In the fourth quarter, the Health Care sector was the best performing group in the small cap benchmark, returning 22.3%, or more than double the Russell 2000 Index’s 9.9% return. Over that same period, our small cap strategy had a negative selection effect in Health Care, despite the fact that our portfolio’s weight in Health Care was in line with that of the benchmark (i.e., we are sector neutral). Running further tests revealed an interesting symptom. The issue was with stock selection, or more specifically, negative selection. That is to say, not owning a specific security within the portfolio created an ailment.
Sector-based attribution helps to understand what drove returns. It can show if our performance was due to weighting differences and/or stock selection within sectors. Our long-only equity strategies are constructed to be sector-neutral to their benchmarks. Therefore, return contributions from sector weightings are rarely a material driver and contributions from stock selection carries more weight.
Jumping to the large cap universe for a second, it easy to understand how not owning/underweighting “FAANG”, or mega cap in general, creates a headwind for active portfolio managers. Benchmarking to a capitalization-weighted index can lead to an impulse to own the largest stocks just to keep up with the benchmark. This leads to the known problem of “closet indexing”. As more managers undertake this, those trades become “crowded” and the marginal buyer is purchasing stocks at very high prices for no other reason than because peers are doing so. This creates a circuitous cycle until something causes sentiment to change. This dynamic is less of a concern in the small cap space. In fact, the opposite effect occurred in the fourth quarter. There was a multitude of Health Care companies, particularly in the Biotechnology industry, many of which are very small, which created a drag on performance.
Let’s look at the charts
Within Health Care, the Pharmaceuticals, Biotechnology and Life Sciences sub-sector was a major driver. The Russell 2000 Biotechnology Index (BBG Ticker: RGUSHSBT) gained 32.9% in the quarter.
|Russell 2000 (white line)||9.9%|
|Russell 2000 Health Care Sector (green line)||22.3%|
|Russell 2000 Pharmaceuticals Industry (orange line)||17.5%|
|Russell 2000 Biotechnology Industry (pink line)||32.3%|
There has been a significant increase in the number of Biotechnology stocks since 2014. Prior to 2014, Biotechnology companies numbered around 100; as of the end of 2019, there are over 225.
Source: S&P Global/Clarifi, 361 Capital.
There is probably not a single cause for the increase. One hypothesis is the strong equity markets with low rates could have been an enabler for investors to put money into riskier, growthier, more volatile, low-priced stocks. Another is an industry tailwind due to a conducive regulatory picture. According to a recent research note, new drug approvals are tracking above average, with some experiencing shorter timelines. M&A activity has been healthy as well, with the number and deal size each above ten-year averages.
To add a little more perspective, in the fourth quarter, 19 of the top 20 stocks in the Russell 2000, by price return, were in the Health Care sector. Of those 19, 18 were in the Pharmaceuticals, Biotechnology & Life Sciences sub-sector. Of those 18, the 14 Biotechnology firms had an average return of 294% and the four Pharmaceutical companies had an average return of 269%. Eight of the Biotechnology and three of the Pharmaceuticals firms had zero or negligible revenue during the last twelve months. The plot below shows the dispersion of returns by industry and revenue category for the top 18 performing stocks in the Pharmaceuticals, Biotechnology, & Life Sciences sub-sector. This is the top-twenty returns of the Russell 2000 Index, excluding the two stocks not in this sub-sector. (One was in the Health Care Equipment & Services sub-sector, the other in the Communication Services sector).
Source: Zacks Investment Research, S&P Global/Clarifi, 361 Capital.
Highlighting a few points, the eight stocks in Biotechnology and three in Pharmaceuticals that are in the “No Revenue” category had median returns of over 250% and 350%, respectively. Among these top 18, only two had trailing-twelve-month revenue of at least $50M. The next plot is a similar picture of the return dispersion of all Biotechnology and Pharmaceutical companies. Dots further to the right represent companies with greater revenue compared to those on the left. The concentration to the left is companies with little-to-no revenue. The gap between percentiles zero and approximately 30% is due to the amount of companies in the zero-revenue category. The size of the dots indicate weight in the Russell 2000 Index.
Source: S&P Global/Clarifi, 361 Capital.
Within Biotechnology, 109 companies, comprising about 3% of the weight in the Russell 2000 Index, are yet to book any significant revenue.
So, how do we treat this? While the sources of returns, coupled with industry dynamics, are useful to manage risk and articulate results, it would not be prudent to act hastily by increasing the dosage of this sector, without knowing the potential side effects. As mentioned, our portfolios are designed to be sector neutral. Plus, we do not purport to have any foresight as to when this situation may turn.
It does lend itself to ongoing research into portfolio construction and risk models. There are obvious differences in the behavior of small Biotechnology/Pharmaceuticals stocks relative to other industries. Many are low/no revenue, volatile, and have very low prices. These are not attributes that rank well when looking for “healthy” companies with quality financials and reasonable valuation measures. Internal research suggests that, over time, Biotechnology/Pharmaceuticals stocks with more substantial revenue exhibit less volatility than those without, with similar upside. Unfortunately, that was not the case this past quarter.
This should not be construed as an opinion for or against these companies. It is merely assessing the environment. As with any sustainable health plan, long-term success often means short-term discomfort.
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