A Simple Formula for Drug (and Biotech and Spec Pharma) Stock Selection

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Therapeutic (drug, biotech and specialty pharma) stocks tend to gradually outperform their peers in the year or so preceding and following major anticipated product approvals. The exception is the period immediately surrounding the scheduled regulatory action, where risks are skewed to the downside

We have developed a simple set of portfolio construction rules intended to maximize exposure to share price performance in the months before and after major anticipated regulatory actions, while minimizing exposure to risks in the days surrounding these events. The rules are expressly designed to trigger buy and sell actions using only information that would be available to traders in a real-world setting

Back-tested from 1996 through 2h2011, portfolios built using these rules offer superior risk-return characteristics as compared to the DRG, the BTK, and our own ‘innovator index’ of all drug, biotech, and spec pharma stocks. At roughly the same standard deviation of returns as the DRG (0.20) our conservative portfolio (sd returns 0.19) outperformed the DRG by 7.0%. Our aggressive portfolio produced the same total return as the BTK (16.7%), but with far less volatility (aggressive portfolio sd returns = 0.30 v. 0.50 for the BTK)

Our systematic, big picture view of therapeutics generally (and large cap pharma especially) is bearish; accordingly we face the challenge of building healthcare portfolios without over-exposing ourselves to these negative systematic risks. Despite our bearish systematic view, we continue to believe that new product flow can create new economic value and thus relative share price outperformance, thus our motive to find a set of portfolio construction rules that develop a portfolio with as much positive idiosyncratic risk (i.e. new product flow) and as little negative risk (broadly, exposure to earnings drivers outside of the immediate scope of new products; narrowly, exposure to asymmetric risk / reward that immediately surrounds regulatory actions) as possible. We believe our rules achieve this goal, and that our approach should offer better risk-adjusted performance than more traditional approaches to therapeutic (drug, biotech, spec pharma) stock selection

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