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The good times aren't over for biotech

Lower valuations make now a good buying opportunity for long-term growth in the biotech sector
September 22, 2016

The biotech sector has gone from stock market star to political punchbag in a matter of months and shed value since its frothy peak in July 2015. Between 2010 and 2015 the Nasdaq Biotechnology index surged more than 400 per cent. Last June investors were already nervous about valuations, which had ballooned on the back of a spate of frenzied fundraising. Companies without drugs were being snapped up by venture capital firms and in June Axovant Sciences (AXON:NSQ), an eight-month old company developing a single, unproved Alzheimers drug, became the biggest biotech initial public offering (IPO) on record. The shares almost doubled in a single day when the company debuted.

Murmurs of a bubble were rife, but few expected a single tweet to trigger the downturn. However, when Hillary Clinton took to her keypad to denounce "outrageous" price hikes in the biotech industry in September 2015, she triggered a downward spiral that took chunks out of the sector. Already buffeted by a China-led market crash, biotech companies found themselves in the eye of a political storm which is likely to continue affecting share prices until after the US presidential election.

The catalyst for Hillary Clinton's outrage was the decision by infamous hedge fund manager and pharma executive Martin Shkreli to buy lifesaving antimalarial drug Daraprim in September 2015 and promptly jack up its price by 5,000 per cent. Mrs Clinton pledged to "take on" such hikes and aggressive price rises have become a central debate in the hotly contested US election. This year fellow drug company Valeant (VRX:TOR) and Shrekli appeared in Congress to defend their practices and last month Hillary Clinton waged a verbal war on Mylan (MYL:NSQ), the creator of Epipen, for raising the price from $100 to $600 over nine years.

For investors, it means lower share prices and capital loss in the short term. Within a week of Hillary Clinton's tweet last September the Nasdaq Biotechnology Index entered bear territory, falling by more than 20 per cent within a week. Sterling investors have been insulated from much of those losses, but since the start of 2016 the index is still down 5 per cent, and in local currency down 14 per cent.

 

 

Buy now for long-term gain

But according to biotech bulls, high demand, high innovation and lower prices make now a good time to invest, despite - or because of - political headwinds.

"I'm bullish on the long-term prospects for this space," says Ben Yearsley, founder of WealthClub. "A huge amount of capital has flowed into [the sector] in the past few years - $71bn was raised last year for biotech firms and that's driving innovation linked to ageing populations, demographics, bad health and obesity. And these are things that aren't going to go away. There are around 400m people in the world with diabetes and a third of Americans are technically obese, as well as 25 per cent of the UK. These numbers are quite frightening."

Add to that the innovation and new science in areas such as personalised medicines and you have a sector ripe for growth. "15 or 20 years ago you couldn't dream of personalised medicine, but now this looks like being a reality," says Mr Yearsley. "Things like gene therapy are potentially coming through which are huge growth areas. You can treat people more effectively."

 

The companies cracking the cures

Some of the most exciting advances in science today are happening in the biotech sector and our growing understanding of genes is enabling dramatic steps torwards cures never thought possible before. By identifying specific genes and gene mutations, scientists are moving closer towards the goal of replacing faulty human genes.

Orphan disease

Orphan, or rare, diseases might sound just that. But this is one of the most hotly contested therapeutic areas. For example, scientists have recently discovered the gene responsible for the degenerative neurological disease amyotrophic lateral sclerosis (ALS), using funding raised through last year's high-profile Ice Bucket Challenge.

The relatively small number of patients affected by these diseases compared with other more common afflictions also means companies are able to charge high prices for the drugs they develop - annual treatment costing several hundred thousand dollars is not uncommon.

Biotech Growth Trust invests in Vertex Pharmaceuticals, (VRTX:NSQ) a company working on a treatment for cystic fibrosis, UniQure (QURE:NSQ), which is developing a gene therapy for haemophilia and BioMarin Pharmaceutical (BMRN:NSQ), which is working on an enzyme replacement therapy treatment for Batten's disease.

Immuno-oncology

Finding a cure for cancer is the biotech holy grail and immuno-oncology is taking companies tantalisingly closer to that dream. Immuno-oncology is a completely new approach to tackling cancer and the first to use the body's immune system to fight back. Cancer immunotherapies activate cells in your immune system to attack cancer cells and have already made major strides.

Both Biotech Growth Trust and International Biotechnology Trust hold Incyte, which is working on a treatment for lung cancer.

 

Mr Yearsley believes the US election, whichever way it goes, will not adversely affect drug pricing due to the difficulty of passing radical legislation through US Congress, and the ability of new and innovative companies to retain pricing power over new drugs. However, in the short term it will create volatility in share prices. "In the very long term, I'm a bull, but in the short term I have mixed feelings because of the elections," he says.

Biotech fund managers also argue that the sell-off in biotech has been unfair and indiscriminate, hurting both older companies ratcheting up the prices for old drugs, and more nimble, innovative younger names coming up with new treatments, which will retain pricing power for those drugs.

