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Fidelity® Select Biotechnology Portfolio

  • Symbol: FBIOX
  • No Transaction Fee No Transaction Fee 1
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  • Quarterly Fund Review
Select Biotechnology Portfolio: Quarterly Fund Review
DECEMBER 31, 2014
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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 December 31, 2014, the biotechnology industry returned 10.50%, as measured by the MSCI U.S. IMI Biotechnology 25-50 Index, outperforming the broadly based S&P 500® Index, which returned 4.93%.

Stock prices were volatile but resilient, recovering from one sharp sell-off in mid-October and another in mid-December to close the period with the S&P 500® near all-time high ground. A steep drop in the price of crude oil and a surging U.S. dollar were two factors contributing to investors' anxiety. Oil's decline accelerated following the late November decision by the Organization of the Petroleum Exporting Countries (OPEC) not to cut production.

U.S. third-quarter economic growth came in strong at an upwardly revised 5.0%. The U.S. was virtually alone among developed nations in reporting stronger-than-expected economic expansion. In contrast, the nations making up the eurozone jointly grew at a meager 0.2% pace during the third quarter, and Japan's economy contracted for the second consecutive quarter.

The biotechnology industry continued its multiyear climb with ongoing breakthrough drug releases. The U.S. Food and Drug Administration approved 41 new molecular entities in 2014, the highest rate since 1997. The industry's outperformance for the quarter was primarily driven by high double-digit returns from the mid- and smaller-sized companies. Promising science continues to propel the industry to outperform the broader market. Encouraging data releases from bluebird bio and Regulus Therapeutics pushed their stocks to triple-digit gains for the quarter.

Index stalwarts Gilead Sciences, Biogen Idec and Vertex Pharmaceuticals experienced setbacks during the quarter and lagged the broader industry.

Performance Review

The fund outpaced the MSCI U.S. IMI Biotechnology 25-50 Index for the fourth quarter of 2014.

Strong security selection helped relative results. Underweighting some of the larger index names in favor of smaller-cap names proved beneficial for the quarter. A sizable underweighting in Gilead Sciences underscores this point. After hitting record prices in November, shares of Gilead Sciences tumbled mid-December on approval of a potentially cheaper alternative to the company's breakthrough drug to treat hepatitis C, Harvoni®. Gilead returned about -11% for the quarter. Despite this apparent setback, the company remains a leader in certain HIV and cardiovascular therapies and owns several pipeline prospects undergoing clinical trials. The company's share price picked up a bit near quarter-end amid rumors of a possible - and possibly substantial - stock buyback program in the works. Likewise, underweighting Biogen Idec was a contributor. Shares of the biotech company fell after safety concerns surfaced regarding Biogen's leading multiple sclerosis oral drug, Tecfidera. We narrowed our underweight in Biogen during the quarter as its price became more attractive.

Overweighting Intercept Pharmaceuticals and Puma Biotechnology were drags on performance. Although Intercept released in-line results from a trial of its drug that fights liver disease, investors expected more progress and sold shares of the biopharmaceuticals company. Our outlook for Intercept remains optimistic and we maintained our overweight. After a huge run-up earlier in the year, shares of Puma Biotechnology ran into some profit-taking and volatility, returning about -21% for the quarter. In July, the company had enjoyed positive results for neratinib, its drug candidate for treating breast cancer, tripling its stock price. But in December the company postponed its proposed New Drug Application, citing expansion of the drug's potential applications and, thus, its data requirements.

LARGEST CONTRIBUTORS VS. BENCHMARK
Holding Market Segment Average Relative Weight Relative Contribution (basis points)*
Gilead Sciences, Inc. Biotechnology -8.89% 212
Biogen Idec, Inc. Biotechnology -4.40% 52
Avanir Pharmaceuticals, Inc. Class A Pharmaceuticals 0.99% 41
Juno Therapeutics, Inc. Biotechnology 0.05% 40
Paratek Pharmaceuticals, Inc. Biotechnology 0.18% 33
* 1 basis point = 0.01%.
LARGEST DETRACTORS VS. BENCHMARK
Holding Market Segment Average Relative Weight Relative Contribution (basis points)*
Intercept Pharmaceuticals, Inc. Biotechnology 1.67% -103
Bluebird Bio, Inc. Biotechnology -0.53% -54
Puma Biotechnology, Inc. Biotechnology 1.29% -45
Amgen, Inc. Biotechnology -11.83% -39
Ultragenyx Pharmaceutical, Inc. Biotechnology 0.78% -37
* 1 basis point = 0.01%.

Outlook and Positioning

We have positioned the fund to take advantage of select small- and mid-cap stocks that we believe have promising science and were attractively valued following the volatility in 2014, giving the fund a small-cap bias relative to the benchmark at quarter-end. In general, most candidate drugs fail; consequently, most mid- and small-cap biotechs never make money. However, if a therapy is approved and an unmet medical need is addressed, the earnings potential is very favorable for a blockbuster drug, given the majority of the costs are behind the company. At the end of the period, through careful selection, the potential risk/reward ratio of owning certain mid- and small-cap biotechnology stocks still looks good based on our fundamental analysis. 

Clinical failure remains the biggest risk in the industry, where the success-rate of new drug development has not materially improved over the last decade. This risk is balanced with exposure to attractively-valued, cash generative large-cap businesses with sound capital allocation practices. We remain generally optimistic on large-cap biotechs owing to reasonable valuations, new product cycles, undervalued pipelines and low Wall Street estimates on out-year earnings. As the bigger pharmaceutical companies go through patent expirations, the larger biotech companies have become more attractive acquisition targets.

We maintained selective exposure to pharmaceuticals companies that we believe have reasonable valuations, exciting new product cycles and undervalued drug pipelines.

In the face of increased reimbursement pressure, the fund's holdings emphasized therapies focused on unmet medical needs.

Health care reform has created a pathway for the FDA to regulate biologics. Because biotechnology drugs are complex to manufacture, makers of generic versions of branded products will have to incur time and costs plus the risk of running full-scale clinical trials. Unlike their pharmaceuticals-industry counterparts, biogeneric producers will not be able to gain approval for their drugs based on bio-equivalence, i.e., where the associated compounds are assumed to be chemically equivalent. So despite a regulatory pathway approved by Congress, we expect the barriers to entry for biogenerics to remain high.

We maintained a positive outlook on drug development in the biotechnology industry. We believe reasons for a rich pipeline of drugs in clinical development include advances in basic research, advances in diagnostic tools, improved access to capital, and increased outsourcing of research and development by large pharmaceuticals companies.

1. No Transaction Fee Fidelity funds are available without paying a trading fee to Fidelity or a sales load to the fund. However, the fund may charge a short-term trading or redemption fee to protect the interests of long-term shareholders of the fund. Shares are subject to the fund's management and operating expenses. See Expenses & Fees for more information.

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