XBI: Underperformance Of Small Cap Biotech Likely To Continue

By Rob Isbitts

SPDR S&P Biotech ETF (NYSEARCA:XBI) is likely in the early to mid stages of a period of underperformance, both versus its larger-cap peers and the broad US stock market. While this ETF allocates assets in an equal-weighted fashion among approximately 150 biotech stocks, those stocks are much smaller in capitalization size than the well-known group of biotech behemoths that are better-known to investors. During more than a decade of extremely loose monetary conditions, this was a tailwind for XBI. However, that all changed with 2022 and the current tighter credit conditions. This brings a whole host of difficult challenges for a group of businesses that in many cases, are not yet profitable, and may never be.

The price trend of XBI, both on a relative and absolute basis, has been breaking down since early 2021. However, things took a further turn for the worst recently. After trading in an admittedly wide but consistent range of $75-$95, this ETF dipped below that bottom level earlier this month.

A small break of a big 9-month trading range is not by itself significant. However, the backdrop of a weaker economy, and thus a diminished appetite for small biotech stocks by investors seeking relative stability provides me with the 1-2 punch (fundamental, confirmed by technical) that XBI is a low reward/risk tradeoff here. Thus, while I was willing to give it the benefit of the doubt until now, I see "falling knife" potential here, and thus assign a Sell rating to this biotech ETF.

How the small-but-mighty have fallen!

Among its biotech peers, I view XBI as akin to a venture capital fund, focused on a single, dynamic, high-return-potential industry through innovation, but in a convenient ETF package. Its portfolio has a weighted average market cap of under $3B. Its 46% allocation to companies considered micro-cap in size is extremely high for any ETF not specifically focused on such stocks. However, this is an ETF truly built to try to capture the success of a large number of high-risk/high reward potential business, diversified across many dozens of companies and medical missions. Another 32% of XBI is invested in small cap names, so more than 3/4 of the ETF is below mid cap range. This fund is not to be confused with the other very large biotech ETF, iShares Biotechnology ETF (IBB), whose average market cap is more than 7 times that of XBI, and whose top 25 holdings currently make up about 75% that fund.

The chart below shows that XBI came sprinting out of the pandemic in 2020 to rally more than 130% in well under a year, as investors bought high-potential-growth stories with reckless abandon. As the chart shows, that changed abruptly, and XBI has fallen hard, while IBB has fallen, but by a fraction of that amount. Meanwhile, biotech as a whole has grossly underperformed the S&P 500 over the past 3 years. This may cause XBI to appear cheap to some, but the reasons behind the decline are deeper than just "buy it, its good value."

58% off its all-time high, and still not a Buy?

Yes, XBI is that far off of that 2021 high as of this writing. And, its technical view is, shall we say, not encouraging. Here's how I see it. I note 2 troublesome signs here. First, in the top part of the graph, XBI has been fighting the same type of price downtrend line that has inflicted the S&P 500 and much of the stock market over the past year or so. In the bottom half of the chart, I have circled 3 separate instances where momentum has peaked and then declined in earnest. The past 2 times coincided with significant price peaks in XBI. The third time is now, and in addition to seeing that indicator (PPO: Percentage Price Oscillator) rolling over, it is occurring at a lower level than the previous 2 instances. Translated from chart language to English: that's a bad sign.

Isn't there any good news?

Increased financing needs at time of high interest rates and now, likely restricted lending activity, especially by banks, combine to create a forward-looking environment for small biotech firms that is as steep as the price mountain XBI will need to climb, as shown in the chart immediately above. Many companies in this ETF will likely need to cut expenses to preserve cash, since there are now new threats to their very existence, given the sharp change in the economic climate.

In addition, XBI may now suffer from what I'd call a "cannibalization" effect. According to a recent analysis by RBC Capital Markets many companies are competing to solve the same problems. That increases competition for candidates for clinical trials. However, there is some reason for hope, as many of these niche biotech companies may be acquisition candidates by some of the more fundamentally-sound larger firms in the industry, many of whom are dealing with near-term patent cliffs (i.e. their big-money-making drugs are nearing the point where their patent periods run out, and generic competition can invade their sales and profit margins. This again brings to mind the "venture capital" analogy I noted earlier.

The small will be mighty again one day...just not today

Biotech is about innovation as much as anything else. This still makes it a must-follow industry. There will likely come a time where a 2020 type of price boost is potentially there for investors. I just don't think we are approaching that now.