Deerfield Management is a long-short, bottom-up hedge fund that invests in the healthcare sector only. It manages about 3 billion dollars and has been under the stewardship of its managing member James Flynn since 2000.

According to its October 2012 Letter to Shareholders, the biotechnology sector might be in a bubble right now. While the markets have generally recovered from the 2008 lows and are somewhat back to 2007 levels, “in looking at biotechnology companies, this may be true in more ways than one”.

First, the biotechnology sector is up between 30 to 40%, depending on the index. Second, “any company with a pulse is being given credit for clinical success and downstream earnings power.”  This is of course driven by low interest rates that “have generated bubbles in the past and may be on their way to doing so here once again”.

As a specific example, Mr. Flynn points to the biotech company Gilead (symbol GILD) — it surpassed the market cap of pharma bellwethers such as Bristol Myers (symbol BMY) and Eli Lilly (symbol LLY). Now Gilead has sales of $9 billion in contrast to the $18 billion for Bristol Myers and $23 billion for Eli Lilly. Although there are some nuances to be considered such as patent expiration and product pipeline, this is mostly a “testament to relative valuations in the biotechnology industry and how much investors are willing to bank on future earnings materializing”.

Nevertheless, there are true pockets of innovation creating real value and not merely speculative “value”. Mr. Flynn and his team, most of which like him tend to have domain expertise in healthcare and finance acumen, see the opportunity to selectively invest in “notable clinical successes and some meaningful new product launches”. But Mr. Flynn is rather cautious as “there is a balance between the real and the unreal which can be at times difficult to dissect”.

Also, there are tempting opportunities to short the higher valuations, but “it is also true that you can never exactly define what something is worth and valuation extremism is nothing like it was at the turn of the century” which means that “arguably there could be a long way to go before prices settle back down”.

Because of this two-way caution and the impending presidential elections with its focus on healthcare issues, the fund has accordingly reduced its gross and net exposure. We will have to wait to see when Deerfield Management feels the bubble is about to burst, but we have been forewarned.

http://www.hedgefundletters.com/sector-focused-hedge-fund-sees-bubble-in-its-sector/