Wall Street can be a fickle place. One minute investors are super-excited about a particular sector, and the next, they're running for the hills.
Perhaps nowhere is this manic state more evident than the healthcare sector. This year, healthcare stocks in general, and biotech stocks in particular, have waxed and waned in a gut-wrenching manner, as the following chart for the iShares Nasdaq Biotech ETF (NASDAQ:IBB) and the SPDR S&P Biotech (NASDAQ:XBIT) shows.
This extreme level of volatility among healthcare stocks has been due in part to the changing ownership profile across the sector. Many major investing firms, for instance, have decided to reduce their exposure to biopharmaceutical companies since the middle of the year as a result of the emerging political debate over branded-drug prices within the United States.
Perhaps most telling is that more conservative, value-based money-management firms have shied away from the sector almost entirely of late. According to the recently filed 13Fs, for example, Quantum Capital Management, a value-based firm designed for high-net-worth individuals and businesses, owned only a single healthcare-related stock in the third quarter of 2015, namely Computer Programs & Systems (NASDAQ:CPSI).
Even more intriguing is that Computer Programs & Systems isn't really a healthcare company per se. Instead, the company's primary business focuses on the logistics of clinical and financial management for rural and community hospitals in the United States, showing that it's essentially a technology company working in the healthcare-services industry.
Quantum's interest in this small-cap stock therefore probably lies in the 2010 Affordable Care Act's stated goal of lowering healthcare costs whenever possible. So we're not exactly talking about a speculative biopharma working on a potential cure for HIV or cancer.
Why is Wall Street losing its appetite for biopharma?
There are probably two good reasons for this more risk-averse attitude that's starting to take hold on Wall Street right now. First, there is the serious concern that the U.S. presidential election next year could lead to sweeping reforms regarding how manufacturers price their new medicines.
After all, Express Scripts (NASDAQ:ESRX), a top opinion leader among pharmacy benefits mangers, has repeatedly called for innovative pricing schemes to hem in the cost of newer medicines, and the company's efforts have started to make inroads toward this goal. Express Scripts, for example, was able to dramatically lower the cost of next-generation hepatitis C drugs by pitting AbbVie's (NYSE:ABBV) Viekira Pak against Gilead Science' (NASDAQ:GILD) Sovaldi.
Although Express Scripts got the ball rolling on this front, Democratic front-runners Hillary Clinton and Bernie Sanders have both seemed eager to carry the ball across the finish line, so to speak. The days of heady 90% gross margins among drug manufacturers therefore might be coming to an end.
The second less-talked-about problem is that many drug companies have put the health of their balance sheets at risk to pursue a growth-by-acquisition strategy.
As it stands now, the average debt-to-equity ratio among drug manufacturers sits at 64.8%, according to S&P Capital IQ. This worrisome level of debt becomes even more concerning when singling out the top dogs in the pharma industry.
AbbVie, for instance, sports a 660% debt-to-equity ratio, and Gilead isn't doing much better at 123%. Worse still, AbbVie and Gilead have both indicated that they would be open to further M&A activity in the near term if the right opportunity presents itself, implying that they may leverage up further still in the quest to keep their top lines pushing higher.
All told, the danger that the industry could see its average gross margin take a major hit soon, combined with sky-high amounts of leverage across the pharma landscape, is probably scaring off some money managers such as Quantum Capital Management.
Should average investors move to the sidelines?
If you're a heavy biotech or healthcare investor like me, you may want to mull over these issues carefully in the coming months. I've started to rotate out of individual stocks and into less risky, broader industry-focused funds such as IBB and XBI because of these headwinds. Keeping with this risk-off strategy, I'm also thinking of hedging my remaining long positions in healthcare using options.
Overall, I think the time of unabashed bullishness for biotech and healthcare stocks is in its twilight, and caution is advised moving forward.