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A healthy investment?

Created:

30 November 2009

Written by:

Leonora Walters

Investor concerns over the future profitability of the US healthcare and biotech industry are over-blown and in fact open up a great opportunity to buy into this sector, argues Geoffrey Hsu, co-manager of the Biotech Growth Trust.

While valuations are at historic lows thanks to the Nasdaq Biotech Index underperforming the S&P 500 and Nasdaq Composite since US healthcare proposals were published on 26 February - and defensives are lagging the rally in cyclical stocks, Mr Hsu says that once the US government passes a bill on healthcare reform – likely in the next month or first few months of 2010 - there should be a relief rally in biotech stocks. He expects generalist investors to reinvest in large liquid pharmaceutical companies as visibility returns to the sector.

"Now is the time to buy because when the situation is clearer you will have missed the cheap valuations, which will already be reflected in share prices," says Mr Hsu, pointing to the resurgence in biotech valuations in 1994 after a conclusion on Hillary Clinton's healthcare proposals was reached - in this case a decision not to implement them.

To exploit what they see as an impending investment opportunity, the Biotech Growth Trust's managers and board are now seeking to raise £50m in new ordinary shares. The proceeds will also be used to increase the liquidity and size of the investment trust (its market cap was just over £69m as of 27 November) as well as lowering its total expense ratio (TER).

US healthcare bill is good news

Mr Hsu says that the US healthcare reforms - if passed - could offer some substantial benefits. While opponents of healthcare reform believe a government-backed plan to cover the roughly 45m Americans who do not have health insurance could lead to a single payer nationalised healthcare system which would limit the cost of drugs and reduce profits for the drugs companies, Mr Hsu says a single payer nationalised healthcare system is unlikely in the short-term, and the pricing of drugs seems unlikely to change. "However extending cover to the uninsured would be a net positive for the healthcare industry because it would provide 45m potential new customers and increased drug use," he adds.

Another benefit for drugs companies would be an extension of market exclusivity for drugs from the current five years to 12 - a period during which generic forms of drugs cannot be produced, creating rival products. This would be a concession to the industry for accepting reform, and in addition to any patents a company has on its drugs.

Over the longer-term the US healthcare industry is due to benefit from the ageing population and consequent increased drug use - as is the case in a number of developed countries.

As time passes the likelihood that a bill will be passed becomes less likely - elections for the US Congress are due next year and if a bill is not passed before then it may get dropped. Healthcare reform is a controversial issue for US voters and if it is damaging to the electoral prospects of the government it may be abandoned.

Beyond politics

Politics aside, there are strong fundamentals backing the pharmaceutical and biotech industry, says Mr Hsu. The sector is undergoing a round of mergers and acquisitions (M&A) activity, with smaller emerging biotech companies being swallowed up by larger players.

The Biotech Growth Trust typically has 60 to 80 per cent of its holdings in emerging US biotech companies with a market capitalisation of less than $3m (£1.83m), which may be unprofitable but whose valuations are driven by profitable developments, clinical trials and partnerships. The rest of its investments are in biotech majors, with nearly 93 per cent of the trust's assets invested in the US.

"At the moment the trust is at the upper end of its range in majors because the valuations of these companies are so compelling," says Mr Hsu.

The trust has already benefited from M&A activity. In May this year Cougar Biotechnology was acquired by Johnson & Johnson - one of six companies in its portfolio to be acquired since May 2008. Several of the trust's current holdings could also be takeover targets, including Dendreon, one of its top 10 holdings.

But Mr Hsu says that buying takeover targets is not the primary investment aim of the trust, instead it seeks companies with fundamentally good assets which often tend to be attractive takeover targets. Biotech Growth Trust's investment team of five selects stocks via a bottom-up approach, often including a scientific assessment on potential therapeutic developments. Some of its stocks are also due to have drugs approved.

Typically the trust will hold between 30 and 40 stocks, with 38 holdings currently in the portfolio. Mr Hsu says a concentrated portfolio has the best chance of excess returns over the benchmark although this does means that the fund has a higher risk profile.

OrbiMed Capital assumed management of the trust in 2005. Since then the trust's net asset value (NAV) performance over one and three years has stood at 23 per cent and 18 per cent compared with a sector average of 17 per cent and 13 per cent, while its benchmark Nasdaq Biotechnology returned 14 per cent and 15 per cent.

If markets continue to rally cyclical stocks are likely to do better than defensives such as healthcare, but Mr Hsu maintains that biotech valuations are so low their share prices are unlikely to fall further, while smaller emerging biotech share prices should rise regardless of market conditions thanks to factors such as M&A, scientific developments and product approvals.

And if the rally does not continue, as many suspect, biotechnology could outperform as it did in 2008, when the Biotech Growth Trust's NAV rose a staggering 32 per cent, while the MSCI World Index nosedived by 22 per cent.