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Fidelity® Select Biotechnology Portfolio

  • Symbol: FBIOX
  • No Transaction Fee No Transaction Fee 1
  • Fidelity Fund Pick Fidelity Fund Pick  2
Select Biotechnology Portfolio: Quarterly Fund Review
SEPTEMBER 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 and industry 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 September 30, 2015, the biotechnology industry, as measured by the MSCI U.S. IMI Biotechnology 25/50 Index, considerably trailed the broadly based S&P 500® index.

Global stocks were weak in the third quarter, and biotechnology was not spared from the pain. China's troubles were in focus, as the populous nation struggled to stabilize its economy. China's decision on August 11 to devalue its currency was one factor unnerving investors, as it underscored the country's need to boost exports.

Volatility in Chinese stocks - partly a result of local investors buying on margin - also weighed on U.S. share prices. China's market had little effect on U.S. securities markets for much of 2015, but that changed in August, as the Shanghai Stock Exchange Composite Index plunged to new lows following its mid-June peak.

The other factor pressuring stocks was the decline in commodity prices, with crude oil leading the way. On August 19, global Brent crude closed at $47.16 per barrel, below its previous low close for the year of $47.43, registered on January 12, a psychologically important threshold. Crude's price slid further in August, taking the major U.S. stock indexes with it.

U.S. stocks recovered somewhat in early September but slipped back near their August lows at quarter end. Biotechnology shares roughly kept pace with the broader S&P 500® index for most of the quarter but significantly underperformed in the final weeks after one of the U.S. presidential candidates complained of "price-gouging" by drug companies. Some key components hampering the MSCI index were Biogen (-28%) and Valeant Pharmaceuticals International (-14%).

Performance Review

For the quarter, the fund underperformed its benchmark, the MSCI U.S. IMI Biotechnology 25/50 Index. The main reason for the relative underperformance was the fund's tilt in favor of smaller-cap biotech stocks, which significantly underperformed large-caps during a quarter marked by rising risk aversion. As a reminder, we believe smaller companies typically offer the best opportunities for identifying undiscovered value through the kind of comprehensive research we bring to bear here at Fidelity. This is a long-term strategy, though, and it is admittedly sometimes at odds with short-term market dynamics.

For example, MSCI index heavyweight Amgen was by far the largest relative detractor because the stock held up better than the index, and the fund had negligible exposure here.

Overweighting Esperion Therapeutics hampered relative performance too. Much of this stock's -71% return occurred near the end of the quarter, after the company reported that the U.S. Food and Drug Administration had requested a "cardiovascular outcome" study on its experimental ETC-1002 treatment for very high cholesterol. Such studies are typically costly and time-consuming, which explains investors' unfavorable reaction. We remained optimistic about the company's longer-term prospects and added to the position.

Conversely, an overweighting in Anacor Pharmaceuticals bolstered relative performance and returned 52%. Investors aggressively bought this mid-cap stock in July after the company reported positive results from two key phase 3 studies on crisaborole, a non-steroidal ointment for patients with mild to moderate dermatitis.

An out-of-benchmark stake in Global Blood Therapeutics, a biotech firm working on a treatment for sickle cell disease, also bolstered performance. This position returned 166%, reflecting our timely investment in advance of the company's August 11 initial public offering.

Holding Market Segment Average Relative Weight Relative Contribution (basis points)*
Anacor Pharmaceuticals, Inc. Biotechnology 1.24% 43
Global Blood Therapeutics, Inc. Biotechnology 0.42% 41
Radius Health, Inc. Biotechnology 1.39% 26
Genmab A/S Biotechnology 1.26% 26
Aimmune Therapeutics, Inc. Biotechnology 0.31% 23
* 1 basis point = 0.01%.
Holding Market Segment Average Relative Weight Relative Contribution (basis points)*
Amgen, Inc. Biotechnology -11.42% -91
Celgene Corp. Biotechnology -4.20% -47
Esperion Therapeutics, Inc. Biotechnology 0.69% -46
Horizon Pharma PLC Pharmaceuticals 1.70% -44
Tetraphase Pharmaceuticals, Inc. Pharmaceuticals 0.39% -32
* 1 basis point = 0.01%.

Outlook and Positioning

We remain big believers in biotechnology stocks as a valuable component of a well-diversified portfolio. 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, and we as investors can try to ride their coattails.

That's the long-term picture. Over shorter periods, investors in biotech stocks must remember that they are a volatile group, as we saw in the third quarter. However, volatility can be turned to our advantage, as corrections can be used to upgrade the fund's holdings. At period end, some of our favorite names were approaching double-digit free cash flow yields, with valuations reflecting minimal acknowledgement of their pipeline potential, in our view. To us, that spells opportunity.

Additionally, 2015 has been a record year for mergers and acquisitions in this group. The larger pharmaceuticals companies have a lot of cash on their balance sheets and are in need of the innovation that biotechnology firms can provide.

For example, during the global economic downturn in 2008, Genetech was one of the fund's largest positions. The stock sold off during the bear market that accompanied that recession, creating an opportunity for Swiss drug company Roche Holding to acquire it, with the deal being struck early in 2009. Genentech was one of the larger biotechnology stocks by market capitalization, yet it was considerably smaller than Roche.

We foresee a continuation of this pattern in which larger pharmaceutical companies swoop in to buy biotech companies at discounted prices, and we also look for larger biotech firms to acquire their smaller peers.

Consequently, we believe 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.

At the end of the quarter, the largest individual overweighting was Ireland-based Radius Health, a biopharmaceutical firm focused on developing therapeutics for patients with osteoporosis and other serious endocrine-related diseases. Other noteworthy overweightings included a sizable non-index stake in Genmab, a Denmark-based biotechnology firm, and Anacor Pharmaceuticals, mentioned earlier as a contributor.

In line with our philosophy of tilting the fund toward smaller companies, our biggest underweightings at the end of September all were large-caps: Amgen, Gilead Sciences and Celgene.

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