Investing in biotech - the best of times or the worst?

In the past 10 years the Nasdaq biotechnology index has soared, returning 565.5 per cent compared with 211.5 per cent from the Nasdaq Composite index, and the sector is showing no sign of running out of steam. Share prices are surging, fuelled by mega merger and acquisition (M&A) deals and a long list of initial public offerings (IPOs).

Reasons to be nervous

Money has been flooding into biotech companies across the market cap spectrum in the past year, with the number of IPOs reaching a new record in 2014. The Nasdaq Biotechnology index is hovering just below 4000, a major turnaround from 2010 when it hit 781.71 at its lowest point. Biotech IPOs accounted for around a quarter of the total 275 IPOs in the US last year, according to research house Renaissance Capital, which said in March: "Today's technology IPOs look much tamer in number than they did 15 years ago, but a boom in biotech IPOs raises concerns over a bubble in the biotech sector."

Companies in the biotech sector rely on capital-raising due to their high costs and low revenue streams in the run-up to producing a drug. But has hype around the market sent capital surging into inappropriate ventures? Of the 71 biotech companies listed in the US last year about 40 per cent were not even at pre-clinical stage, according to Renaissance Capital, and the average biotech that listed in 2013-14 now trades 78 per cent above its offer price, more than three times the average for non-biotech stocks.

And that trend has continued in 2015. In June, Axovant Sciences (US:AXON), an eight-month-old company developing a single, unproved Alzheimer's drug went public, becoming the biggest biotech IPO on record, with both its deal size and initial market cap proving larger than the week's other four offerings combined. Axovant Sciences bought its Alzheimer's drug for $5m in October from GlaxoSmithKline (GSK), which shelved the compound four years ago after testing it in 13 trials on 1,250 patients. Axovant's shares nearly doubled in a day when the company made its debut.

The sector is undoubtedly high risk, sparking comparisons with the tech sector boom and subsequent dot-com crash of 2000, and working out the winners from the losers is no easy task.

"It's the small companies where you can make the big money," says Tim Cockerill, investment director at Rowan Dartington. "But they have a series of hurdles to jump over and if they fall at any of them the share price can get absolutely hammered - a 60 per cent fall is common. But if they get to the approval stage then the upside is the equivalent and more."

Reasons to be cheerful

Some argue that there is more room for growth in biotech, attributing the capital surging into the sector and rapidly appreciating share prices to a dramatic pick-up in technological and scientific innovation.

Over the past few years the sector has seen major advances in the scientific understanding of diseases and accelerated drug approval rates from the US Food and Drug Administration, which approved 40 drugs in 2014 - the highest number since the industry's record in 1996. Meanwhile, advances in immuno-oncology and gene therapy could demonstrate real value behind the rapid market uptick.

Geoffrey Hsu, manager of IC Top 100 Fund Biotech Growth Trust (BIOG), says: "There has been true value creation in biotech over the past few years, which has driven a lot of the share gains. The large profitable companies have been delivering significant earnings growth over the past two years from the launch of some major products."

However he warns: "There are companies out there which, due to a halo effect, might be experiencing share price appreciation because of the success of other companies. There may also be pockets of overvaluation among emerging biotech companies which are not yet profitable, where one has to make larger assumptions about their approach and the possibility of success."

What is in a biotech fund and should you invest?

Biotech funds give UK investors access to the biggest and fastest growing names in biotech, which tend to be US giants not listed on the London Stock Exchange. There are not many to choose from, but the listed biotech trusts have been the most successful in the entire retail market. The Biotech Growth Trust and International Biotechnology Trust (IBT) returned more than any other trust over the past 10 years: Biotech Growth has delivered total returns of more than 760 per cent in the period, compared with just over 400 per cent for the third best performer and 444.5 per cent for International Biotechnology.

Jason Hollands, managing director at Tilney Bestinvest, says: "If I was going to buy any trust in this area, Biotech Growth Trust is the one I'd get. It's all the manager does and it has fantastic experience in the area." Mr Hsu says he likes large-caps "because we don't think the valuations are stretched", but also looks at small-caps. "These will typically trade based on pivotal clinical trial results or FDA [US Food and Drug Administration] approval decisions so they tend to be much more volatile, but if you can do some deep research into the drug or trial we think it is possible to beat the market."

A large chunk of the portfolio is in big-name companies with strong earnings growth and pipelines, including Gilead Sciences (US:GILD), which recently launched a new Hepatitis C drug, and genomic testing machine producer Illumina (US:ILMN).