"I'm not worried at all (about the political risk)," says Carl Harald Janson, manager of International Biotechnology Trust (IBT). "The price gouging Hillary is referring to is related to the non-innovative end of the market where some manufacturers have increased the price of old cheap drugs due to the level of innovation, for example Daraprim.

"We invest in highly profitable biotech companies with innovative drugs rather than low-margin generic specialty pharma that's not biotech."

 

Picking the right fund

As an investor in biotech, you want to achieve a healthy balance between high-growth, speculative companies and more mature, revenue-generating names such as Gilead (GILD:NSQ) and Celgene (CELG:NSQ). The managers of an active fund should be able to achieve that balance to deliver strong growth.

The key risk of investing in biotech shares is that many companies either thrive or die on the outcome of a single drug - also the reason for their high growth potential. For example, earlier this year Circassia (CIR) shares tanked by two-thirds in a single day when a placebo proved more effective than the company's cat allergy treatment at a late stage of development.

"Share prices are dependent on the outcomes of clinical data," explains Ben Yearsley. "It is very unusual to have a binary outcome in investment: you might have a company whose share price falls because it has delivered a different profit level to the one expected. In a lot of cases, it either works or it fails."

That makes a fund the best route into biotech for UK investors, which enables easier access to the US market where the majority of this sector is concentrated. Buying overseas shares directly can prove expensive because brokers typically charge more to trade them, and there can be unfavourable tax implications.

 

Fund advantages

■ Access to US stocks

■ Diversified mixture of high-growth, high-risk and slower-growth companies

■ Potential for strong long-term outperformance

■ Avoidance of binary outcomes from investing in single stocks

 

Investment trust options include International Biotechnology Trust and Biotech Growth Trust (BIOG). Biotech Growth Trust has outperformed the former by some margin over 10 years, returning 557.4 per cent compared with 279 per cent for International Biotechnology Trust.

Over the short term, neither trust has beaten the Nasdaq Biotechnology Index. The index has returned 262.6 per cent over five years and 490.7 per cent over 10 years, which Biotech Growth Trust has beaten.

Kieran Drake, analyst at Winterflood Securities, says: "Biotech Growth Trust has been the standout performer. The fund is managed by medical doctors and PHD scientists, and they really dig deeply into the science behind the companies. They have done very well over the past 10 years, consistently outperforming the index and other trusts."

The trust divides its portfolio between large, profitable biotech companies, mid-cap emerging biotech companies launching their first drug or approaching profitability, and early-stage emerging biotech stocks.

Its manager, Geoffrey Hsu, says: "The major profitable biotech companies include Amgen (AMGN:NSQ), Biogen (BIIB:NSQ), Gilead and Celgene, which we invest in for strong earnings growth and compelling valuations. In this space we prefer companies that have some blockbusters in the pipeline."

The portfolio is weighted roughly 50 per cent towards larger companies, with the balance invested in emerging companies whose results are likely to hinge on clinical data.

"We take a very scientific approach to our investing, so we are not afraid to invest before clinical data events that many other investors might avoid because of the binary risk involved," says Mr Hsu. "We spend a lot of time reading clinical literature, going to medical conferences and looking at clinical trial design."

Younger emerging companies in Biotech Growth's portfolio include Incyte Corporation (INCY:NSQ), which has an immuno-oncology asset and accounts for 6.6 per cent of the trust's assets, and Dynavax (DVAX:NAQ), which is bringing out a new Hepatitis B vaccine.

Despite being the best-performing biotech trust over the long term, Biotech Growth was hurt harder in the recent fall due to its higher gearing. It has 5 per cent gearing (debt), while International Biotechnology has none. It is also more concentrated than International Biotechnology.

"Biotech Growth Trust has recently shifted towards large-cap stocks, but is also quite concentrated [it has 74 per cent of assets in its top 10 stocks]," says Mr Drake. "The majority of its top 10 holdings are the same as those in the top 10 of the Nasdaq Biotechnology Index. International Biotechnology is less concentrated in its top 10 holdings and they overlap less with the index."

Since Mr Janson became manager of International Biotechnology in 2013 performance has also improved - the trust has beaten the benchmark each year since then, suggesting it could outperform from here.

A large chunk of its holdings are early-stage companies, which did not perform as well as the listed sector during the rally. "IBT has an allocation to private equity, which at times have been a drag on performance," says Mr Drake.

However this exposure enables investors access to a broader spread of investments.

"The unquoted investments make this trust different," says Mr Janson. "It gives you the ability to access all parts of the sector - not only the profitable quoted names, but also the new science, an area in which there is a lot of dynamism which I think will contribute to the performance of the fund."

Mr Janson remains committed to these names, but has been reducing exposure to unlisted companies, which account for 11 per cent of the portfolio. In 2014 the board halted new unquoted investments. However in the coming weeks it will vote on whether to start investing in unquoted funds that invest in biotech stocks, as well as investing directly in unquoted stocks. This is expected to increase the liquidity of those holdings, due to the larger secondary market for unquoted funds.

International Biotechnology has also announced it will introduce dividend payments, subject to board approval. These will be paid twice a year out of capital reserves.

