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Fidelity® Select Biotechnology Portfolio

  • Symbol: FBIOX
  • No Transaction Fee No Transaction Fee 1
  • Fidelity Fund Pick Fidelity Fund Pick  2
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  • Quarterly Fund Review
Select Biotechnology Portfolio: Quarterly Fund Review
JUNE 30, 2015
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Investment Approach

  • Fidelity® Select Biotechnology Portfolio is an industry-based, equity-focused strategy that seeks to outperform its benchmark through active management.
  • Fundamental, bottom-up research leveraging Fidelity's experienced global health care team is the primary source of idea generation. Our analysis is driven by a data and statistical approach that places an emphasis on valuation through free cash flow and the probability risk-adjusted net present value of future earnings, the standard valuation method in the drug-development industry.
  • Our investment approach includes evaluating a company's drug pipeline, the size of its market opportunity and its relative valuation. We position the fund around four major themes: long-term winners with strong product pipelines - our primary focus - turnaround situations, breakthrough innovations and early-stage firms with promising science.
  • Sector strategies could be used by investors as alternatives to individual stocks for either tactical- or strategic-allocation purposes.

Market Review

For the three months ending June 30, 2015, the biotechnology industry, as measured by the MSCI U.S. IMI Biotechnology 25-50 Index, strongly outperformed the broadly based S&P 500® Index. As a group, biotech shares struggled early in the quarter versus the broader market. However, the relative strength of the  segment improved later on, and biotech stocks managed to hang on to some decent gains despite the late-June stock-market slide attributable to concern about Greece's debt woes.

One factor lifting the MSCI index was major component Gilead Sciences, which delivered a 20% return. Other large-caps in this index were not so fortunate. For example, Amgen returned about -3%, while Biogen and Celgene returned -4% and 0%, respectively.

Several factors contributed to a favorable climate for biotechnology shares. For one thing, credit conditions remained benign, with low interest rates giving investors confidence that smaller firms in the industry could access the credit markets for needed capital.

The regulatory environment also was positive. With uncertainty around health care reform largely diminished, the U.S. Food and Drug Administration (FDA) has been faster to approve novel drugs in areas of unmet need.

Additionally, merger-and-acquisition activity continued at a record pace in the biotechnology space. In the second quarter, about $2.1 billion was pumped into biotech companies through 126 deals, the largest dollar total since an industry group began tracking the figure in 1995.

Performance Review

During the second quarter, the fund slightly outperformed its benchmark, the MSCI U.S. IMI Biotechnology 25-50 Index.

Having marginal exposure to weak-performing index giant Amgen made this stock by far the biggest relative contributor. While Amgen is a very profitable company with an enviable product pipeline, the stock had several outstanding years leading up to 2015, and we thought it was less attractively valued than a number of mid- and small-cap shares. We're not opposed to owning large-caps in the biotech area, but we think it's important to buy them when they're out of favor.

A large overweighting in Radius Health was beneficial to relative performance. The stock had a particularly good June after the company announced positive phase III results in clinical testing of the drug abaloparatide-SC to help reduce fractures in women with postmenopausal osteoporosis. This stock fit in with our effort to find companies that are addressing unmet medical needs and whose growth prospects are underappreciated by investors.

Conversely, underweighting Gilead Sciences dampened relative results, as it was the MSCI index's largest component and it posted a strong gain, reaching an all-time high above $120 per share in the process. The company continued to dominate the market for hepatitis C drugs. While we continue to view the stock favorably, we are more optimistic on the growth profile of other small- and mid-cap stocks, where credit is cheap and M&A tailwinds exist. 

An overweighting in Intercept Pharmaceuticals also curbed results. The firm focuses on treating liver conditions such as nonalcoholic steatohepatitis (NASH), which is expected to soon surpass hepatitis C as the leading cause of liver transplants. After stunning gains earlier in the year, shares of the development-stage biotechnology innovator reversed course to return roughly -14% this quarter. In mid-May, Intercept announced a new trial design that was longer and larger than many had anticipated, and the stock took a sharp dive.

LARGEST CONTRIBUTORS VS. BENCHMARK
Holding Market Segment Average Relative Weight Relative Contribution (basis points)*
Amgen, Inc. Biotechnology -11.35% 137
Radius Health, Inc. Biotechnology 0.95% 49
Aduro Biotech, Inc. Series D Biotechnology 0.03% 41
Horizon Pharma PLC Pharmaceuticals 1.68% 36
Ultragenyx Pharmaceutical, Inc. Biotechnology 0.68% 33
* 1 basis point = 0.01%.
LARGEST DETRACTORS VS. BENCHMARK
Holding Market Segment Average Relative Weight Relative Contribution (basis points)*
Gilead Sciences, Inc. Biotechnology -8.85% -97
Intercept Pharmaceuticals, Inc. Biotechnology 1.32% -33
Puma Biotechnology, Inc. Biotechnology 0.34% -25
bluebird bio, Inc. Biotechnology -0.69% -23
Esperion Therapeutics, Inc. Biotechnology 1.06% -20
* 1 basis point = 0.01%.

Outlook and Positioning

We remain big believers in biotechnology stocks as a valuable component of a well-diversified portfolio, although we are well aware that diversification does not ensure a profit or guarantee against a loss.

This industry has the potential to offer discoveries that can treat and even prevent many diseases, while providing ways to lower the cost of health care through safer, less-invasive treatments. In turn, companies that participate in this process with commercially successful drugs have the opportunity to earn enviable profits.

At the end of 2014, there were more than 1,750 molecules in various clinical programs, compared with 500 molecules a decade ago. Over the last decade, the number of new biotechnology products approved by the FDA has increased by a factor of four, to over 225. More than 300 clinical trials are in phase II or phase III - in other words, the latter stages of testing. Over 400 new biotechnology companies have been started during the past five years and at least another 400 new companies are projected to start between now and 2020.

Clearly, the industry is growing rapidly, and we believe the fund is positioned to try to capture a significant portion of the value expected to be generated by the industry. In our view, the fund's approach of emphasizing smaller companies, alongside select positions in industry leaders, offers a prudent yet potentially rewarding way to gain exposure to this dynamic market. Investing in a basket of smaller companies doesn't eliminate market risk, of course, but it helps reduce company-specific risk.

Importantly, despite this exciting opportunity set, we believe valuations in the group remain reasonable and within historical parameters across the key metrics - price-to-earnings-growth (PEG) ratios versus pharmaceutical companies and versus the market.

We continue to target companies we think can do well over the longer term, meaning three to five years. It takes time to develop good products, bring them to market and build sales volume. We pay little attention to the short term. This industry tends to be volatile and is prone to bubbles and busts, but they are typically clearer in retrospect than before the fact.

At the end of the quarter, the largest individual overweighting was Ireland-based Horizon Pharma, a biopharmaceutical company that develops and commercializes medicines to target unmet therapeutic needs in arthritis, pain and inflammatory diseases. Other meaningful overweightings were Receptos and Radius Health, the latter of which was mentioned earlier as a contributor.

In line with our philosophy of tilting the fund toward smaller companies, our biggest underweightings at the end of June all were large-caps: Amgen, Gilead Sciences and Celgene. Because of their size in the index, the latter two also were among our largest absolute holdings.

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