Tag Archives: opinion

What’s Ailing Biotech?

Summary Concerns about profitability and valuations had already infected US biotechnology stock prices in September. Increased political and media attention on rising drug costs sent the sector deeper into a decline. Evan McCulloch shares his insights on the drug-cost debate, presidential candidate Hillary Clinton’s proposal, and the fallout on the biotech sector at large. Evan McCulloch Senior Vice President, Director of Research Franklin Equity Group® Portfolio Manager, Franklin Biotechnology Discovery Fund (MUTF: FBDIX ) ________________________________________________________ We have seen some turmoil in the biotech sector over the last few weeks. What’s been driving this volatility? There’s been some volatility in the equity market at large, which has resulted in investor skittishness overall and a hypersensitivity to potential fundamental concerns. Specifically for the biotechnology sector, however, the threat of heightened scrutiny of drug prices has reared its head again. It started with an article in The New York Times on September 20 about a small private company called Turing Pharmaceuticals 1 that raised the price of an anti-toxoplasmosis drug it had acquired by 5,000%. This is very unusual for an older drug, so it was a case the media latched on to. The article was followed by a tweet from Democratic presidential candidate Hillary Clinton, indicating she thought some drug prices were excessive and that she had a plan to reduce prescription drug costs. Clinton subsequently announced her plan, which proposed that Medicare leverage its buying power to negotiate directly with drug companies. After that, other politicians jumped on the bandwagon and railed against high drug prices. The House Committee on Oversight and Reform already had been seeking to subpoena documents relating to Valeant Pharmaceuticals’ 2 price increases earlier this year on a pair of cardiovascular drugs, and it then asked to subpoena Turing Pharmaceuticals about the price increase on its drug, which treats parasitic infections. It’s interesting to note that the pricing noise has been around for a while; there have been a series of press articles on the subject going back to July. President Obama has made periodic comments about high drug prices, and Senator Bernie Sanders, who also is vying for the Democratic presidential nomination, released a plan focused on pricing which generated renewed attention. So while this is an issue that bears watching, I think it’s a culmination of sector-specific concerns about drug pricing on top of some broader market issues that has caused recent volatility in share prices. So where could this all be going? Might it result in a reduction in drug prices, in your opinion? For better or for worse, in my view the answer is no. All Clinton did was articulate a plan; it is not legislation. The price of prescription drugs is a popular topic because most people in the United States think drug prices are high, and it’s an issue that resonates well with voters. Again, this is not legislation, and if it were, it would not likely be approved by a Republican-majority Congress. Given that the Republicans seem likely to retain their majority in the House of Representatives after the 2016 election, I don’t believe any legislation can pass until 2018 at the earliest. Even if Clinton’s plan, as we currently understand it, did ultimately pass, in my view the impact would be very manageable for the sector. Most notably, according to our estimates, any cut to drug prices inside the Medicare program would be far less than the recent 15%-20% stock correction in the sector might imply. However, we do expect more market-based reforms. This public shaming process that politicians are employing will likely cause companies to moderate price increases going forward and also empower insurance companies to drive toward higher rebates and more substitution of cheaper drugs. So, we do expect some growth moderation at the margin, but it will probably be imperceptible at a sector level. In the fund, we focus on investing in companies with drugs that deliver strong clinical value and have limited competition, which seeks to mitigate the impact of some of these initiatives. Moving on to the topic of patent protection, do you have any concerns about the exclusivity provisions offered in the Trans-Pacific Partnership ( TPP ), the proposed trade agreement between 12 Pacific Rim countries? No, I don’t have any concerns about it. The TPP proposes that drugs sold outside the United States get eight years of exclusivity. Patents currently don’t protect US drugs overseas. So, granted, eight years is lower than the current 12 years of exclusivity in the United States, but eight years should be compared to virtually no exclusivity right now, as many of the countries covered in that partnership do not honor intellectual property rights. So, this provision would protect pharmaceutical companies for eight years, which would actually be a positive for the sector, in our opinion. What do you think the media is either not covering or may be misreporting about the biotech sector that you think investors should know? The media has focused on gross price increases on drugs, and that is very different from actual price increases or net price increases. In most cases, price increases are moderated through rebates to the payers, but since that’s a negotiated price, the actual price being paid by insurance plans to the drug companies is not transparent to investors or the media. In most cases, when we see a price increase, we know only about one-third to two-thirds of that price increase is realized, so the actual price increases are much lower than what is being reported in the press right now. What is your current outlook for the biotechnology space? I think fundamentals in the biotechnology sector are as strong as ever. In our view, the sector’s new-product pipeline is full, and important new treatments are advancing for cancer, Alzheimer’s dementia, and a whole range of rare genetic diseases. In cancer treatment, interest is very high in using drugs that harness the immune system to fight tumors. A number of new drug discovery technologies, like gene therapy, RNAi (RNA interference) and antisense, allow companies to target rare genetic diseases that were previously untreatable with more traditional drug approaches. For drugs that make it through the clinical trials process, the US Food and Drug Administration is working cooperatively with the sector to bring new drugs to patients, and in most situations has approved drugs that have strong value propositions for patients. Until recently, investor concern was generally constrained to stock valuations, not fundamentals. Although concerns about drug pricing power have arisen, I don’t expect any major change. And with more attractive valuations following this recent correction, we think the outlook for the sector is very positive. To get insights from Franklin Templeton Investments delivered to your inbox, subscribe to the Beyond Bulls & Bears blog. For timely investing tidbits, follow us on Twitter @FTI_US and on LinkedIn . This information is intended for US residents only. Evan McCulloch’s comments, opinions and analyses are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy. What Are the Risks? F ranklin Biotechnology Discovery Fund All investments involve risks, including possible loss of principal. The fund is a non-diversified fund that concentrates in a single sector, which involves risks such as patent considerations, product liability, government regulatory requirements, and regulatory approval for new drugs and medical products. Biotechnology companies often are small and/or relatively new. Smaller companies can be particularly sensitive to changes in economic conditions and have less certain growth prospects than larger, more established companies and can be volatile, especially over the short term. The fund may also invest in foreign companies, which involve special risks, including currency fluctuations and political uncertainty. These and other risks are described more fully in the fund’s prospectus. Investors should carefully consider a fund’s investment goals, risks, sales charges and expenses before investing. To obtain a summary prospectus and/or prospectus, which contains this and other information, talk to your financial advisor, call us at (800) DIAL BEN®/342-5236 or visit franklintempleton.com. Please carefully read a prospectus before you invest or send money. _________________________________________________________________ 1. As of 9/30/2015, Turing Pharmaceuticals was not a holding of Franklin Biotechnology Discovery Fund. Holdings are subject to change without notice. 2. As of 9/30/2015, Valeant Pharmaceuticals was not a holding of Franklin Biotechnology Discovery Fund. Holdings are subject to change without notice.

