Most people can all agree that healthcare spending is already complicated. Whether government intervention through the Affordable Care Act (AKA Obamacare) will result in a net positive is still unknown, but it seems safe to assume that it won’t make spending any simpler or much lower. Last week’s price shock in biotech stocks is a good example of the risks investors may be exposed to as that issue continues to become more complicated.

It Costs How Much!?

On Friday, Gilead Sciences (GILD) received a letter from two members of the U.S. House of Representatives asking for the rationale for charging $84,000 for a single course of its new treatment for hepatitis C. The new treatment, called Sovaldi, costs $1,000 a pill and is taken over the course of 12 weeks. Sales of the new treatment are expected to hit $8 billion (more than 2% of total prescription spending) over the next year – so why is Congress concerned?

A drug like Sovaldi will be used more by low-income patients because they disproportionately suffer from hepatitis C in the U.S. That means Medicare and Medicaid recipients will need the treatment and the government will have to pay the bill. Right or wrong, this letter was a pretty effective threat. Essentially, the government is asking for those costs to be justified or they will seek to intervene.

GILD has already made an argument for the cost of the treatment by comparing it to the cost of liver treatments, transplants, and end of life care for patients without access to the drug. Ultimately, its explanation may prevail but investors freaked out anyway and sold GILD with a vengeance. The halo-effect caused other, profitable, and unprofitable biotechs to selloff as well. For example Arrowhead Research Corp. (ARWR) lost 24% over the same period. This was a major hit to investors in ARWR who have enjoyed more than a 900% return over the last year.

The bottom line is that biotech stocks have had a lot of buying interest on the assumption that the ACA will increase healthcare spending in the U.S. We have made this same argument ourselves, but now that the initial gains have been made, who is likely to continue to grow from here? We think the government’s reaction to Sovaldi provides an important hint.

The government can’t stop paying for expensive medication, and, to a certain extent, it may be able to put pressure on biotechs to lower prices. But there is something else important that could lead to big profits in the near term. There are a handful of very expensive medications like Sovaldi that dominate prescription spending. What if generic producers had an easier environment to develop and market their “knock offs” of specialty medications?

“Store Brand” Biotech Stocks are Ready to Move Up Again

For example, Teva Pharmaceuticals (TEVA) produces the top-selling multiple sclerosis drug, Copaxone. The company earns sales of $4.33 billion per year from that drug alone. To put that in perspective, Copaxone represents 1.3% of all prescription drug sales in the country. At $500,000 to $800,000 per/month, per/patient, it’s not a surprise that one drug could account for such a massive share of total revenue.

Waiting in the wings are two companies working on Copaxone alternatives. One of these is Mylan (MYL) who will be releasing a Copaxone alternative this year. A leaked report from TEVA last year estimated that this competition will cost them 42% of its Copaxone profits. TEVA says those numbers are outdated but clearly they are expecting problems.

In our opinion MYL is poised to benefit from secular shift in the market that further favors cheaper, generic medication. The U.S. government has to do something about the costs it is paying and this week’s salvo over GILD’s bow is only the start. However, is this as simple as opening a long position on MYL and reducing exposure to companies like GILD and TEVA? That may work, but for aggressive traders we like this as an opportunity to set up a pairs trade. Full details of the trade are on the next page.

The Best of Both Worlds

A pairs position is constructed from a long position in a stock you favor and an equivalent short position in a similar company that is expected to underperform. For example, we recommend opening a long position in MYL along with a short position in TEVA. The strategy attempts to profit regardless of the average direction of the industry group.

If biotech stocks fall, we expect MYL to fall less than TEVA. The profits from the short position should offset the losses in the long MYL trade. Similarly, MYL should outperform when the group trends bullishly offsetting the losses from the TEVA short.

In the chart above, you can see MYL and a comparative relative strength analysis comparing it to TEVA. Just like a regular stock chart, the relative strength line between the two stocks has ups and downs but the trend is clear. The recent downtrend on MYL seems to be mostly profit-taking after the company reported stellar earnings in February. If relative performance bounces back up as expected, this would be the right time to accumulate a paired position.

As a side note, although it is a long-shot, a potential merger between TEVA and MYL has been rumored for a long time. The average premium paid to the target (MYL) in this situation is 30% while the acquirer (TEVA) drops an average of 3%. That would be a great windfall and isn’t outside the realm of possibilities. Keep in mind that a similar situation is playing out in the merger between Actavis (ACT) and Forrest Labs (FRX).

A pairs trade has disadvantages, as well. If a trader is extremely confident in the upside of a particular company then an outright long position will perform better. However, we think taking advantage of a disconnection between the relative, intrinsic value of these two firms in this market will help increase the potential for profits even if the biotech-bubble finally pops in 2014 or 2015.

InvestorPlace advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news.  Get in on the next trade and get 1 free month today by clicking here.

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