A Bet on the Biotech Bull

After years of being ignored by most investors, biotech began its recent resurgence when Swiss pharmaceuticals giant Roche recently made a surprise $44 billion bid for the 44% of San Francisco-based Genentech that it does not already own. Genentech is already responsible for developing many of Roche’s most successful drugs and has consistently boosted Roche’s financial results. A prime example is Genentech-developed Avastin, which already earns $4 billion a year as a cancer fighter, and is on track to become the world’s most profitable drug by 2014.

That announcement soon was followed by Bristol-Myers Squibb’s $4.5 billion bid for 83% of ImClone. And both of these bids came on the heels of earlier deals in which former Global Bull Market Alert holding and British drugs giant Astra Zeneca bought MedImmune for $15.6 billion, and Takeda of Japan paid $8.8 billion for Millennium.

So why the sudden merger and acquisitions frenzy in biotech? Put simply, Big Pharma is cash-rich but innovation-poor. As patents on huge profit generators such as Pfizer’s Lipitor expire, the traditional pharmaceutical industry is eager to refill its emptying drug pipelines. On the one hand, Big Pharma hopes giant acquisitions jump start pharmaceuticals’ sputtering innovation machines. On the other hand, existing biotech blockbusters would also hedge against the coming  collapse in earnings from drugs that are coming off patent.

Biotech’s newfound moment in the sun comes as a rather sudden change. Notwithstanding all of the excitement the sector generated in its infancy, investors got both bored and frustrated with biotech after getting burned by a couple of Biotech boom bust runs in the 1990s. Some biotech mutual funds shriveled to less than 5% of their former size.

Yet when biotech bull markets hit, they offer the promise of unusually big gains. Investors have made 6.6x returns in less than three years in an average biotech bull market.

So why buy biotech now? Technically, biotech is one of the few sectors in the market that are in an uptrend, trading both above its 50-day and 200-day moving averages. And since hitting record highs about a month ago, the sector has sold off slightly, making it a good time to get in. Biotech also tends to be highly seasonal. That means many hedge funds will be picking up biotech stocks during this time of the year, only to sell them off in November.

The best way to profit from the biotech bull is through the S&P Biotech ETF (XBI). Unlike some other market cap weighted biotech ETFs which heavily lean toward industry giants Genentech and Amgen, XBI holds about 25 of the top companies across the entire sector. Each company is equally weighted between 3-5% of the ETF. With an industry low expense ratio of 0.35%, it is also the bargain of the biotech ETF sector.

So buy XBI at market today and set your stop at $55.50. For even bigger potential gains, buy the December $65 call options (XBILM.X).

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