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It's Time to Trust Your Biotech Portfolio

The market's volatility means you have to know what you're holding.

Updated from 12:15 p.m. EDT

BOSTON -- I called a biotech analyst at one of New York's largest health care hedge funds last Friday to see how he dealt with what was a very volatile week of trading.

"I rigged a noose in my office, just in case," he said.

He was kidding, sort of.

What was rattling his nerves was not overall performance -- his fund was up for the week and is in the black for the year.

Instead, it's the tremendous intraday volatility in stock prices that seems to be the hallmark of this subprime mortgage meltdown market.

Exhibit A of the roller-coaster ride in biotech stocks last week was

Myriad Genetics

(MYGN) - Get Myriad Genetics, Inc. Report

. At one point on Thursday, the stock of the genetics testing company was up 30% for the week on no apparent news.

After hitting an intraday high of $48.20 on Thursday, the stock sold off and closed Friday at $41.56, still good enough for a 10% gain over the five trading days.

The volatility hit short-sellers hard. About 20% of the Myriad's freely traded shares are sold short.

The overall market volatility is helping small- and mid-cap biotech stocks to outperform their big-cap brethren. This is causing some anxiety in hedge fund trading circles because the summer is usually a weak time for biotech stocks, in general, which means many trading-oriented funds are operating with a short bias toward small-cap stocks.

"We're hedged, but still, this market hurts," said another biotech hedge fund analyst. "Small-cap shorts have been going against us, while our bigger cap longs have not been performing as well."

The Nasdaq Biotechnology Index, or NBI, a broad measure of the sector's performance, was up 1.5% last week, beating the overall market. At one point Thursday, the index was up 5%. For the year, the NBI is essentially flat.

The reason for the extreme day-to-day moves in stocks like Myriad Genetics is hard to pinpoint, but many market observers lay the blame on the trading desks of the large hedge funds using quantitative, computer-driven, trading strategies.

"Quant funds have been getting killed this summer, so they're being forced to unwind long and short positions," said a biotech hedge fund portfolio manager.

His advice on how to handle this market is simple: Know what you own and don't let the volatility drive you crazy. This mantra, in various forms, was repeated over several conversations Friday with several biotech fund managers.

The biotech sector -- and much of health care overall -- is seen as a defensive play against worries over a liquidity crisis in the economy. Credit crunch or not, people still get sick and they still need drugs. Plus, biotech and drug companies tend not to pile on large amounts of debt.

Several fund managers told me they were using intraday weakness to add to core positions in quality biotech names --

Genentech

(DNA)

,

Gilead Sciences

(GILD) - Get Gilead Sciences, Inc. (GILD) Report

,

Celgene

(CELG) - Get Celgene Corporation Report

and

Cephalon

(CEPH)

, among other stocks.

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"We own Celgene and Genentech and we're not going to sell just because the market is weak," said one of these fund managers. "We're trying not to let the current market change our strategy, which is to pick good fundamental health care stocks.

"The volatility is going to affect our portfolio, but we have longer than a one-month time horizon," said another biotech-focused fund manager who is also trying to add to core positions.

As for trading in this environment, he says, "If we do any trading, we trade on the margins of our portfolio. If a quant fund is going to drive up one of our positions 20% so that it approaches our price target, we will sell some to take advantage of it."

Having a time horizon of one year or more on biotech investments makes navigating this summer's volatile markets easier. It's been more stressful and difficult for those with shorter time frames.

One stock trader I spoke with, who focused almost exclusively on the biotech sector, said he had sold off most of his peripheral stocks while keeping a core group of favorites.

Trying to make money on the wild gyrations of biotech stocks, however, has been difficult.

Last week, he did well by buying

Amag Pharmaceuticals

(AMAG) - Get AMAG Pharmaceuticals, Inc. Report

when it hit $52, selling it at $58 just a couple of days later.

There was an 18% swing between AMAG's intraday low and high last week. He also traded in and out of

Omrix Biopharmaceuticals

(OMRI)

.

He thought about trying to trade around Myriad Genetics, but the volatility there was just too much.

"Some of this is scary to me," he says. "It's not easy to get me scared. The market is not acting normal, and good things usually don't come from that."

The liquidity crisis in the markets, if sustained, could hurt biotech companies in need of cash. Fund-raising isn't likely to dry up completely, but companies floating new stock, convertible debt offerings and initial public offerings might find demand from buyers on the light side.

While this list isn't comprehensive, a screen for biotech companies with cash reserves of a year or less at their current burn rates includes

Osiris Therapeutics

(OSIR) - Get Osiris Therapeutics, Inc. Report

,

Neurochem

(NRMX)

and

Emisphere Tech

(EMIS)

.

The best way for biotech companies to solve a cash crunch, of course, is to attract money from partnerships with larger drug companies. Several fund managers mentioned the possibility that merger and acquisition activity, as well as product partnership deals, could increase as we leave the summer months behind.

The fall is also the season where, historically, the biotech sector awakens from the summer doldrums, moving stock prices higher.

"It's only the beginning of August, and already so much has happened," said one biotech fund manager clearly in need of a few days at the beach. "I'm definitely ready for September."

Adam Feuerstein writes regularly for RealMoney.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. Feuerstein appreciates your feedback;

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