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While the biotech sector had long enjoyed investors’ attention, it was never as pronounced as around the time the pandemic was felt around the world. However, as 2022 unravels, so has the interest, with a steady downward trend in stock valuations across the board. The reasons behind the ongoing market slowdown are complex and multifaceted. Let’s start with a broad analysis of the biotech sector.
Biotech ETFs and Regional Bias
Let’s consider 4 popular Exchange-Traded Funds (ETFs): the iShares Biotechnology ETF (IBB), the ARK Genomic Revolution ETF (ARKG), the Invesco Dynamic BioTech & Genome ETF (PBE) and the VanEck Biotech ETF (BBH). As of January 3 of this year, these 4 ETFs collectively accounted for nearly $16.2 billion in Assets Under Management (AUM).
Let’s consider a series of yearly “snapshots” in May of 2019 through 2021 – along with an additional snapshot at the dawn of this year as well as the end of April each. Companies incorporated in the U.S. and Canada as well as U.S./Canadian companies headquartered in Ireland, Cayman Islands or Jersey will be grouped into the “North America” region. Similarly, all companies from Europe (including the United Kingdom) will be grouped into the “Europe” region.
There’s an interesting study of contrasts in the 2019 snapshot vis-à-vis the present: while ARKG has between 2 and 4 European companies in its holdings in the entire period, their weights were substantially higher than that in IBB which – with between 13 and 32 European companies in its holdings – has the largest number of European companies in holdings among the 4 ETFs. In the present day, this situation has reversed; IBB now has both the highest weight and number of European constituents while ARKG has the lowest average weight per European company.
ARKG’s investment methodology is proprietary, i.e. it isn’t publicly available unlike the other ETFs. Ark Invest buys into companies that it deems to have the edge necessary to be a disruptor while the other fund managers rely on objective numbers and set criteria. Almost all of the ETFs have a heavy concentration in stocks of companies based in the U.S. – home to the world’s most overvalued equity market.
A record 44% of fund managers responding to a monthly survey conducted by Bank of America Merrill Lynch in June 2017 considered U.S. equities to be overvalued. Deloitte’s surveys reported that most Fortune 500 CFOs and fund managers held this belief in 2020. Mr. Charlie Munger, Vice Chairman of Berkshire Hathaway, reiterated this in 2021 and added that the market will correct soon.
When it comes to equities at least, the overvaluation issue can be put in more stark terms when considering the ratio between stock prices and fundamentals. Given that IBB has by far the largest number of holdings on both sides of the Atlantic relative to the other 3 ETFs, let’s parse out the ratios across the “snapshot” dates of IBB for a clearer picture.
Ratio Analysis: Europe versus North America
Let’s consider three ratios comparing the stock price of IBB’s constituent companies to their fundamentals – the Price to Earnings (PE), the Price to Sales (PS) and the Price to Earnings (PS). These ratios can be imagined to form a 3-dimensional axis that would describe a plane along which the price is observed. Each axis, in theory, should have the same effect on the plane. In practice, this does not hold true.
The prospect of overvaluation has an interesting effect on these ratios as reported by data services such as Bloomberg: metrics that are too high or too low are not reported as they’re not considered to hold any meaningful information for the investor. Thus, the proportion of tickers with unreported PE ratios relative to total number of tickers is calculated in both regions as well as the ETF in total for each of the “snapshot” dates.
Given ETFs don’t have overall ratios, proximate aggregations of these metrics are carried out in two formats to arrive at an effective proxy for regional contribution:
The average; wherein the reported ratios of each of the ETF’s constituents are averaged outright;
The weighted-average; wherein the reported ratios have each constituent’s weight factored in.
The picture that emerges is quite interesting.
The core observations discernible are:
The “Unreported PE Percentage” metric tended to be higher among European stocks than in North American stocks until recently, where they’re running nearly at par.
After a brief spike in May 2020, European PE and PS aggregates tended to be lower than the North American equivalents in the average and of significantly lower contributory effect, as exemplified in the weighted-average.
The outsized PS aggregates across both regions is an interesting feature of the biotech sector, indicating that revenues (and not earnings) have an outsized influence on stock valuation. This has been significantly more prevalent in North American stocks than in European stocks since 2020. In the most recent “snapshot”, it can be seen that European stocks have had a substantial cool-off relative to 2019, unlike North American stocks.
