Hedging Strategies In Biotech Investing: (very) Basic Concepts
(originally appeared in Forbes, Mar 7, 2014, titled “Hedging Strategies in a Hot Biotech Market (part 2)”)
The Wall Street Journal reported this morning that the Allman Brothers are ending their yearly March concert series at the Beacon Theater in my Upper West Side neighborhood. The end of winter will never be the same.
I’m bummed about the Allman Brothers at the Beacon, but I think biotechnology has a very bright future, near-term and long-term.
A few days ago, we considered a couple of strategies to protect gains from the recent biotechnology stock run. Let’s take a deeper look.
The strategies we discussed, selling short a biotechnology index fund or pairing individual short sales to your long positions, are logical but also difficult to do successfully. Index funds can be poor surrogates — and inappropriate hedges — for individual portfolios, placing you at risk to be wrong on both sides of a long-short strategy, losing money on your long names and on your short names.
And selling short individual names, particularly those that are small or micro-cap and illiquid, can expose you to losses far in excess of the money you thought you placed at risk.
So short carefully. Thankfully, you can partly mitigate the risk of short sales. You can look for companies with seller’s insurance.
What’s seller’s insurance? It’s when a company sabotages its stock performance with an ugly capital structure, making it less likely the stock will have a sustained run, even with good news.
Remember that the cap structure, the right side of the balance sheet, is the combination of debt and equity upon which the company is built.
For a pre-revenue, cash burning company, the best cap structure is 100% common stock. The fully diluted share count (outstanding shares plus preferred shares plus warrants plus options plus shares underlying convertible debt plus whatever else the bankers and the CFO can think up) should be only marginally higher than the number of shares outstanding. Huge warrant pools, preferred stock layers, convertible debt, and other derivatives disperse value creation away from common share price. Owners of warrants and convertible debt can use these instruments to hedge their own portfolios, and effectively cap the stock price close to the strike prices or conversion prices.
If you want to choose safer (if not totally safe) stocks to short, look for those with these highly inflated fully diluted share accounts.
Where do you find this information? You have to dig into the company’s filings. These are available online, in PDF form, which can be searched with a simple control-F.
Want an example? Go back and look at the effect $200 million of convertible debt had on the share price movement of Indevus Pharmaceuticals (IDEV) when its first product was approved in 2004.
I learned that particular lesson the hard way.
Another idea (maybe): sell call options on the stocks you hold.
Remember the components of the Black-Scholes equation, particularly the correlation between option pricing and volatility. In a hot, volatile market, options should be expensive. In theory you can take advantage of the high pricing, and use the shares you already own to cap the exposure.
If you don’t know what I am talking about, then you should not consider this strategy. Frankly, I’m not a big fan of casual options trading, which can be an invitation to be the sucker at the poker table. Options pricing is an art in and of itself, is much more opaque than stock pricing, and liquidity (the ability to unwind your position) is different than buying and selling stock.
Shifting from the complex to the obvious and most basic strategy: decreasing your exposure.
Not all-or-nothing “keep the whole portfolio or sell the whole portfolio” binary decisions, but a discriminating and disciplined process. Take a step back and examine your portfolio. Manage it stock-by-stock, not as one large entity. Look at each and define your investment objective.
Investment or trade?
There is nothing illegal, immoral, or driver impairing about selling stock for short-term reasons. However, if you buy an asset because you feel that its long-term prospects are enormous, short-term market changes are not important. Good management teams manage their companies, not their stock prices. Long-term investors watch execution too, and ignore short-term volatility.
If you bought Celgene (CELG) at $19 in 2000 because you had the foresight and judgment to handicap its future, then you did not sell the stock when the biotech market dropped over the next two years. If you were an investor, you increased the size of your position.
If your position was a short-term trade you may have managed it differently. You likely would have traded out at $19 (Celgene was low single digits a year before.)
It’s easy, but not wise, to settle into a nebulous, ill-defined place on the investor-trader continuum. But be disciplined. You don’t have to be consistent — different stocks can have different goals, but for each name have a thesis and act upon it.
Ask yourself: is this a long-term investment or a shorter-term trade? If it’s a long-term investment, and the price drops — buy more. Down markets are a gift to long-term investors. This is Warren Buffett 101.
If this is a short-term trade, do you have reason to think it is immune to short-term sector drops? If so, keep it. Otherwise, consider selling it to free up the cash to buy the things you really like.
And if you have never listened to the Allman Brothers I recommend you start.
So, to summarize:
1) Resist the temptation to hedge your entire portfolio by shorting an index or ETF unless you are convinced that the particular index is a good surrogate for your portfolio.
2) Be careful in creating a short portfolio, and recognize that the dynamic of a short sale gone wrong is much more harmful than that of a long sale gone wrong.
3) For short sales, look for companies that provide you with seller’s insurance in the form of ugly and unnecessarily complex capital structures.
4) Consider selling covered call options against your long positions, but don’t dabble in it. Make sure you know the dynamic of options trading. Spend more time learning how to buy and sell options then you spent learning how to buy and sell stock. Or don’t do it at all.
5) Evaluate your long positions, define for each name whether the position is an investment or a shorter term trade. Sector downturns are opportunities to add to your long-term investments. Fair value with a possibility of sector downturn is a signal to sell short-term trades.
6) Have reasons. You will sometimes do the wrong thing for the right reasons (and the right thing for the wrong reasons) but you’ll learn.
7) Finally: heed my surgical mentor’s advice and strive to always be the calmest person in the room, regardless of what the market is doing.