Sector-Focused Hedge Fund Sees Bubble in its Sub-Sector

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My medicine, work! Thus credulous fools are caught

- Othello: IV, i.

Deerfield Management is a long-short, bottom-up hedge fund that invests in the healthcare sector only. It manages about 3 billion dollars and has been under the stewardship of its managing member James Flynn since 2000.

According to its October 2012 Letter to Shareholders, the biotechnology sector might be in a bubble right now. While the markets have generally recovered from the 2008 lows and are somewhat back to 2007 levels, “in looking at biotechnology companies, this may be true in more ways than one.”

First, the biotechnology sector is up between 30 to 40%, depending on the index. Second, “any company with a pulse is being given credit for clinical success and downstream earnings power.”  This is of course driven by low interest rates that “have generated bubbles in the past and may be on their way to doing so here once again”.

As a specific example, Mr. Flynn points to the biotech company Gilead (NASDAQ: GILD) -- it surpassed the market cap of pharma bellwethers such as Bristol Myers (NYSE: BMY) and Eli Lilly (NYSE: LLY). Now Gilead has sales of $9 billion in contrast to the $18 billion for Bristol Myers and $23 billion for Eli Lilly. Although there are some nuances to be considered such as patent expiration and product pipeline, this is mostly a “testament to relative valuations in the biotechnology industry and how much investors are willing to bank on future earnings materializing.”

While Mr. Flynn simply uses an expanding market cap relative to sales to illustrate the point about Gilead in contrast to Bristol Myers and Eli Lilly, it is worthwhile (or, at any rate, Foolish enough) to take a deeper look into the fundamental metrics of the companies. To make the analysis a little more fair and balanced, we add Amgen (NASDAQ: AMGN) to see how the biotech with the biggest market cap of $ 67.6 billion and sales of $16.8 billion compares in valuation to the singled-out Gilead.

Since Deerfield wrote the letter on October 3, the market caps have changed, whereby Gilead stands at $51 billion, behind Bristol Myers’ $56.6 billion and Eli Lilly’s $57.1 billion capitalizations. Looking at the Price/Sales ratios, however, Mr. Flynn’s story continues to hold water: 5.56 for Gilead, 2.71 for Bristol Myers, 2.41 for Eli Lilly, and 4.0 for Amgen.

A glance at the P/E ratios again shows the highest valuation for Gilead at 20.94 in contrast to 16.22, 14.15 and 15.81 for Bristol Myers, Eli Lilly and Amgen respectively. (Yes, the PEG ratios, based on the stretched 5 year expected growth rates, justify Gilead, but that is taking five steps beyond Mr. Flynn’s caution about banking on future earnings. In any case, the PEG ratios are 1.12 for Gilead, 1.25 for Amgen, 6.36 for Bristol Myers, and negative 2.57 for Eli Lilly.) Also, in case anyone cares about “real” money, Bristol Myers's shares sport a dividend yield of 4.1%, Eli Lilly yields 3.8%, Amgen 1.6%, and Gilead (you guessed it) zilch.

Nevertheless, coming back to Deerfield’s analysis, there are true pockets of innovation creating real value and not merely speculative “value.” Mr. Flynn and his team, most of which like him tend to have both domain expertise in healthcare and finance acumen, see the opportunity to selectively invest in “notable clinical successes and some meaningful new product launches.” But Mr. Flynn is rather cautious as “there is a balance between the real and the unreal which can be at times difficult to dissect.”

Also, there are tempting opportunities to short the higher valuations, but “it is also true that you can never exactly define what something is worth and valuation extremism is nothing like it was at the turn of the century” which means that “arguably there could be a long way to go before prices settle back down.” 

Because of this two-way caution and the impending presidential elections with its focus on healthcare issues, the fund has accordingly reduced its gross and net exposure. We will have to wait to see when Deerfield Management feels the biotech bubble is about to burst, but we have been forewarned by the guru of the health sector. For those more Foolish than us, the implied short and long trades can be executed ahead of the curve.

JaySingh11 has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Gilead Sciences. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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