As of the most recent “snapshot” date, 30 of IBB’s 372 constituents were also among ARKG’s 49 constituents. Two of them are European – Switzerland-based Crispr Therapeutics AG and Germany-based Atai Life Sciences N.V. Furthermore, 26 of these have unreported PE Ratios –including Atai. Overall, 43 of ARKG’s constituents have unreported PE Ratios.
The massive preponderance of unreported PE ratios in both ETFs is an indicator of how overvalued the biotech sector is. Overvaluation influences volatility which, in the economic picture emerging, makes a continued downward trend more likely than the converse. As of March 31 of this year, Morningstar’s Star Rating system assigns ARKG a 1-star rating over a 3-year horizon and 2-star rating over a 5-year horizon. IBB does a little better (but not by much): 2 stars in both horizons as well as the 10-year horizon.
Gauging Investor Sentiment
Let’s now gauge investor sentiment via AUM trajectories between each “snapshot” date. May 2019 would be the “zero line”, i.e. relative to itself, the net change in AUM and price is zero.
Until 2022, ARKG’s AUM “deltas” relative to prices suggest stronger capital inflows than with the other 3. In 2022, ARKG is witnessing a substantially greater outflow than IBB and PBE while BBH’s AUM suggests that investors are holding steady.
This differential behaviour between BBH and IBB – both with market capitalization-driven constituent selection rules – lie in the “size effect”. Larger companies are expected to be more robust than smaller ones. Given the overvaluation, smaller overvalued companies are deemed more vulnerable than larger overvalued companies despite both categories facing downside risk.
For equity investors, this sector would likely turn out to be less attractive until the floor for “ratio cool-offs” become more apparent. Those already invested in this sector would likely do well with an increased focus on diversification into classical themes such as energy or financials. Tactical investors in Europe have access to Exchange Traded Products (ETPs) to capitalize on stock trajectories in either direction for short-term plays. For instance, ARG3 and ARGS (on Euronext Amsterdam) give +3X and -3X exposure to the daily returns on ARKG respectively while 3IBB and SIBB do the same for IBB.
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Sandeep joined Leverage Shares in September 2020. He leads research on existing and new product lines, asset classes, and strategies, with special emphasis on analysis of recent events and developments.
Sandeep has longstanding experience with financial markets. Starting with a Chicago-based hedge fund as a financial engineer, his career has spanned a variety of domains and organizations over a course of 8 years – from Barclays Capital’s Prime Services Division to (most recently) Nasdaq’s Index Research Team.
Sandeep holds an M.S. in Finance as well as an MBA from Illinois Institute of Technology Chicago.
Violeta joined Leverage Shares in September 2022. She is responsible for conducting technical analysis, macro and equity research, providing valuable insights to help shape investment strategies for clients.
Prior to joining LS, Violeta worked at several high-profile investment firms in Australia, such as Tollhurst and Morgans Financial where she spent the past 12 years of her career.
Violeta is a certified market technician from the Australian Technical Analysts Association and holds a Post Graduate Diploma of Applied Finance and Investment from Kaplan Professional (FINSIA), Australia, where she was a lecturer for a number of years.
Julian joined Leverage Shares in 2018 as part of the company’s premier expansion in Eastern Europe. He is responsible for web content and raising brand awareness.
Julian has been academically involved with economics, psychology, sociology, European politics & linguistics. He has experience in business development and marketing through business ventures of his own.
For Julian, Leverage Shares is an innovator in the field of finance & fintech, and he always looks forward with excitement to share the next big news with investors in the UK & Europe.
Oktay joined Leverage Shares in late 2019. He is responsible for driving business growth by maintaining key relationships and developing sales activity across English-speaking markets.
He joined LS from UniCredit, where he was a corporate relationship manager for multinationals. His previous experience is in corporate finance and fund administration at firms like IBM Bulgaria and DeGiro / FundShare.
Oktay holds a BA in Finance & Accounting and a post-graduate certificate in Entrepreneurship from Babson College. He is also a CFA charterholder.
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