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How China's Troubles Affect Biotech and Pharma Stocks, Part 1

Posted at 6:12 a.m. EDT on Thursday, Aug. 27, 2015

The question's a simple one on its face: "what do the biotechs and new old/pharma have to do with the China rotation?"

The problem is, the answer's incredibly complicated, because on the one hand, they should have nothing to do with each other and on the other, they are deeply intertwined. It's the intersection where there's an amazing amount of both treachery and opportunity.

First, let's accept that the Twitter reader's baffled because the fortunes of biotechs and old pharmaceutical companies have very little to do with the fortunes of China.

Regardless of whether there is a slowdown in economic growth or a stock market that seems to go down almost daily except last night, something's rotten in China. But it isn't so rotten or pervasive that it is going to hurt drug sales of a company either like Celgene (CELG) - Get Report or like Dividend Stock Advisor portfolio holding Pfizer(PFE) - Get Report. People get sick, they take medicine.

So on the surface the answer is that they have nothing to do with each other, so any weakness that's ostensibly caused by China woes shouldn't impact these stocks. That would mean that you should be a buyer of both if they decline on China.

That's not a totally wrong assumption. Many are making it; some are putting their money to work in these stocks because of it. They could be very right, but not necessarily for those reasons.

That's why I don't want to be dismissive of it.

But let's layer on some complications that come into play.

There are all kinds of money managers, ones who want to have lots of exposure to stocks, ones who want lots of fixed income, ones who don't like risk and ones who do.

If China's really in trouble, meaning if its economy is downshifting more quickly than people realize, then it could cause a worldwide recession and many of the companies that provide raw materials to China will find their balance sheets stressed. Some will default.

If a manager who has a choice between stocks and bonds knows that a worldwide recession could occur, he also knows that creates pressure on the riskiest assets and makes the safest prized. Think back to 2007 to 2009, you wouldn't describe stocks as a safe haven vs. that economic backdrop, would you?

China's the second largest economy on Earth. If it implodes, then you can bet that some managers are going to think it is 2007 to 2009 all over again, and they are going to run from equities into bonds worldwide.

Biotech and old pharma stocks are part of the indices and they get sold down.

Now, in that same scenario, bonds become safe havens, driving down interest rates even further than they have come down.

That puts a floor under companies that pay above average dividends, as many of the big pharmaceutical companies do. So they could go higher in this scenario. But the biotechs don't pay dividends.

In a time of turmoil the speculator class, which tends to use borrowed money and buys biotech with it because that's where the biggest gains come from, comes under stress. As these stocks come down along with all others and don't have the support of dividends, the speculator class, your fellow shareholders in many of these stocks, gets margined out, or sold out by margin clerks right out from underneath them, because they don't have enough capital to make margin calls.

In other words, the profits of, say, Regeneron(REGN) - Get Report, won't be hurt by the turmoil, but the stock could go down as part of a worldwide retreat of all stocks and then the decline would be accelerated because speculators who were renting the stocks for quick gains get evicted because they borrowed money to finance their purchases.

So, you have a real bad shareholder base coupled with the fact that portfolio managers always want to take on less risk in dicier times, and it isn't like the biotechs are brimming with earnings to fall back on. Most of them lose money and trade up not on earnings, but on drug approvals. 

I discuss currencies and mergers and acquisitions in Part 2. 

At the time of publication, Action Alerts PLUS, which Cramer co-manages as a charitable trust, had no positions in the stocks mentioned.

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How China's Troubles Affect Biotech and Pharma Stocks, Part 2

Posted at 7:10 a.m. EDT on Thursday, Aug. 27, 2015

In Part 1, I focused on the effect the shareholder base and portfolio managers have on these shares, but there are other things to consider as well.

I like to think of biotech stocks as black double diamond runs on the slopes: they are fabulous to ski on when the powder's perfect and the sky is blue, but foolhardy to go down on when it is frozen, stormy and icy.

Now, how about those big pharma stocks that are protected by their dividends? Can we take solace that they are true safe havens?

No.

Because there's another part of the landscape that changes in times of stress: currencies. The world's money flows seek to be in the strongest currencies for protection against the chaos that might be occurring elsewhere. The U.S. right now is perceived as the strongest nation on Earth, and its currency therefore attracts capital from all over the world.

That's terrific if you are a buyer of goods from overseas. It is not so terrific if you sell them overseas in weaker currencies and then try to translate those gains back to the U.S. One of the reasons why the U.S.-based pharmaceutical companies do so well is because they have huge worldwide sales. But when the dollar gets stronger against the currencies in which they sell overseas, the companies make less than the analysts thought they would have, because the U.S. profits are reduced by those declines. In simple terms, estimate numbers get cut for big pharma every time the dollar rises against a basket of currencies.

So when you hear, "cutting numbers Merck(MRK) - Get Report," that stock (which is a holding of the Trifecta Stocks (paywall) portfolio) is going lower. That's what happens. And Merck's 3% yield doesn't help much against, say, a three or four point decline in the stock because of the estimate cuts -- a very realistic possibility.

Let's make it even tougher for Merck. If the Federal Reserve thinks that our economy is on solid footing and wants to start the process of taking up short-term interest rates, then the dividend yield isn't as attractive as it would have been vs. cash itself, and higher short-term rates will make dollars even more sought-after by foreigners than before. So numbers come down AGAIN, and the dividend yield is even less of a protection.

So now, let's come full circle: Chinese turmoil breeds an aversion to risk which then causes stocks, especially riskier stocks like biotechs -- without dividend or even earnings protection -- to fall harder and faster than others, exacerbated by a weaker shareholder base many of whom are playing with borrowed money, who must sell as the stocks go down. Big pharma stocks are safer, but their earnings are hurt by a stronger dollar and the dividend doesn't protect the principal from declining much, especially when the dividend yield is challenged by competition from risk-free assets like Treasuries.

So, long story short, neither biotech nor big pharma stocks are truly safe from the China syndrome, so to speak.

Now, let's layer on one more positive complication. Take yourself outside the stock market. Picture yourself as the head of a major pharmaceutical company that does not have a strong pipeline of drugs or needs to augment its current, undiversified pipeline. Its actual core business, as the tweeter first suggested, is doing just fine. The company has a lot of money. What does it do when these biotechs come down?

It buys them. Think of Celgene(CELG) - Get Report buying Receptos (RCPT)  for $7 billion to diversify away from its blood cancer franchise. Think of AbbVie(ABBV) - Get Report purchasing Pharmacyclics for $21 billion to get a better call on cancer drugs.

That's right, the real world collides with the stock world to create bargains for companies like Celgene and Abbvie to take advantage of.

So look at it as a process. While biotechs and pharma stocks invent and sell products that are immune from business cycles that could be hurt by a flailing China, their STOCKS could be hurt regardless of the steadiness of their research labs or product sales.

But once the stocks come down hard, the dividends of the big pharma companies might offer some protection to the shareholders, although perhaps not enough to offset losses of principal, especially when you consider the suspect earnings streams that come from weak currency translations.

Biotech stocks get sold down because they are too risky, but then biotech companies get scooped up because they get cheap enough that their pipelines become accessible to old-line pharma looking to upgrade.

In the end, that's why I say let the worldwide turmoil bring down the stocks of the companies you like to levels where good things can happen.

But understand that regardless of what they sell or do, these companies' stocks should and will go down on world recession before they bounce because of other, more positive characteristics that can save the day and produce steady gains when the smoke of the distant fire at last clears from the planet.

At the time of publication, Action Alerts PLUS, which Cramer co-manages as a charitable trust, had no positions in the stocks mentioned.