Does This ETF Exceed the Sum of Its Parts?

If there's an industry that should be immune to the recent market turmoil we've seen, it's biotechnology. Although a severe liquidity crisis could crimp biotech firms' access to capital, demand for innovative, life-saving treatments is largely recession-proof.

Yet, biotech hasn't been a port in the storm of late, with biotech stocks turning in a decidedly mixed showing for the year to date. With that in mind, it seems worthwhile to examine the biotech market environment, reassess the factors that can drive short-term volatility, and consider alternative means of exploiting compelling biotech ideas, such as the Biotech HOLDRs  exchange-traded fund.

Taking Stock
Larger-cap biotechs have been hurt by concerns about drug safety and new competition. For example,  Amgen (AMGN) shares have taken a beating due to safety concerns, tightened Medicare reimbursement for its anemia drugs, and fears that reimbursement for other therapies--particularly innovative cancer drugs--could also be curtailed in the future. Investors are also beginning to fret about the looming entrance of generic biologics into the U.S. market, though we think fears of rapid adoption and severe markdowns are overdone (as the requirements for approval will likely be individualized for each drug).

At the other end of the spectrum, some smaller-cap names have done quite well this year, thanks to a mixture of takeover speculation and positive clinical data.  Onyx Pharmaceuticals , which is a good example of both, is up a dizzying 305% for the year to date through Sept. 9. However, others have been hammered by poor clinical data or surprising FDA rejections and delays.

Takeaways
These wildly divergent showings, and the factors behind them, offer a vivid illustration of how unpredictable biotech performance can be. While we're mindful not to confuse stock price volatility with fundamental business risk, the biotech business' boom/bust nature subjects even the most-thoughtful forecasts to significant uncertainty. Not coincidentally, we rate all but a handful of the biotech stocks that we cover as "above-average" or "speculative" risk.

Given this risk, it can be worthwhile to consider investing in a basket of biotech stocks as an alternative to a stake in a single stock, as the diversification across names can help to diffuse some of this uncertainty. That is, the whole can exceed the sum of the parts. With that possibility in mind, we thought we'd take a closer look at Biotech HOLDRs, an ETF that spreads its assets across 15 biotech stocks--14 of which we cover here at Morningstar.

Biotech HOLDRs
Valuation
Our fair value estimate for Biotech HOLDRs was $185 per share as of Sept. 6, 2007, or roughly 8% above the ETF's market price on that date. Given the fund's narrow subsector focus and concentration in just a handful of names, we'd only be enthusiastic buyers of the shares when they were trading a 10% or greater discount to fair value. Therefore, while this ETF looks cheap, it's not yet a screaming bargain in our book.

Our fair value estimate is largely driven by our take on the fund's top two holdings,  Genentech  and Amgen, which together recently comprised roughly 60% of assets. Genentech, the biggest holding, and Amgen were down 3% and 24%, respectively, for the year through Sept. 6. That has thrown both stocks into the bargain bin (each garners 4 stars) while also, by virtue of those stocks' weight in the portfolio, putting this ETF on sale.

Potential investors should note that in valuing biotechs, we credit firms even for drugs that haven't yet reached the market. For example, although Amgen's osteoporosis drug candidate denosumab is still in Phase III clinical trials, we already incorporate 60% of potential cash flows (discounted at our weighted-average cost of capital) from this drug into our value of the firm. If Amgen or any of the other biotechs in this ETF were to encounter unexpected hurdles on the road to FDA approval, our fair value estimates--for the individual stocks and this ETF alike--could take a hit.

Thesis
We like this fund's selection of biotechs, but heavy concentration in two key stocks keeps us wary.

Comparing the 15 stocks in Biotech HOLDRs to our complete biotech coverage list, one finds that the portfolio skews toward the industry's higher-quality names. For example, while fewer than 20% of the biotechs we cover have established a significant and durable enough competitive advantage to warrant an economic moat, 60% of this ETF's holdings boast a moat, with traits like strong drug portfolios, proven research and development capabilities, and effective salesforces fortifying those advantages.

The individual stocks in Biotech HOLDRs also court less business risk, on average, than the typical biotech stock that we cover. For example, we consider almost 40% of the biotechs that we follow to be "speculative" investments. However, only one stock in Biotech HOLDRs--  Human Genome Sciences --receives Morningstar's highest risk rating, and this stock does not appear in the top 10 holdings.

That said, there are certainly risks to consider here. For instance, if Amgen's anemia drugs are slapped with further restrictions or if any of the other biotechs experience unforeseen pipeline disappointments, our fair value estimates for these stocks--and, thus, this ETF--could prove overly optimistic. Thus, after taking together the ETF's subsector focus and heavy emphasis on two stocks, we'd require a suitably wide margin of safety before recommending this ETF.

Portfolio Construction
This ETF's 15-stock portfolio is market-cap weighted. As such, a small handful of names soaks up a disproportionate share of the fund's assets, with Amgen and Genentech recently accounting for 60% of assets alone.

Disclosure: Morningstar licenses its indexes to certain ETF providers, including Barclays Global Investors (BGI) and First Trust, for use in exchange-traded funds. These ETFs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs that are based on Morningstar indexes.