There are three open-ended funds invested in biotechnology widely available on platforms, however all have consistently underperformed the benchmark. Over three years the performance of AXA Framlington Biotech (GB00B784NS11), Pictet Biotech (LU0448836352) and Polar Capital Biotechnology (IE00B42P0H75) has been in line with many of the closed-ended funds, but Biotech Growth beats all over five and 10 years.

The best performer has been AXA Framlington Biotech, which is fairly concentrated with just 56 holdings, of which its top 10 are very similar to the Nasdaq Biotechnology Index. Its largest holdings are Biogen, Celgene and Gilead, and 85.6 per cent of its assets are listed in the US. Over five years, however, it has returned 249.6 per cent, underperforming the biotech index which returned 262.6 per cent.

A lower-risk approach is to invest in the broader healthcare sector via a trust such as Worldwide Healthcare Trust (WWH), which is managed by Orbimed, also manager of Biotech Growth Trust. Worldwide Healthcare has a diversified portfolio of pharmaceutical and biotech companies, and related healthcare sector stocks. Over 10 years it has returned 374.1 per cent.

 

Active or passive?

There are only a few biotech funds to choose from and many of these have failed to outperform the Nasdaq Biotechnology Index. Biotech Growth Trust has outperformed the index over the long term, otherwise the returns of most other funds have been broadly similar.

Their top 10 holdings do not look very different from either each other or the biotech index.

"Active funds have broadly performed the same," says Mr Yearlsey. "In an area where there isn't much choice passive is as good an option as any."

However, there is only one passive fund tracking the Nasdaq Biotechnology Index listed in the UK - Source Nasdaq Biotech UCITS ETF (SBIO), which launched in November 2014. It has tracked well and has an ongoing charge of 0.40 per cent.

But there are good reasons to back an active manager in this risky sector. "Although we've seen an increase in similarity between the top 10 holdings of the active funds and the index, that's not always been the case," says Mr Drake. "It is a reflection of what managers perceive the current market environment to be. There is undoubtedly a benefit to having active management in this area because often, for the smallest companies with a single product in development, it's a binary outcome. And an active manager who can demonstrate an ability to avoid the negative outcomes and cherry pick the positive ones is beneficial."

Peter Hewitt, manager of F&C Managed Portfolio Trust (FMPG), which invests in Biotech Growth Trust, adds: "I would prefer to have an active fund manager looking after my portfolio. These trusts have quite focused portfolios and take quite big bets, but they will also have exposure to some of the up-and-coming newer names that maybe aren't such a big portion of the index."

 

Performance of biotech and healthcare funds

1 month (%)3 months (%)6 months (%)1 year (%)3 years (%)5 years (%)10 years (%)
Investment trusts
Biotech Growth Trust -0.419.721.1-7.864.7305.7557.4
International Biotechnology -2.415.821.7-8.178.5249.5279.0
Worldwide Healthcare Trust -2.317.422.311.984.6225.0374.1
Open-ended funds 
AXA Framlington Biotech -3.117.821.2-9.764.1249.6387.7
Pictet Biotech -2.116.722.7-8.546.6178.1273.1
Polar Capital Biotechnology 1.218.728.65.2
Source Nasdaq Biotech UCITS ETF -2.018.124.0-4.0
Nasdaq Biotechnology Index TR in GB-1.918.224.2-3.770.2262.6490.7

Source: FE Analytics, as at 19.09.16

 

Biotech grows up

The biotech industry today is a different beast to the highly speculative, nascent industry of 20 years ago and elements of it are starting to look more like big pharma, where growth is driven by mergers and acquisitions (M&A) rather than drug innovation. Managers argue that makes it a lower-risk sector than in the past.

"The biotech industry as a whole has matured over the past ten years and I think one of the perceptions out there among investors, which we think is incorrect, is that this is still a very volatile sector where a lot of the companies are in danger of going out of business overnight," says Geoffrey Hsu, manager of Biotech Growth Trust. "The large companies like Amgen, Celgene and Biogen have steady earnings growth and they've matured quite a bit since a decade ago."

These larger stocks will be likely to buy up smaller biotech companies rather than develop new drugs, and biotech funds will equally benefit from holding M&A targets and their existing pipelines, and innovation in new drugs. With valuations looking less stretched, this is a reason to take heart. Steadier revenues mean lower volatility and fewer stocks dependent on binary outcomes from drug trials.

However that also means funds need to avoid stocks where stagnating growth could be an issue. Companies with existing pipelines are also more vulnerable to patent expiry and falling sales of their existing drugs, an issue that hurt Gilead last month when sales of its hepatitis C drug were lower than anticipated.

"We do not like certain biotech companies because we don't think they have the growth," says Mr jansonen. "Gilead to a certain extent now resembles big pharma. It is dependent on a few drugs and certain molecules, and does not have much of an external pipeline."

He prefers Celgene, which has agreements with smaller companies to share the risk of development of innovative drugs.

"Biogen's sales increases are currently not that big, but on the other hand the company has a huge event coming up in a year with [trials for] its Alzheimer's drug," he adds.