Drug Merger Boom Sends Hedging Costs to Eight-Year High
Takeover-fueled gains that have made health-care companies America’s best-performing stocks over the past three years are pushing up the cost of hedges, too.
Implied volatility, the main gauge of options prices, on drug and device makers reached the highest level in eight years this month relative to the Standard & Poor’s 500 Index, according to data compiled by Bloomberg. The increase comes as proposed mergers and acquisitions worth $285 billion helped send health-care stocks up 84 percent since the start of 2011, the most of any industry.
Hedging is increasing due to the size of the rally and because traders burned by a 20 percent rout in biotechnology stocks aren’t waiting around for the same thing to happen in drugmakers, said Gareth Powell of Polar Capital Holdings Plc. Investors have pulled about $1 billion out of health-care funds in the week ended April 23 and poured it into energy, financial and technology funds, according to Bank of America Corp.
“All these deals going on and yet there’s incredible fear,” said Powell, who helps manage health-care funds at Polar Capital in London. His firm manages about $12 billion. “The move down in biotech was so vicious and painful, and the positioning was so excessive, this is the best way to protect themselves. People aren’t guessing there will be impending doom on pharma stocks, they’re just finding a vehicle to hedge their risk.”
Biotech stocks, one of the biggest winners of the five-year bull market, plunged as much as 21 percent this year. Investors’ euphoric mood came to an end amid concern over valuations and as U.S. lawmakers asked Gilead Sciences Inc. (GILD) to explain the $84,000 price tag for a 12-week course of its hepatitis C drug. Gilead is the S&P 500 Health Care Index’s fourth-largest member after Johnson & Johnson, Pfizer Inc. and Merck & Co.
The biotech selloff has coincided with merger announcements by Pfizer, Forest Laboratories Inc. (FRX), Allergan Inc. and Eli Lilly & Co. that have boosted deals by more than fourfold over the same period in 2013, data compiled by Bloomberg show.
The $115 billion of pharmaceutical deals that have been announced or reported so far this quarter are about $1 billion shy of the record set in the first quarter of 2009, data compiled by Bloomberg show.
Three main catalysts are driving the action: an increasingly popular tax inversion strategy, a desire of the industry leaders to become a one-stop shop for niche products and a hunger for growth and cost-cutting opportunities while interest rates are still low, Timothy Chiang, an analyst at CRT Capital Group LLC, said in a phone interview.
Options on the Health Care Select Sector SPDR (XLV) Fund with an exercise price closest to the shares cost 3 points more than for an exchange-traded fund tracking the S&P 500, according to three-month implied volatility data compiled by Bloomberg. The gap widened to 3.2 on April 16, the widest since November 2005.
Traders own more puts of the health-care ETF than calls. Puts totaled 183,052 on April 25, more than double the number of options to buy. Of the 10 most-owned options of the fund, eight are bearish. Wagers betting on a 3.6 percent decline to $56 by June 21 were the most owned, followed by bets betting on a drop to $51 over the same period, data compiled by Bloomberg show.
At the same time, analysts are projecting faster profit growth for health-care companies than for the overall market. Earnings in 2014 will surge 11 percent, more than the 7.2 percent increase for the S&P 500, according to analyst estimates compiled by Bloomberg. The majority of U.S. health-care companies that have reported first-quarter results surpassed analysts’ earnings estimates, the data show.
“Suddenly there’s activity and finally pharma companies are getting their strategies straightened out,” Les Funtleyder, a partner at New York-based Bluecloud Healthcare, said in an interview. “Pharma’s always been a consolidating industry, so we’re going to see more transactions. Tax inversion strategies are all the rage and interest rates continue to be low. Health care is a big growth area.”
The S&P 500 Health Care Index has climbed 4.6 percent this year, exceeding the 1.6 percent gain in the broader measure. The group is trading at 19.6 times reported profits, 14 percent above the S&P 500’s multiple, data compiled by Bloomberg show.
The Chicago Board Options Exchange Volatility Index, a gauge of U.S. stock volatility known as the VIX (VIX), fell 1.9 percent to 13.71 yesterday. The VStoxx Index, its counterpart for the euro area, lost 0.9 percent to 17.19 at 9:21 a.m. in London today.
The boom in pharmaceutical deals is failing to sway investors who are shifting their portfolios to sectors geared toward faster economic growth, according to Guillaume Duchesne, an equity strategist at BGL BNP Paribas SA.
“Even with the M&A trends, it’s really too late to do something with health-care,” Luxembourg-based Duchesne said by phone. “We have a neutral view. Health-care was a very good sector in a time of slow recovery and no real impressive figures on the macro and earnings side. But now we have a rotation in the markets, and there’s been a change of sentiment.”
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