Murphy: Biotech at a Discount

11/22/2002 12:00 am EST

Focus:

Michael Murphy

Former Editor, New World Investor

Mutual funds trade at the value of their net assets. However, a closed-end fundlike a stockcan trade at either a discount or premium to its net assets, based on investor optimism or pessimism regarding the future value of the fund's holdings. For those seeking exposure to the biotech sector, Michael Murphy, editor of Health Investing, recommends a closed-end fund that is trading at a 20% discount to its assets.

“Most small- and mid-cap biotechs are unprofitable and risky, and as such I won’t recommend early-stage companies. Nevertheless, I want you to have some exposure to these companies. The way to do that while minimizing risk is with biotech mutual funds that give us decent diversification. H&Q Life Sciences Investors (HQL NYSE) is a closed-end fund that lets you buy into a biotech portfolio at a 20% discount. In addition, the fund pays a 2% per quarter distributionproviding an 8% annual yield. (This distribution is normally from capital gains and therefore taxable, so you might want to buy this closed-end fund in your retirement plan.)

“The fund is allowed to invest in private company venture capital investments. It currently holds 30% of its portfolio in these restricted securities. The fund can invest as much as 40% in this sector. These investments are carried at cost or the valuation set for a subsequent financing round. Yet many of them will be worth more than that in the next round of financing, or an initial public offering, or merger. You get a double discount on thesethe low valuation is part of the current net asset value, and then you buy at a 20% discount to that.

“HQL is mostly invested in biotechnology, almost 50%. The current cash position is abnormally high at 20%, but management has been cautious during this downturn. The fund has a September fiscal year, and as of the end of the June quarter, the largest holdings were Gilead Sciences, Martek Biosciences, Endocardial Solutions, Cubist Pharmaceuticals, and CV Therapeutics.

“Overall, investors can gain as a result of appreciation in the net asset value of these biotech holdings. Investors can also benefit if the discount to net asset value shrinks. We note that in a bull market, the fund can even trade at a premium to its net assets. Meanwhile, investors get an 8% or better annual distribution. Together, these factors make this an excellent investment. Buy HQL at a discount of 20% or more. (To calculate the discount, divide the closing price of HQL by the net asset value on that day and subtract 1.)  I think the fund can trade up to $14.50 by the end of 2003, plus pay its 8% distribution. That adds up to a nice 25% return by the end of next year.”

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