With just 39 holdings, the trust is highly concentrated and its large exposure to companies such as Amgen (US:AMGN) could cause issues if the new market in biosimilars - which act as substitutes for major biotechnology drugs - takes off. As one of the older biotech companies with patents due to expire sooner Amgen could face competition from that market. However, the company is also working on a cholesterol-lowering drug, "a blockbuster category" according to Mr Hsu and a "multibillion opportunity which would help offset any issues it may suffer from biosimilars".

International Biotechnology Trust invests in similar companies, and it has some of the same top 10 holdings as Biotech Growth. However, this could be a better trust for cautious investors as it has gearing of just 4 per cent, compared with Biotech Growth's 14 per cent. It has returned less over the long term than its rival, but in the short term has outperformed its benchmark. Kieran Drake, analyst at Winterflood, says: "For a number of years International Biotechnology's quoted portfolio failed to keep up with the index and the unquoted portfolio was a notable drag on performance. However the stars have aligned for the fund over the past year or so."

Carl Harald Janson, lead fund manager, says: "We try to avoid hype and invest in things we know work." The trust recently reduced its annual management fee from 1.15 per cent to 0.9 per cent of NAV and the ongoing charge now stands at 1.65 per cent.

It is also worth considering BB Biotech (EU:BIO), a trust listed in Italy, Switzerland and Germany but due to launch in London later this year. In February, Anthony Stern, analyst at Stifel, said: "The fund should continue to be supported by its core portfolio of large-cap, profitable biotech companies, a section of the biotech market that appears to be trading at reasonable valuations.” However, he noted that the trust's discount, which has remained consistently wide, was in part due to the fact that it is not listed in London.

There is also AXA Framlington Biotechnology (GB00B784NS11), which leads the open-ended fund universe in terms of returns. It has topped the 3,210-strong list of UK-listed funds for five years, and has generated a total return of 477 per cent over 10 years. It also has a high concentration in the US, at 86 per cent, and its top 10 holdings are large-cap names including Celgene (US:CELG), Gilead and Biogen (BIIB:NSQ). It has a relatively low ongoing charge of 0.83 per cent.

Lower-risk alternatives

For slightly lower risk, you could choose to invest in the slightly wider healthcare sector. Mr Cockerill says: "Worldwide Healthcare (WWH) holds both biotech and large-cap pharma so is much more broadly based, and has the same dedicated people behind it as Biotech Growth - it is also run by Orbimed."

The trust invests across the healthcare sector, investing in biotech, pharma and related industries and also uses derivatives to boost returns. The trust has a 29 per cent exposure to small-caps and is 4 per cent invested in derivatives to achieve capital growth. We also count the trust among our IC Top 100 Funds.

Another broader, more cautious trust is Polar Capital Healthcare Growth and Income (PCGH). Manager Dan Mahony says the fund is aimed at delivering income as well as capital growth, and argues that the fund falls behind the benchmark due to its underweight position in biotech and focus on long-term dividend growth. The fund has a yield of 2.07 per cent, but has fallen some way behind the MSCI Global Healthcare Index over the longer term.

The fund differs from its benchmark, with an active share of around 55 per cent. Mr Mahony says the fund is seeing two investment trends, "the consolidators - looking to take cost out of healthcare systems - and the innovators, developing products and services that disrupt existing systems, and improve the quality of healthcare". Among those are medical technology company Medtronic (US:MDT), which is working with hospitals to run clinics across Europe, and insurer UnitedHealth (US:UNH), which is the largest medical insurer in the US and a beneficiary of Obamacare.

Tactics

The key risk when it comes to investing in biotech today is getting in at the top of the market and losing when it falls. The astronomical growth experienced by the sector is unlikely to be repeated this year and you need to think carefully about your investment tactics.

If you are not already invested, think carefully about getting in now. Mr Cockerill says: "I would be reluctant to buy in at this level. You look at these funds and see returns of 70 per cent in a year, but the funds won't do that again next year - it's almost guaranteed. So I think if investors are keen to put money in, phasing it in makes sense. If you want to put money in, drip it in, because I think it's volatile and these things can turn quite quickly."

Patrick Connolly, certified financial planner at Chase de Vere, says: "Those who jump in now risk joining in at the top. It's always dangerous to invest in an asset class that has already performed strongly."

If you are already invested, now might be a good time to take profits. Mr Connolly says: "Existing investors probably have a much bigger exposure than when they got in, so it makes sense to take profits now."

Mr Cockerill says: "The underlying drivers are still there. I'm always a bit reluctant to come out completely because you don't know what's going to happen. But anyone in for the past few years will have made a healthy profit and taking profit is always a good thing to do."

Performance of recommended funds (% cumulative share price return)

*Performance for R share class

Source: FE Trustnet, as at 22 June 2015