MOAT: Have You Considered Using An ETF To Find Companies With Moats?

Summary The sector allocations were a bit surprising to me. Industrials were heavily weighted while utilities and health care were not. The fund has a 15% turnover ratio, which seems within reason for the strategy. The idea of holding attractively priced companies with solid economic moats makes sense, but applying that strategy as an ETF is problematic. The sheer size of the ETF would be a huge problem for acquiring shares in smaller companies with the equal weighting philosophy. Larger companies will receive significantly more coverage and the market should be more efficient. Investors should be seeking to improve their risk adjusted returns. I’m a big fan of using ETFs to achieve the risk adjusted returns relative to the portfolios that a normal investor can generate for themselves after trading costs. One of the funds that I’m researching is the Market Vectors Wide Moat ETF (NYSEARCA: MOAT ). I’ll be performing a substantial portion of my analysis along the lines of modern portfolio theory, so my goal is to find ways to minimize costs while achieving diversification to reduce my risk level. Expense Ratio The net expense ratio for MOAT is .49%. I tend to be very frugal with my expense ratios, so I like to see those low levels. When I’m looking at a simple market cap weighted broad market or total market ETF I would expect to see single digit expense ratios. On the other hand, this portfolio would require analysis on the individual companies so higher expenses would be expected. Sector The following chart breaks down the sector allocations: I don’t love huge allocations to consumer discretionary, but I can believe that they would make sense for a portfolio based on having economic moats since there should be some material differentiation in the products provided by the companies. On the other hand, seeing industrials at almost 25% is quite a surprise to me. Perhaps their concept of a moat is different from mine, but they clearly don’t weight utilities high despite the utilities having regulated monopolies. I would think a monopoly that was protected through regulation would have a fairly solid economic moat. In a similar manner I would have expected stronger allocations to health care because the patent system provides long lasting economic moats. Largest Holdings The following chart shows the largest holdings for the fund from the end of the third quarter: I pulled up the daily list of holdings to verify that they were not materially changed. Since the goal here is to buy companies with durable economic moats, I would expect the allocations to remain similar with some small variations as shares go up and down in value causing them to trade places on the list. (click to enlarge) I had to pull the fund up on Schwab to find the turnover ratio, which was listed at 15%. All in all that suggests the portfolio would be turned over about once every 6 to 7 years. That isn’t too bad. The reason for the turnover seems to be that the portfolio is designed to be allocated as an equal weight portfolio across the “most attractively priced” companies that have been classified as having large moats. If the case is based on most attractively priced, then it starts to seem strange that the companies are not moving up in price enough to force the positions to be turned over the next time the index is updated. Conclusion There is nothing wrong with the concept of selecting stocks based on finding reasonably priced companies that have economic moats to prevent competition from eroding their profits. The strategy makes a great deal of sense and investors selecting individual companies would be wise to consider the influence of future competition on the success of their investment. A challenge for an ETF attempting to follow the same strategy is that it could require some fairly significant capital flows if the ETF becomes larger. The need to completely remove companies and buy up a 5% allocation in another company would risk moving market prices if the ETF were large and their strategy included fairly small companies. While moats may be much more common for established companies that rule their space, that doesn’t mean there won’t be very attractively priced smaller companies that are flying under the radar. The nature of needing to be able to suddenly buy up around $30 million to $40 million would be a difficulty for companies with a market capitalization lower than $1 billion since it could require purchasing at least 3% of the company. This will probably force the ETF to only consider larger companies. The concept makes sense, but execution of the strategy seems like a logistical nightmare unless the investment universe is significantly restricted to limit the list of potential investments to medium and larger companies. Once those restrictions are in place, it seems much more difficult to find and select the best securities because larger capitalization companies attract substantially more analyst attention and should generally be priced be more efficiently.

