Sticking with biotech

Sound fundamentals

The case for biotech is well rehearsed. The world's population is set to grow by nearly 2bn by 2050 if not sooner, while ageing demographics and rising expectations all provide favourable tailwinds. The potential in the emerging economies is particularly good given their growing and increasingly aspirant middle classes - drug expenditure here is around $20 (£11.80) per head compared with $800 in the US.

Whatever the twists and turns of the global economy, there is an increasing demand for medicines and healthcare products. This should be positive for the large pharmaceutical companies with their enormous research and development pipelines and clout. But, as the chairman of AstraZeneca (AZN) almost admitted last week, they have been poor at producing new treatments of late - in part because of rising costs in bringing drugs to market, and because of increased timelines and the subsequent pressures on 20-year patents courtesy of generic versions.

Instead, it has been the smaller biotech companies that have risen to the challenge. For the first time last year, these companies accounted for more than half of all new drug approvals. The DNA discoveries of Watson and Crick in 1953, the sequencing of the human genome, and the falling cost and increased power of computer technology, has transformed the potential, outlook and efficacy of these more nimble operators.

The future is exciting. A significant proportion of recent treatment advances has emanated from essentially three technology platforms - the next decade could benefit from as many as 10, including stem cells and gene therapy. But other factors support the fundamental case for the biotech sector.

Regulators globally are relaxing the rules and making it easier and cheaper to bring drugs to market. This may in part be because the authorities realise there remain significant challenges ahead regarding the threat of disease.

For example, there was a time after the Second World War when the battle against infectious diseases was thought to be won. No longer. Around 20,000 people die each year because of antibiotic-resistant bacteria - and the figure is growing. Standard operations could become far more dangerous if antibiotics stop being effective. The World Health Organisation believes many common infections could again kill unabated. Not enough new antibiotics are being approved - only seven since 2003, compared with 30 during the previous 10 years.

The good news is that innovation is the hallmark of this sector. Better managements are constantly reinvesting their increasingly positive cash flows into new research and treatments to good effect, in stark contrast with the large pharmaceutical companies. No wonder the regulators are reducing the hurdles and big pharma has been knocking at the biotech door - a combination of large but idle cash balances and the right biotech companies could help both, but particularly the latter.

Mankind is indeed set to benefit, provided science is not stifled by prejudice, needless meddling or vested interests - let us hope this is not too much of a big ask.

Trailing sentiment

The sector setback has made valuations very attractive once more. The Nasdaq Biotech index has fallen by around 20 per cent since its record high in February. However, we should remember that, even before the fall, sector valuations did not come close to previous peaks. Because profits have been growing so fast, company valuations had remained attractive despite the sector's good stock market run.

After the setback, this is even more the case. The price-earnings growth (PEG) ratio for many biotech companies looks compelling. A PEG of around one is seen as cheap. Twenty or so Nasdaq biotech companies - the index has 120 components - now trade at or below one. Compare this with a PEG of between two and three for the large pharma companies, and the case is almost self-made.

The sector has witnessed a rotation by some investors out of 'growth' and into 'value' stocks - essentially dumping what did well last year, and buying what did badly. For reasons given in my last column ('Seeking value', 4 Apr 2014), I believe this is a temporary phase given that 'growth' is going to be hard to come by. Because economies and consumers are burdened with debt, recoveries will be sluggish by past standards and investors will pay up for the genuine 'growth' stories.

I've always said this sector will not be a smooth ride, but volatility can often be your friend if you know where you are going. Sentiment trails fundamentals - this setback is a buying opportunity.

Portfolio changes

The price of both our existing holdings - Biotech Growth Trust (BIOG) and International Biotechnology Trust (IBT) - has fallen broadly in line with the Nasdaq index, but the discount on IBT has widened and at times has exceeded 20 per cent.

I recently spoke with Carl Harald Janson, the new fund manager. I was impressed with his approach - particularly his emphasis on avoiding losses. He also comes with a good track record. Over his six years as the main fund manager of the Carnegie Biotechnology Fund, he was recognised by Bloomberg as the top-performing biotech fund manager worldwide.

Over the period, the fund had a total return of 54 per cent (in dollar terms) compared with a negative return of 26 per cent for the Nasdaq Biotech index. He has settled in well, the amounts invested are broadly the same, he has a good team, and the working environment is very similar to that at Carnegie.

Meanwhile, a 12 per cent exposure to unquoted companies, two-thirds of portfolio holdings being profitable or 'on the turn', and a 50:50 split between large and smaller companies, are further positives. This all suggests IBT, when in its present 15-20 per cent discount range, is worth accumulating.

Accordingly, within the Growth portfolio, I have reduced the holding of BIOG when standing on a 5 per cent discount and added to IBT when standing at 20 per cent. I have also switched holdings within the Income portfolio - selling BIOG (which had fallen to a near 2 per cent portfolio weighting) and introducing a 2.5 per cent weighting of IBT.

Discounts such as these do not come along every day - seize the moment!

View John Baron's updated Investment Trust Portfolio