The Realistic Side to Investing in Biotechnology

If you haven’t realized by now, biotechnology is one of my favorite investment fields, and by finding the right formula you will be able to tap into one of the fastest growing industries of the 21st century. In my previous article I discussed the pros and cons of investing in small or large biotech companies, and the historical performance of each of those strategies. Well, in this blog I am going to explore a momentum based strategy when it comes to investing in biotechnology.

The Screener –

  • Screen for only biotechnology and drug manufacturing companies.
  • Has spent more than 15 million dollars on R&D in the past quarter.
  • Volume has increased by 20% in the past 30 days.
  • Have a work in process project that they have spent over $10 million on in the past quarter.

As stated in Dr.Ray’s book, The Principles of Quantitative Investing, one must define the purpose of their strategy. Without a purpose there is no way to guarantee the longevity of an investment strategy. So, what is there purpose here, past making money of course? Well, when I was taking a look at the biotech sector this alcohol rehab points out that the probability a company would be bought out was much lower than the probability of their most recent drug being bought, or their most recent drug being approved by the FDA and going to market. This sort of news always creates sort of excitement around a stock, thus increasing its momentum in the marketplace.

With this screen I wanted to find companies that, within the past 30 days, released some sort of news that inspired the people within the market to pick up their phones and call their brokers. Not only that, but I wanted it to be a significant movement when it comes to volume; therefore, I set the change in volume requirements to be 20% in the past 30 days.

So, enough about why I built what I built. How does it do? Because, in reality, that’s the only factor that really matters. I could spend hours talking about my rationale behind a decision, and if it didn’t work you’d all be horribly angry at me for leading you on. Well count your lucky stars as I haven’t done that this time, instead, I’m bringing you a strategy that, over the past three years, as an annualized return of 35.54% at its base.

Sadly, this base case isn’t a truly realistic example as everyone reacts differently when it comes to their investment portfolio. As we explore this strategy I will use my own thresholds as the set rules.

First, though we all wish they were, trades aren’t free and in this strategy you will be making a lot of trades over a three years period as you will be rebalancing on a quarterly basis. This equates to 203 trades over that time. Let’s rerun the backtest with a .1% trading cost for each position. This doesn’t change the overall return slightly, adjusting the annualized return to 34.80%.

Unless you’re a turtle investor, someone who buys and holds forever, you will most likely be following your portfolios performance throughout the quarter. This would be fine if you were a highly disciplined investor; however, you are merely human… we all are. Therefore, we have a threshold for the amount of pain we can endure and the amount of excitement we can endure when it comes to our investments. Let’s focus on the downside. Setting the stop loss at 15% to allow for some fluctuation in the stock price and rerunning the backtest results in fairly small 5% drop in performance down to 30.20% annually.

Now for the upside. Biotech companies tend to have a decent amount of volatility. They could go up 50% one day and drop 75% the next. Knowing this, we want to make sure that we are getting out somewhere near the top, and minimizing the risk of getting caught in a mass sell-off. Thus, we are setting the stop gain at 50%. This, surprisingly, doesn’t change our annualized return much, dropping it down to 29.12%, which is still far higher than the overall markets return of 14.77% annually.

Even with all of these “real life” investment factors we are still beating the market by almost double on an annual basis. We are doing this while maintaining a beta lower than 2, meaning we are doubling the market without doubling the risk. We also don’t hold more than 23 positions at any one point in time. Conclusion, this strategy kicks market butt. Now, a lot of people believe that the biotech sector is just another bubble that is bound to burst here in the near future, and they may very well be right. This strategy, like almost all other biotechnology strategies did not work prior to 2010, and really didn’t start gaining traction until 2012. There is no guarantee that these strategies will continue working in the future, but one can hope.

About Aaron G

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