We are very pleased to announce that Erik Nelson, President of Sterling Investment Services had the following artilce, ‘Searching for a Micro-Cap Biotechnology Fund‘ published in the 2nd Quarter edition of Micro-Cap Review Magazine. We have reprinted the article below for your reading, and a printer friendly copy of is available here.
Searching for a Micro-Cap Biotechnology Fund
By Erik S. Nelson
When I was asked to write an article on micro?cap biotechnology mutual funds and exchange traded funds (ETFs) I thought, how hard can it be? While I wasn’t expecting many ETFs to exist in the micro-cap biotechnology or pharmaceutical space, I thought there would be at least one or two. It turned out that I could not find a single ETF. While I was not completely surprised by this, I was somewhat surprised that no one had attempted to open this area of the market to the broader investing public. After all, the biotech industry is one of the great success stories of American business. The biotech industry has been a major force in creating jobs and improving the quality of life. It is also one of the few areas of the U.S. economy where innovation and discovery are still taking place.
The biotech and pharmaceutical industries are similar industries with potentially great returns. These industries can also be very difficult for the average investor to understand because of the technology and discovery process, not to mention the real prospects for the product being developed. I will be the first to admit that I do not have the knowledge to know for certain whether biotech and pharmaceutical products under development will receive Food and Drug Administration (FDA) approval. As a result, I believe diversification and professional management are the key to invest in the micro-cap biotech and pharmaceutical space.
In researching micro and small-cap biotech and pharmaceutical funds, I managed to find only one mutual fund and no exchange traded funds. I wondered why that was so. What is it that makes this space unattractive to an ETF but workable for a mutual fund? I wanted to gain some insight into that question to help me better understand the performance and evaluate the mutual fund in this market.
In looking at the overall characteristics of the micro and small-cap market, I discovered a couple key items which are going to make things hard for a mutual fund but exceptionally difficult for any ETF in this space.
First , there’s a lack of information about micro and small-cap companies. Few analysts cover companies in this space, and most do not have the budgets to attend the many conferences and trade shows. This means that fund managers who want to invest in this space have to do a lot of the research themselves. And the more complex the product, the more difficult it is to assess the company., which makes it tougher to analyze and invest in biotech and pharmaceutical companies.
Second, there’s a general lack of liquidity in the micro and small-cap space. Herein lies the single biggest reason why ETFs have not entered this space. Exchange traded funds typically post their positions and their holding percentages on web sites. This simply won’t work well when there is limited liquidity in the micro and small-cap market. With the real-time creation of shares in an ETF, we can only imagine the possibilities for sophisticated traders to front run the buying and selling of the positions owned by the ETFs. It would create unbelievable havoc. Mutual funds do not have this problem. Trades in mutual fund shares are considered to occur at the end of the day. Mutual funds have much greater flexibility with their investment decisions and cash holdings. This allows them to better navigate the rough waters of the micro and small-cap market.
The only mutual fund that I found to invest in the small-cap biotechnology space is the Franklin Biotechnology Discovery A (FBDIX). It is part of the Franklin series of mutual funds from Franklin Templeton Investments (www.frankintempleton.com). The fund has been around since 1997 and has approximately $327 million under management. The fund invests at least 80 percent of its net assets in the equity securities of biotech companies. The fund appears to have a dual class structure, one with a sales charge, and one without. I recommend the Advisor share class because it has a better rate of return.
The biotechnology and pharmaceutical sectors are tough industries to invest in. Last year the funds posted a 17.28 percent return for the Advisor share class with a five?year annualized return of 3.99 percent and a lifetime annualized return of 8.12 percent. Unfortunately over the last 10 years, the average return has been a negative 0.58 percent.
When considering an investment in this fund, one of the key questions to ask is how well does the fund stack up with the overall market and the biotech/pharmaceutical sectors? The answer is somewhere in between. The Franklin Biotech Discovery A fund almost splits the difference in the performance of the two sectors. I looked at the performance of the Amex Biotechnology Index ‘BTK’ and the Amex Pharmaceuticals Index ‘DRG’ over the same period. Granted those two indices track large-cap stocks, but they are the best representatives of those two sectors for the period in review. The Amex Biotechnology Index ‘BTK’ was the better performer of the two indices. For the 1-year, 5-year, 10-year, and comparative lifetime (starting in 1997) periods, the index returned 37.7 percent, 17.5 percent, 8.3 percent, and 18.9 percent. Unfortunately the Amex Pharmaceuticals Index ‘DRG’ faired far worse. It returned -1.08% percent, -1.15% percent, -4.15 percent, and 1.15 percent for the same periods.
How would I rate the Franklin Biotech Discovery A fund in comparison? It is not too bad. This is a very tough sector to invest in. Even the best fund managers are going to have a tough time matching the result of the best performing sector indices. It should be noted that the Franklin Biotech Discovery A fund has out-performed the Dow Jones Industrial Average, which has posted returns of 11 percent, 1.95 percent, 0.79 percent, and 3.23 percent for the same periods.
Many investors with holdings in small and micro-cap companies in the biotech and pharmaceutical sectors are interested in advancing societal goals. Investors believe that they are not only helping to bring important drugs to the market, but also to create jobs. Those who are committed to invest in small and micro?cap companies in these sectors should consider the Franklin Biotechnology Discovery A (FBDIX) mutual fund. It is a solid option.
About the Author:
Erik S. Nelson is the president of Sterling Investment Services, Inc. (www.sterlinginvestments.com). Sterling is a publisher of a weekly market commentary and a daily trading newsletter. Mr. Nelson is also the president of Coral Capital Partners, Inc. (www.coralcapital.com). Coral Capital provides advisory services to private and publicly traded companies. He can be reached at (404) 816-8240 or enelson@sterlinginvestments.com.