ITOT: A Solid Core Holding For Building An Efficient Portfolio

Summary This ETF has a low expense ratio and looks like a solid option for a core position. As a total market ETF there is very little opportunity to modify exposures. Due to the sector allocations I believe the fund is best utilized when combining it with a small position in more specialized ETFs to tailor the sector allocations. Investors should be seeking to improve their risk adjusted returns. I’m a big fan of using ETFs to achieve the risk adjusted returns relative to the portfolios that a normal investor can generate for themselves after trading costs. One of the funds that I’m researching is the iShares Core S&P Total U.S. Stock Market ETF (NYSEARCA: ITOT ). I’ll be performing a substantial portion of my analysis along the lines of modern portfolio theory, so my goal is to find ways to minimize costs while achieving diversification to reduce my risk level. Expense Ratio The expense ratio for ITOT is only .07%. I tend to be very frugal with my expense ratios, so I like to see those low levels. There are a couple lower expense ratio ETFs in the categories of broad or total market, but .07% is still pretty good. Depending on where an investor does their brokerage, they may have incentives to use different ETFs to mitigate trading fees. Largest Holdings The following chart shows the largest holdings for the fund: These shouldn’t be a surprise since this is a total market ETF. The holdings across most total market ETFs will be very similar which gives investors a good reason to watch for high expense ratios, bid-ask spreads, and trading commissions to determine their long term costs. These allocations are subject to change, but I wouldn’t expect much in the way of change. Given the presence of such strong dividend champions at the top of the chart, investors might expect a strong dividend yield. Instead, they’ll find the yield is only around 2%. That’s no problem for most investors that would just reinvest their dividends anyway, but it may be less than optimal for investors in retirement seeking stronger yields to provide income without selling shares. Sectors The following chart breaks down the allocation by sector: The only sector I’ve been generally opposed to over the last several months has been telecommunications due to the aggressive price wars being waged. In this case the telecommunications allocation is just over 2.14%. In my view, that is a positive factor because 2.14% is a fairly low allocation for telecommunications among domestic equity ETFs. Using the holdings chart above, we can also determine that AT&T (NYSE: T ) and Verizon (NYSE: VZ ) combined to be about 1.92% of the portfolio, so most of the telecommunications allocation is right there. Energy Energy can be a fairly tricky sector because it can be referring to established champions like Exxon Mobil (NYSE: XOM ) or it can be referring to massively more aggressive plays such as off shore oil drilling. I like the fundamental premise of owning enormous producers of oil. If oil ever becomes irrelevant, it would be a very bullish sign for the rest of the economy pointing towards very low cost transportation and more capital available for spending on other goods and services. In order to hedge that risk, I want to see some of the established oil companies in the ETFs I use in my personal portfolios. I really wouldn’t mind seeing a higher allocation here so long as it was those established champions. They don’t have anywhere near as much upside as buying those drilling operations, but I am happy to sacrifice the upside to have dramatically reduced downside. Information Technology I know this is a growing part of our economy and it may continue to grow dramatically because information technology firms will generally have access to great economies of scale. I want some exposure to this part of the economy, but I wouldn’t mind seeing a slightly lower allocation because with great economies of scale comes the opportunity for earnings to get punished by a large drawdown in the economy or a black swan event. By definition, we won’t be able to predict black swans. However, I do believe we can estimate which industries have more exposure to those events. One Other Note There are 1509 holdings in this fund and it tracks the S&P Composite 1500 index. In my opinion a fund holding 1500 individual securities and tracking an index of 1500 securities is a broad market ETF, not a total market ETF. In my view any domestic ETF with fewer than 2000 holdings looks more like a broad market ETF than a total market ETF. Conclusion Overall this looks like a fairly good ETF. Since the ETF is going for a very low expense ratio and a passive style, there is not much to be done about adjusting the allocations. My preferred way to use an ETF like this would be to combine it with another more specialized ETF that placed a very high emphasis on my preferred sectors. When the investor combines the iShares Core S&P Total U.S. Stock Market ETF with another domestic equity fund they can look at the weighted average of the sector allocations which would be nice for building a very efficient portfolio.