May 1, 2014
David R. Kotok
We have been getting emails with questions regarding the biotech sector. The primary question is, “Is this a bubble?”
Here is our view.
First, we do not know that a bubble is a bubble until after the fact – after the bubble pops. What we can do is estimate levels of risk; and a high level of risk often, though not always, coincides with a bubble. But the confirmation of a bubble can come only after the fact.
One can look back at the “dot.com” bubble in 1999 and 2000 and say in retrospect that the excess market value was measurable in the trillions when that sector exploded. It was trading at all-time high levels of price/earnings, price/sales, price/book, and other metrics we use to value stocks. During that time, we at Cumberland created a hypothetical model in which we merged Microsoft and Cisco into one company. We then valued that combined company at current market prices. At the peak, the combined company had a market value of $1 trillion and earnings of $10 billion. Thus it was trading at 100 times earnings. At the same time, the output of the entire world – think of it as a world summation of GDP – was approximately $30 trillion. There was nothing wrong at the time with companies like Microsoft and Cisco. Instead, the problem was the stock prices. They were too high.
Let’s turn to the biotech sector now. We had a position in the biotech sector for an extended period of time. It was a profitable trade. It did well. We exited it several months ago and have not reentered the group. Why?
The issue again is valuation. How much is a biotech company worth? How much is an ETF worth if it is holding a basket of biotech companies? The answer is not clear.
The biotech industry has very long-term growth characteristics. However, it became extended due to substantial momentum-driven inflows into the stocks themselves and into the funds and ETF baskets that owned them. Our management focus in the equity market is on ETFs, and we held two of them that specialized in the biotech sector. It was incumbent on us to do deep-enough valuation to come to a conclusion.
In our judgment, biotechs have reached a level too high relative to the valuation metrics. Just as in the tech stock bubble of yesteryear, there is not necessarily anything wrong with this biotech company or that one; but the price of the stock has risen too high for the characteristics and metrics being applied.
Cumberland Advisors is presently underweight in this sector. We are not holding any special large cap biotech ETFs.
David R. Kotok, Chairman and Chief Investment Officer