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scott barlow

When the most profitable U.S. market sector is trading at a discount to the S&P 500, investors should take notice.

The biotechnology sector has the highest gross profit margins – 84 per cent – of any of the more than 100 major market sector groups in the S&P 500. The industry is basically a machine for turning revenues into bottom-line earnings.

Furthermore, as Merrill Lynch quantitative strategist Savita Subramanian writes, we are now in one of the rare periods when biotech stocks trade at a discount to the overall market.

"At just 14 times forward earnings, biotech is trading at a 20 per cent discount to the S&P 500 – close to its lowest discount in our data history – and well off its average market premium of 40 per cent," Ms. Subramanian writes in a research report. "And buy-side positioning in biotech has fallen to its lowest level in six years." The first chart below shows the historical effects of relative valuation on biotechnology stock performance. Using 15 years of data, the average two-year cumulative return for the S&P biotechnology index when the sector was trading at a discount to the overall market was 55 per cent.

Sector performance was also impressive when biotech stocks were trading at a small valuation premium to the broader benchmark. When biotech forward-price-to-earnings ratios were in a range between equal to and 20 per cent higher than the S&P 500, returns averaged 45 per cent.

The strong returns result primarily from technological advancements that assist in new drug discoveries. In a number of cases, biotechnology firms have been acquired by traditional pharmaceutical companies at far higher than market price, helping boost sector returns. In August, 2016, for instance, Pfizer Inc. bought Medivation Inc. for $14-billion (U.S.), a 26-per-cent premium.

The sector also has demographics on its side. An aging population in the developed world should ensure steadily rising demand for new and improved treatments. Increasing government scrutiny on drug pricing practices is a risk factor for investors, and a diversified ETF approach is recommended.

The regulatory risks are real, but the depressed valuation levels and high profitability combined with demographic trends have me putting money where my mouth is in this case: I bought a position in the iShares Nasdaq Biotechnology ETF on Friday.

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