The manager of the $377m Legg Mason Royce US Smaller Companies fund regrets an underweight to sector over the past few years given its huge gains but believes its strong run will not last long and expects investors to feel substantial pain in the near future.
“It has hurt being out of that sector but we still feel like it is good to stick to our discipline [as] valuations are getting into bubble territory. It feels like that time in terms of the euphoria in terms of what has been going on in that space. We are wary of this sector,” she said.
“It feels like a bubble but they always pop way later than you expect them to. The dot com bubble went on a lot longer than people expected it to and you are having a whole new influx of investors [in biotech]. Investment managers such as Fidelity and Wellington have started to invest in biotech. Part of it is investors are desperate for returns and are running out of places to look.”
“That is always a sign that you are starting to near a mature part of the cycle – when non-traditional investors are coming into the space.”
Romeo also says murmurs from the venture capital space are suggesting that valuations are too high but money keeps on being invested because the private money thinks “they have to play the game”.
"At some point it will come to an ugly ending, although I don’t know when it will be," the manager warns.
Biotechnology has consistently been very interesting to FE Trustnet’s readers with the Axa Framlington Biotech fund one of the most viewed fact sheets of late and for an understandable reason.
According to FE Analytics, biotech stocks have rallied hard since the financial crisis, particularly in the US where the Nasdaq Biotechnology index has gained almost 500 per cent over the past seven years. Interestingly, in 2008/9 it also stood up better than the broader US equity market.
Performance of index over 7yrs
Source: FE Analytics
Romeo says biotech’s boom seems to have been fuelled by the US's quantitative easing programme, which was swiftly ushered in during 2008 and was wound up last year only to be seamlessly replaced by similar policies in Japan and more latterly in the eurozone. However, she says a widely expected rate rise in late 2015 could be the catalyst for a large correction.
“During the whole QE period it has been lower quality companies, the higher leveraged companies and the biotech companies that are driving a lot of the performance of the index,” she added.
“Rising rates [this year] might immediately cause the bubble to burst but what it would also do is be a good sign for companies that are economically sensitive because rising rates would be a sign the economy was accelerating and are able to withstand it without impairing growth.”
“This should skew people back to these sorts of sectors where valuations are really attractive but the growth rates haven't been as compelling.”
Romeo says even with a correction biotech would be a hard place to find value because many of the companies are unprofitable and don't make regular returns, although last year’s correction provided some bargain hunting.
“It is often a binary outcome that the product gets approval or it doesn't and you lose all your money. So we'll probably always be underweight although there are a few exceptions.”
“If there is a correction, and we did see one last year at the end of the first quarter, that does create some opportunities because it creates indiscriminate selling and we were able to find some opportunities in life sciences.”
The Legg Mason Royce US Smaller Companies fund has underperformed its index – the Russell 2000 – over the past three years as well as its sector average, having gained 29.52 per cent, less than half the gain of the index and sector.
Performance of fund, sector and index over 3yrs
Source: FE Analytics
Romeo has generally kept an underweight to the sector in recent years which she says has hurt performance.
“Over the past few years we have found the most value in economically sensitive areas but we have struggled to find any value in biotech. It has been on a tremendous run with the sector up 56 per cent in 2013 and almost 30 per cent in 2014,” she said.
“For us it is hard, particularly in the small cap space where it is usually a one-product company that doesn't have cash flow yet and is still seeking external funding.”
“It’s more of the biotech and small cap pharma rather than purely healthcare. In the small cap world pharmaceutical companies tend to be smaller portfolio products but in the larger cap stocks you can buy companies that have portfolios of drugs that are generating a lot of cash flow.”
Pharma and biotech make up about half the healthcare weight in the Russell 2000 index and as the graph below shows it has massively outperformed the broader index.
Performance of indices over 3yrs
Source: FE Analytics
Daniel Lanyon was a guest of Legg Mason, Royce Associates’ parent company, in New York.