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The Smartest Way to Play the Booming Biotech Sector

Break out the bubbly for biotech stocks.

Yesterday, the Nasdaq Biotechnology Index (^NBI) hit an all-time high at 2,125.57. The sector is on an absolute tear this year – up 48% (and counting). That’s almost triple the return of the S&P 500 Index, mind you.

The outperformance isn’t going unnoticed among the denizens of the Wall Street Daily Nation, either.

Todd L., for instance, sent me this short and sweet fan letter yesterday: “You suck, Lou! You haven’t recommended a single biotech stock this year. Yet it’s the hottest sector in the market. Why are you completely ignoring it?”

Ask and ye shall receive, Todd. Today, I’m going to share the smartest, safest and easiest way to profit from the continued rally…

Avoid Making Stupid Bets

Charles Munger, the unsung hero behind the success at Berkshire Hathaway (BRK.A), once summed up the firm’s investment approach by saying, “At Berkshire we have three buckets: yes, no and too hard. We just throw some decisions into the ‘too hard’ file and go on to the others.”

For many investors, biotech stocks would fall into that “too hard” bucket.

Why? Because the biotech sector isn’t like most other sectors. It doesn’t benefit from broader trends that promise to bring growth to the entire industry. Like, for example, the exploding use of smartphones does for all companies involved in the mobile market.

A company either succeeds or fails based on its own merits.

Put another way, there’s no safety net for poor execution in the biotech sector. Either the science works or it doesn’t. And trying to handicap the odds for individual biotech companies requires a level of expertise that most investors don’t possess.

Not only do we need to understand the biological nuances of particular diseases, we also need to understand the science behind potential drugs aimed to treat them.

Talk about a daunting task. Heck, it’s so difficult to gain a consistent edge in the biotech sector, that some professionals feel the need to cheat. (One of the SEC charges against SAC Capital involves a portfolio manager relying on an unlawful “network of field doctors” to obtain non-public drug trial results.)

Of course, the rewards for getting it right can’t be beat. But, by the same token, the penalty for getting it wrong is steep.

As Mark Lehmann of JMP Securities says, “Returns have been great but the risk is huge… If a company gets a drug to market, the stock can double or triple. If not, the results can be devastating to your portfolio.”

So what’s an everyday investor to do? Simply move on to other opportunities outside biotech, as Munger suggests?

Heck no! The profit potential is too strong to do that. Here’s what I recommend, instead…

How to Exploit Average Intelligence for Above-Average Gains

If you don’t have the time or expertise to sleuth out individual biotech stocks destined to surge, the smartest (and safest) way to invest in the sector is via an exchange-traded fund.

Of course, whenever anyone talks about biotech ETFs, they default to the iShares Nasdaq Biotech ETF (IBB).

It’s the biggest biotech ETF, with roughly $3.7 billion under management. But it’s really nothing more than an over-weighted bet on the four bellwethers in the sector: Celgene (CELG), Gilead Sciences (GILD), Amgen (AMGN) and Biogen Idec (BIIB). The market caps for each company check in at $61 billion, $95 billion, $84 billion and $53 billion, respectively.

A whopping 32% of the fund’s assets are tied up in these mega-cap stocks. Meanwhile, investments in biotech stocks with the most upside potential (i.e. – small and micro caps that are on the cusp of FDA approvals or being acquired) routinely make up less than 1% of the fund’s investments.

Case in point, only 0.53% of the fund’s assets are invested in promising biotech, like Celldex Therapeutics (CLDX).

Not to mention that 97 stocks out of the 125 tracked by the ETF – or almost 80% of its holdings – have portfolio weightings of less than 1%. More than a dozen carry less than a 0.10% weighting.

So no matter how high and how fast these tiny stocks rise, the impact on the overall fund performance promises to be muted.

That’s the downside of a market cap-weighted fund, though. You get too much exposure to the big companies and too little exposure to the smaller ones.

And everyone knows that it’s much harder for a large company (like $61-billion market cap Celgene) to double its business and share price than it is for a smaller company (like $2-billion Celldex).

Enter, SPDR S&PBiotech ETF (XBI).

Instead of being market cap-weighted, XBI is equal-weighted. So an equal proportion of the fund’s assets are invested in each holding.

That means each stock promises to impact the overall fund performance equally, too.

Although it boasts just 58 holdings, it provides much more exposure (55%) to smaller- and micro-cap names, including Celldex. In contrast, large-cap holdings only make up about 14% of the fund’s investments.

Bottom line: The easiest way to overcome the problem of a lack of expertise in biotech stocks is to invest in an ETF, not an individual stock. That way, our downside is protected, thanks to the power of diversification. And to ensure that our upside isn’t capped, too, we just need to focus on funds with more exposure to small caps.

Hope this helps, Todd. If you’re still after a single biotech stock to buy, stay tuned. I’m finishing up my research on a company with a compelling tie-in to the unfolding crisis in Syria. I promise to report back with my findings shortly.

Ahead of the tape,

Louis Basenese