BWI: Failing Growth Narratives and Overvaluation in Biotech (NASDAQ: BWI)

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Although the biotechnology sector has long captured the attention of investors, it has never been more pronounced than when the effects of the pandemic were felt around the world. However, 2022 shows a steady downward trend in stock market valuations across the world. board and the biotechnology sector is no exception, regardless of the perceptions the pandemic may have introduced about this sector. The reasons for the current market downturn are complex and multifaceted.

Let’s start with a broad analysis of the biotechnology sector.

Biotech ETFs and regional biases

For a broad analysis of the sector, consider 4 popular exchange-traded funds ((ETFs)): the iShares Biotechnology ETF (NASDAQ: IBB), ETF ARK Genomic Revolution (ARKG), ETF Invesco Dynamic BioTech & Genome (PBE) and ETF VanEck Biotech (BBH). As of January 3 of this year, these 4 ETFs collectively accounted for nearly $16.2 billion in assets under management (AUM).

Consider a series of annual “snapshots” from May 2019 to 2021 – plus an additional snapshot at the dawn of this year as well as at the end of April each. Companies incorporated in the US and Canada as well as US/Canadian companies having their registered office in Ireland, the Cayman Islands or Jersey will be grouped under the “North America” region. Similarly, all businesses in Europe (including the UK) will be grouped under the “Europe” region.

ETF components by region: IBB, ARKG, PBE, BBH

Created by Sandeep G. Rao using data from Bloomberg

There is an interesting study of the contrasts in the 2019 snapshot vis-à-vis the present: while ARKG has between 2 and 4 European companies in its holdings over the entire period, their weights were significantly higher than that of IBB which – with between 13 and 32 European companies in its holdings – has the largest number of European companies in its holdings among the 4 ETFs. Today, this situation has been reversed; IBB now has both the highest European constituent weight and count, while ARKG has the lowest medium weight per European company.

Today, ARKG is an “active ETF” – holding weights are based on the fund manager’s view of the inherent potential of technological innovation by the portfolio company in creating future value. The “active ETF” structure is very flexible: the fund manager can change holdings quickly as long as investors are informed of the changes made at the end of the day.

In contrast, other ETFs are driven by rule-based index methodologies derived from qualifying equity fundamentals (PBE) or market capitalization (IBB and BBH) which are applied at set intervals (usually quarterly) in the market. ‘year.

Now, ARKG’s investment methodology is proprietary, meaning it is not publicly available unlike other ETFs. Ark Invest buys companies it deems have the edge to be a disruptor while other fund managers rely on objective numbers and set benchmarks. Almost all ETFs have a high concentration in stocks of companies based in the United States, which is home to the most overvalued stock market in the world.

A previous article discussing the recent trajectory of Tesla shares highlighted how overvaluation has been a concern among fund managers for nearly five years now. However, as the “Equity Trap” article pointed out, with Treasury yields being held low amid rising housing and consumables costs, there is simply no choice but to dive. be invested in markets such as stocks, commodities, etc. seek the preservation or growth of monetary value.

With respect to equities at least, the question of overvaluation can be framed in starker terms when considering the relationship between stock prices and fundamentals. Since IBB has by far the largest number of holdings on both sides of the Atlantic compared to the other 3 ETFs, let’s analyze this ETF’s ratios across “snapshot” dates for a clearer picture.

Ratio analysis: Europe versus North America

Consider three ratios comparing the stock price of IBB’s constituent companies to their fundamentals – price on earnings (PE), price on sells (PS), and price on the book (PB). These ratios can be imagined to form a three-dimensional axis that would describe a plane along which price is observed. Each axis, in theory, should have the same effect on the plane. In practice, of course, this is certainly not true.

The prospect of overvaluation has an interesting effect on these ratios, as data services such as Bloomberg report: Measurements that are too high or too low are do not declared because they are not considered to contain significant information for the investor. Thus, the proportion of tickers with unreported PE ratios to the total number of tickers is calculated in both regions as well as the ETF in total for each of the “snapshot” dates.

Since ETFs do not have global ratios, rough aggregations of these metrics are performed in two formats to arrive at an efficient approximation of regional contribution:

  1. The average; where in the reported the ratios of each of the components of the ETF are purely and simply averaged;
  2. The weighted average; where in the reported the ratios take into account the weight of each constituent.

