Small cap value manager Jeff John used to be able to ignore boom-or-bust biotechnology stocks because they had never been a big part of the Russell 2000 Value Index and rarely cleared his firm's quality screens. That changed in June 2021, however: After years of lagging performance, biotechs more than doubled to 6.2% of the benchmark.

John knew he had to double down on his implicit bet against biotechs or figure out a way to invest. “When biotech hurts, it hurts very badly,” he said.

Many managers across the size and style spectrum have had to wrestle with similar conundrums in recent years. Biotechs delivered staggering performance in the five calendar years ended 2015 but have lagged broader benchmarks since. There have been attention-grabbing individual winners, such as coronavirus vaccine makers Moderna MRNA and BioNTech BNTX; they have each soared by more than 300% annualised in the two years since the latter’s American depository receipts started trading in November 2019.

Broader industry results have been more mixed. S&P 500 biotech stocks rose an annualised 9.9% on average in the five years ended October 31, 2021, which is 9 percentage points behind the whole index. And biotechs remain speculative and volatile.

Morningstar analysts recently asked US equity managers how they approach the risks and opportunities of biotech stocks: Does the industry’s lagging performance and increased presence in value benchmarks present buying opportunities, or are they still too fickle for most managers? Three techniques stood out: selection, diversification, and position sizing.

Selection still matters

As usual, security selection is important when considering biotech stocks, managers said. American Century’s John Hardy said he and his team avoid binary-outcome biotechs by shunning stocks without free cash flows. Instead, his portfolio’s only biotech holding, Horizon Therapeutics HZNP, is a value play. Horizon grabbed high market share for its thyroid eye disease medicine after FDA approval in early 2020. But its rollout was dented by its manufacturing partner’s vaccine production, and the market has overly punished Horizon’s stock for it, Hardy’s team believes.

Victory Capital lead manager Scott Tracy said his team seeks biotechs where research suggests that the potential upside is twice that of the potential downside. In addition to Horizon, Tracy owns Jazz Pharmaceuticals JAZZ, Intellia Therapeutics NTLA, and Apellis Pharmaceuticals APLS in his mid-cap portfolio.

Degrees of diversification

Equity managers use a variety of ways to take the edge off biotech holdings. The basket approach Tracy uses is one simple way. As each biotech stock can be prone to wide performance swings and it’s hard to predict which ones will fold and which will turn into blockbusters, Tracy holds many small biotech positions to increase the odds of catching the bigger winners while mitigating the pain of holding the losers.

Other managers look for diversification within biotech companies. A common approach is to look for stocks with multiple ways to succeed. For example, Miller Value Partner comanagers Bill Miller and Samantha McLemore use fundamental research and industry experts to find companies that have several drugs in development with decent odds of success.

Lower weights, lower risk

Finally, managers said they tend to hold biotech stocks at smaller weights if their research suggests they carry greater downside risk. At Carillon Eagle, lead manager Chris Sassouni and his team manage risks through benchmark-relative weights. They consider historical drug approval probabilities and adjust holdings ahead of quarterly reports based on earnings expectations.

Still Skeptical

American Century’s John said he won’t immediately reject all biotech names, but he isn’t sold on other managers’ playbooks for investing in biotechs. Adding dozens of them doesn’t work for his roughly 110-stock portfolio, especially as he estimates only 20 or fewer small-cap biotechs are even profitable. He believes biotechs have entered value benchmarks in recent years for the wrong reasons: They look cheap quantitatively only because many of them have raised a lot of money that they will burn through in the next few years as they try to develop new drugs, only one out of 10 of which historically have won FDA approval. So, he still approaches biotech stocks with skepticism.