching returns. In addition to investing in equity securities of companies directly, investing through an ETF that specializes in large-cap biotech stocks could also lead to attractive returns.
Disclosure: I do not own any stocks mentioned in this article.
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This article first appeared on GuruFocus.