4Q22 Biotech / Pharma investing outlook – negative overall, but some bright spots

We are now just in front of 4Q22 at mid-September.

3Q22 saw great inflection for biotech after big drawdown in 2Q – many investors were caught off guard with this significant upward move in the $XBI. I know many hedge funds lost money being net short through 3Q.

As investors, we must always be on the lookout for what is next and today I discuss key themes for biotech investing for 4Q.

Overall – I expect biotech sector ($XBI) to be underperform the market in remainder of the year. My rationale is based on following reasons:

TIME TO THINK ABOUT WHAT STOCKS WOULD BE CANDIDATES FOR TAX LOSS SELLING/HARVESTING

Tax loss selling means funds are great investing opportunities on the long side – it is artificial selling activity driven by our tax system – many funds sell stocks to generate taxable loss so that it can offset taxable capital gains for the year in order to minimize the tax bill for the year.

This is technically called “tax loss harvesting” – so what happens is that we see heavy selling pressure on stocks that are down significantly for the year if there is no major catalyst for the remainder of the year.

While 3Q saw “GREAT RECOVERY”, majority of biotech companies are still down for the year – particularly loss making, platform companies like $BPMC, $MRTX, $ARWR, $BBIO, $FATE, or $RARE – the list goes on.

As holders sell their holdings to generate losses to offset realized gains to reduce tax bill, those shares are likely to be under pressure.

TAX WASH RULE prevents seller to buy back the stock within 30 days if the seller wants to crystalize the loss this year – so those stocks are likely to remain dead money.

$XBI TENDS TO BE SEASONALLY WEAK IN 4Q

Many portfolio managers look at “seasonality” of stocks as part of technical assessment. XBI is not particularly strong. Over the past five years, $XBI was down -2.7% in October, up +5.7% in November, and down -1.3% in December.

The trend is noticeable with respect to tax loss selling as mentioned above – many mutual funds have to sell before 10/31 to generate tax loss – driving the weakness in October. Then they buy back those shares in November after wash sale period of 30 days – driving strength in November.

Then, rest of us sell in December to harvest our tax loss – hence some weakness in December.

Another reason for weakness is lack of significant clinical catalyst. AHA in November or ASH in December tends to have significant data readouts, but they tend to be more “detailed data presentations” because companies generally have to release outcome of the trial (whether successful or failed) as they become available in accordance with the disclosure law.

With no major clinical catalysts in 4Q, stocks generally tend to just linger around – often drift down because they become good candidates for funding shorts.

BUT 4Q IS ALSO THE TIME TO PREPARE FOR THE BIGGEST M&A SPECULATION EVENT IN JANUARY EVERY YEAR – JPM HEALTHCARE CONFERENCE

However, we should always keep eyes on big winners – those that get taken out at crazy premium at JPM Healthcare conference.

As the first major healthcare conference of every year, JPM Healthcare sets the tone for healthcare investing for the year and many large cap pharma companies tee up major M&A for the event so that they can make a splash and have the opportunity to meet with investors to talk through the rationale of the deal.

For that reason, many investors speculate on which companies are going to get bought out at JPM. Obviously I am playing for that as well – for me, I am focused on single product biotech companies that have pipeline that have potential to become mega blockbusters for the remainder of the decade – after all, large cap pharmas are all trying to backfill the pipeline that can offset big LOE events in the 2nd half of the decade.

As shown in Bristol Myer Squibb’s 2Q22 investor presentations, large cap pharmas are focused on bolt-on acquisitions to bolster their pipeline – rather than big consolidation M&As that were hot in 2017-2019 era.

PFE has made even more clear that they have goal to add $25bn of risk-adjusted revenue to their 2030 top-line expectations through business development (M&A or licensing agreements).

I would say competition is heating up for differentiated assets with strong pipeline potential – some examples are $BPMC, $ASND, $ALNY, $SGEN, $FOLD, $NBIX, etc.

CONCLUSION

Overall, I am negative on the sector – but I am going to be long some small-mid cap stocks that have one, but good/decent product that is funding really exciting pipeline that could turn out to be mega blockbusters and can move the needle for large cap pharmas even on risk-adjusted basis.

As for those companies with no clinical catalysts or no differentiated products, I will be using them as funding shorts.

Market will be what it does (moving up and down with no ending), but biotech investing should continue to reward patient shareholders with large caps’ insatiable demand for innovation providing some price floor and massive upside in the fortunate event of an acquisition.