Is there life left in biotech?

While the sector languished in the doldrums in the first half of the 2000s after the euphoria around the tech bubble and the sequencing of the human genome died down, the sector has more than made up for it since. The Nasdaq Biotechnology index has risen by 291 per cent in just the past five years.

Even the broader healthcare sector, which is dominated far more by large-cap pharmaceuticals than growth companies, has delivered spectacular returns. In the past five years the MSCI ACWI Healthcare index has trounced the performance of the MSCI AC World index, returning 128.5 per cent compared with 68.6 per cent.

The outperformance of healthcare is even more remarkable considering that it has been delivered during an equity bull market. In previous cycles, healthcare has tended to outperform in falling markets because healthcare is seen as non-cyclical; people never stop needing medicine. But now healthcare and biotechnology are outperforming considerably in rising markets.

This extreme outperformance must lead investors to wonder what to do with any exposure they have to these sectors.

A biotech bubble?

Taking biotechnology first, it's striking that in spite of the extraordinary returns seen in recent years, the valuations of the larger biotech companies really don't appear anywhere near bubble territory.

In a recent presentation from Orbimed Partners, a US company that runs the Biotech Growth Trust (BIOG) and the Worldwide Healthcare Trust (WWH), fund manager Samuel Isaly pointed out that at the end of September 2014, the four biggest biotech companies, Gilead Sciences (US:GILDS), Amgen (US:AMGN), Biogen (US:BIIB) and Celgene (US:CELG), traded on an average price-earnings (PE) ratio of 21 times.

That is more than the wider market, but all four companies have significant earnings growth forecast for the next few years, leading to an average PE growth (PEG) ratio of 1.2 times. Not cheap, but certainly not expensive.

The reason for this high earnings growth is the number of new drugs being developed by the larger biotech companies, from hepatitis C drugs at Gilead Sciences to a multiple sclerosis treatment from Biogen. These new treatments are scheduled to generate multiple billions of dollars for these companies.

And the panoply of new drugs is not confined solely to biotech companies; pharmaceutical companies are getting in on the act too.

This is particularly true when it comes to new cancer treatments, which are in development from the likes of AstraZeneca (AZN) and Bristol-Myers Squibb (US:BMY).

Pharmaceutical companies such as AstraZeneca are developing new cancer treatments

New drugs

The factor that has most influenced this increase in new drugs, according to Jason Hollands, managing director for business development and communications at Bestinvest, is a more liberal US Food and Drug Administration (FDA). The FDA, which has to approve any drugs for use in the US, has relaxed its rules and has been encouraged to speed up its approval process; that has seen an increase in new drug approvals.

This has benefited pharmaceutical companies as well as biotechs, with the healthcare sector also receiving a boost this year from a spate of merger and acquisition (M&A) bids and rumours.

But while the large pharmaceuticals (taking the largest firms in the US as a proxy) are trading on slightly lower PE ratios than the biotech large-caps, at 18.1 times 2014 earnings, their predicted earnings growth is much lower, leading to a 2014 PEG ratio of 3.2 times.

And yet industry experts are much more upbeat about prospects for healthcare than for biotechnology, although most still only advocate holding on to existing healthcare holdings and suggest investors should be especially wary of adding money into the sector now.

Ben Yearsley, head of investment research at Charles Stanley Direct, says that even though growth rates are not spectacular at large healthcare firms, which include medical devices companies such as Stryker (US:SYK) as well as the traditional pharma stocks, "cash flow is pretty prodigious".

The cash flow feeds through to returns to shareholders in the form of dividends and share buybacks. And with growing demand for healthcare services from ageing populations in the developed world and growing middle classes in the developing world, that cash flow looks unlikely to dry up.

But in the face of historically high valuations and unspectacular growth, Mr Yearsley says: "I'm not sure I would take profits, but I don't think I would be adding to my positions at the moment in healthcare."

Mr Yearsley sees the "feast or famine" biotech sector differently. He says that because the sector often has "periods of flat performance followed by large gains" then "profit-taking after the good times seems a sensible bet". Given the biotech index is up by 20 per cent in the past month-and-a-half, this would seem to be one of the "good times".

Mr Hollands also signals a note of caution over the biotechnology sector. He says: "Those of us with long memories know that, over the long run, biotech has given investors a rollercoaster ride, delivering spurts of stellar returns in the good times, with periods of brutal losses. You need to be thick-skinned and take a very long-term view or be very disciplined in taking profits."

