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Good Benchmarking Starts with the Right Index

Posted on March 6th, 2013. Posted by

Good Benchmarking Starts with the Right Index

All management teams and boards of directors want to know how they’re doing. For public healthcare companies, the wide variety of stock indices makes it easy to draw a comparison with peer companies. But finding the right index is key to making a meaningful comparison. Just because an index includes “technology,” “healthcare” or “mid-cap” in its name doesn’t mean it’s right for you. And the most popular indices are not always the right choices.

Fund managers, especially those who may not understand nuances in various healthcare sectors, will use an index to evaluate your firm’s performance. But, comparing against the wrong index can have serious implications:  for instance, if an index that includes many larger cap companies (over $1 billion in market capitalization) is rising, but smaller companies aren’t sharing this momentum, then your smaller firm will compare poorly against the index – and undeservedly so.  Further, smaller companies are more vulnerable to certain financial issues than multi-billion dollar firms; access to capital, product pipelines and market volatility can have an outsized effect on a small-cap firm’s stock performance.

So what index is right for you? Typically, a good starting point when selecting an index is the obvious: the more stocks in the index, the better. More importantly, however, a majority of the companies that drive index performance should be in your market capitalization range.  Simply put, it would be a bad idea for $200 million company burning cash to gauge its stock performance against a profitable $5 billion comparator.  Yet, this is what many managements and boards routinely do. As an example, we review three of the most recognizable indices in the biotech sector.

Russell 2000 Growth Biotechnology Index (R2KGBI)

Created in 2008, this index has an upper limit of $2 billion in market capitalization, so there’s no danger of much larger firms skewing the results. It also has more components (that is, companies in the index) than either the BTK or NBI, thus creating a smoother profile of the industry. The R2KGBIperformance can be tracked through a variety of sources including Bloomberg.com. Westwicke Partners routinely uses this index to create meaningful benchmark studies for our clients.

NASDAQ Biotechnology Index (NBI)

Currently the mostly commonly used index amongst money managers, the NBI includes many large companies, like Amgen, Celgene, and Life Technologies. In fact, 51 percent of NBI stock price movement comes from the top eight companies in the index.

Avoid the NBI, however, if you’re a smaller cap biotechnology firm. Since small biotech firms are classified as under $1 billion in market capitalization, the NBI doesn’t provide a very meaningful comparison.

New York Stock Exchange Arca Biotechnology Index (BTK)

The BTK consists of only 20 companies (and 20 percent of those are not therapeutics companies), so any company included in the BTK reporting significant news (good or bad) can materially sway performance of the index. And like the NBI, the BTK includes such behemoths as Amgen and Celgene, and has an average market capitalization of $15 billion. As with the NBI, avoid the BTK if you’re a smaller cap biotechnology firm.

Comparing all three indices is a valuable exercise worth pursuing; it can provide valuable insight into what part of stock movement is due to market mechanics and how much is due to company fundamentals. For example, if the Russell Biotechnology index is weaker but NBI is rising strongly, that suggests that larger cap companies are propelling the stock movement and outperforming the smaller ones.

At Westwicke Partners, we can help you find the right stock index for comparisons, and even create custom indices to gain insight into how your stock is really performing versus peers. Contact us for more information and sign up for our newsletter to stay informed on this and other IR-related topics.

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