The picture that emerges is quite interesting.

iShares Biotechnology ETF: Historical Ratio Analysis

Created by Sandeep G. Rao using data from Bloomberg

The main perceptible observations are as follows:

  1. While European equities make up less than 10% of separate company holdings in IBB, the measure of “percent PE unreported” tended to be higher among European equities than North American equities until recently, where they functioned almost at par.
  2. After a brief spike in May 2020, the European PE and PS aggregates tended to lag their North American equivalents on average and have a significantly lower contributory effect, as illustrated by the weighted average.
  3. The outsized PS aggregates in both regions are an interesting feature of the biotech sector, indicating that revenue (not earnings) has an outsized influence on stock valuations. This has been significantly more prevalent in North American equities than in European equities since 2020. In the latest “snapshot” it can be seen that European equities have experienced a substantial slowdown compared to 2019, unlike North American equities. .

As of the date of the most recent snapshot, 30 of the 372 constituents of IBB were also among the 49 constituents of ARKG. Two of them are European – Crispr Therapeutics AG (CRSP), based in Switzerland, and Atai Life Sciences NV (ATAI), based in Germany. Also, 26 of them have undeclared PE ratios, including Atai. Overall, 43 of ARKG’s constituents have undeclared PE ratios.

The massive preponderance of unreported PE ratios in both ETFs is an indicator of the overvaluation of the biotech sector. Overvaluation influences volatility which, in the emerging economic environment, makes a continuation of the downward trend more likely than the reverse. For the first quarter of this year, Morningstar’s star rating system gave ARKG a 1-star rating over a 3-year horizon and a 2-star rating over a 5-year horizon. IBB does a little better (but not much): 2 stars on both horizons as well as on the 10-year horizon.

Assessing Investor Sentiment: Price Trends vs. Assets Under Management

Let us now assess investor sentiment via the trajectories of assets under management between each “instantaneous” date. May 2019 would be the “zero line”, i.e. relative to itself, the net change in AUM and price is zero.

Price movements vs AUM: IBB, ARKG, PBE, BBH

Created by Sandeep G. Rao using data from Bloomberg

Until 2022 began to approach, ARKG’s AUM “deltas” were above those seen in prices, suggesting strong capital inflows. This was generally not the case with the other 3 ETFs – the “delta” pattern only indicates modest increases in capital inflows (the more concentrated BBH being the better attractor).

Since the dawn of 2022, ARKG “deltas” suggest a disproportionately larger output compared to the downturn. IBB and PBE are showing a slight exit while the nearly identical “deltas” of BBH in AUM and price on the most recent date suggest investors are holding.

This variable behavior between BBH and IBB – both with constituent selection rules focusing on market capitalization – lies in the “size effect”. The first favors the 25 largest companies in the sector while the second is more diversified. Given the overvaluation, small overvalued companies are considered more vulnerable than large overvalued companies despite both categories exposed to downside risk.

However, even large companies are not immune to overvaluations and declining volumes are less likely to continue to support overvalued prices relative to ratios. A previous article on ARKG (written almost 5 months ago had given its opinion:

The hazy notion of triumph for indefinite distancing that had driven many “growth” actions to improbable heights in recent years could be factored in…

This isn’t just a problem with ARKG; it’s a problem with the sector as a whole. The count is currently in progress.

General consequences and recommendations

For biotech startups and private companies, positive stock valuations meant the cost of securing funding to expand or even go public was relatively lower. Today, as the outlook for global growth fades, there is an implication that the terms of the negotiations will be a little more difficult.

For equity investors, this sector would likely prove rather unattractive, at least until the floor via “ratio chills” becomes more apparent. When this bottom will become apparent cannot be predicted in good faith. Those already invested in this sector would do well to focus more on diversifying into “classic themes” such as energy and financial services (both covered in previous articles).

For tactical investors in Europe and Asia, on the other hand, there are a number of margin-free products such as exchange-traded products (ETPs) that can be purchased to take advantage of both the upside and the downside. short-term games. An exploration of alternative instruments and tactical use strategy will likely bring some relief in these times.

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