He also believes that the rally in the sector has been sparked partially by the "extraordinarily loose monetary policies and stimulus programmes we have seen in recent years, which has led to asset price inflation and at the margins rewarded riskier assets". A reversal in these policies, such as rate rises, could hit the biotech sector.

And Darius McDermott, managing director of Chelsea Financial Services, says it is "hard to see an obvious value" in the biotech sector at the moment. He also warns that highly valued sectors, such as biotech and even healthcare now, tend to get sold off harder in any broader market sell-off

Sam Peters, a leading US equity investor at Clearbridge Investors, a subsidiary of Legg Mason, has backed biotech shares even when the sector was completely unloved, more than five years ago.

He says valuations are still "reasonable", but said he had become nervous from all the "hot money" flowing into the sector from short-term investors looking to make quick money and who will bail out at the first sign of trouble.

In anticipation of this, and following strong gains in his healthcare and biotech holdings, Mr Peters says he has been reducing his positioning in the sector, taking profits.

The best healthcare and biotech funds

Experts are united in the belief that now is not the time to pile into the healthcare and biotech sectors, even if the positive long-term outlook remains intact, but for those looking to gain access to the sector, there are several options available - or to put on your watchlist.

Although he sounds a note of caution on the sector, Mr Hollands says that for investors who have a truly long-term view and are prepared to ride out the volatility then the best bet for accessing the biotech sector from a UK retail perspective is the Biotech Growth Trust (BIOG). Run by Orbimed, the trust has a stellar track record, generating a return of nearly 400 per cent for investors in the past five years, including 35 per cent just since the market low in mid-October.

Amgen is the largest holding in Biotech Growth Trust's portfolio

Mr Hollands says the investment trust is the best way to access the sector because the closed end structure is better suited to volatile asset classes, allowing the manager to invest for the long term without having to worry about dealing with money flowing in and out of the fund.

As at 5 December Biotech Growth was trading at a 0.73 per cent premium to its underlying net asset value, compared with a 12-month average discount of -5.45 per cent.

Diversified healthcare exposure is a more sensible option for most investors because it will provide some biotech exposure but also access to pharmaceuticals, medical device manufacturers and other healthcare sectors.

Polar Capital has a strong reputation in the healthcare investment field, with several options available for investors, in both the open and closed-ended space. Run by Daniel Mahoney and Gareth Powell, the Polar Capital Healthcare Opportunities fund (IE00B3NLDF60) is the flagship product in the firm's healthcare range.

It provides diversified exposure to the sector, with only 16 per cent in biotech, and boasts an enviable track record.

Within healthcare, and particularly within biotech, managers stress the need for active management in order to identify the winning companies of tomorrow, especially when new companies generally come forward with only one potential drug or treatment and the investment outcome is binary; win or bust.

But by giving investors access to every company, a tracker fund will eliminate the risk that fund managers will make the wrong binary decision and, while it will expose investors to some busts, you will also have access to all the winners.

For those looking for broad access to healthcare, the open-ended L&G Global Health & Pharmaceutical Index tracker fund (GB00B0CNH387) is actually the best-performing fund in the IMA Global sector in the past five years, even beating a couple of active healthcare funds (although not the Polar Capital fund, which is in the IMA Specialist sector). The fund's ongoing charge is low at just 0.31 per cent.

Unfortunately biotech tracker funds available to UK investors are thin on the ground. In fact, Source launched the very first exchange-traded fund (ETF) tracking the Nasdaq Biotechnology index only last month (November). Given its young life, the Source Nasdaq Biotech Ucits ETF (SBIO) is hard to judge, but it currently stands peerless in the UK.

Investors worried about getting exposure just to the healthcare sector, given its astronomical performance recently, could take a look at the Legg Mason Clearbridge US Aggressive Growth fund (IE00B19ZB102)

Very well known in the US and among offshore investors, the fund has only been made available to the UK retail audience in recent years but has already built up quite a following.

The fund has a 32.4 per cent weighting in healthcare, with two biotech stocks in its top five holdings, and they have a very positive view of the long-term fundamentals for the sector.

Managers Richie Freeman and Evan Baumann have been running the fund for many years and run it with a very long-term, low turnover approach - they regularly express their frustration that the word 'aggressive' in the fund name gives the impression of a highly active, dynamic fund.

This approach has certainly worked for them and the fund has consistently beaten the US stock market, which is a very rare feat.

Performance of recommended healthcare and biotech funds

Source: FE Analytics as at 4 December 2014

Note: *Ongoing charges figure, **Recent launch so figures not available