“The harsh truth is that investing in a small or even medium-sized biotech company is a lot like gambling in Las Vegas,” wrote journalist Robert Langreth several years ago in Forbes magazine. “You are either going to win big or lose big and – short of a true medical breakthrough – it is almost impossible to predict in advance what will happen.”
- Attractive valuations
- Possibility of M&A pick up
- Experienced management team
- Focus on later-stage biotech
- Interest rate and liquidity headwinds
- Relatively high trust fees
- Gearing adds risk (and potential reward)
In recent months, investors have not lacked for reminders of biotechnology’s inherent risks, after speculative bets on the sector during 2020’s flurry of vaccine-induced optimism unwound. The Nasdaq Biotechnology Index (NBI), a key benchmark for the US-dominated sector, fell 24 per cent in the year to 11 February, with losses among many small cap biotech companies significantly steeper. Indeed, within the index there are around 60 stocks whose share prices trade more than 70 per cent below where they were just 12 months ago.
While it may have been a year to forget, it looks like there are now attractive buying opportunities for patient investors. According to SV Health Investors' Ailsa Craig and Marek Poszepczynski, managers of International Biotechnology Trust (IBT), 16 per cent of companies in the NBI are trading below the amount of cash they have in the bank. They say this compares with 2 per cent a year ago, and around 11 per cent at the height of the financial crisis in 2008.
As biotech investing is notoriously difficult and requires specific expertise, getting exposure to the sector via a fund like IBT is a sensible approach. Analysts at Stifel believe the recent share price falls have created “a fertile environment for active funds to pick through the wreckage” and IBT – the more defensive of the UK’s two major biotech investment trusts – looks a good option to play this theme while mitigating ongoing uncertainty. It also has the most attractive dividend of any healthcare investment trust, paying 4 per cent of the net asset value of the trust per year out of its capital account.
These more defensive qualities are reflected in IBT’s one-year share price performance. Though it is down 17 per cent, the NBI is off 22 per cent and Biotech Growth Trust, a key rival focused on earlier-stage stocks, has crashed 43 per cent.
IBT invests in quoted and unquoted companies at the cutting edge of biotechnological innovation. The portfolio is split roughly three-ways between profitable, “revenue growth” and early-stage companies, though IBT’s managers recently added a slew of smaller companies to exploit valuation opportunities. At the end of December, the trust had stakes in 80 listed companies. This was up from 69 a year ago and constituted 92 per cent of the overall portfolio.
An active period for bargain-hunting is reflected in the changes in the composition of the portfolio, 55 per cent of which is now in small or mid-cap stocks, up from 39 per cent in February last year. Most of the unlisted holdings are held via SV Fund VI, managed by former UK vaccine taskforce head Kate Bingham, which has generated a net internal rate of return of 23 per cent since the trust invested in it.
In terms of therapeutic areas, a third of the portfolio is focussed on developing cancer treatments and 31 per cent on treatments for rare diseases. The managers believe that the science and the fundamentals of the companies they invest in remain “robust and exciting,” but what has materially changed in the past 12 months is their valuations. In response, IBT has increased its gearing – the ratio of borrowing to net assets – to its maximum level of 15 per cent. This, the managers say, is the highest it’s been for many years, reflects their positive sentiment and has enabled them to bulk up on smaller stocks.
This shift has been further aided by trimming positions in what the managers call their “pharma-like holdings”, including its largest investment, Amgen (US:AMGN). One of the world’s largest independent biotech firms, the California-based group received approval last year for a first-of-its-kind drug to treat a mutation found in solid tumours common in patients with lung cancer. Other top holdings include Neurocrine Biosciences (US:NBIX), which sells a drug for tardive dyskinesia, a movement disorder which is a devastating irreversible side effect from anti-psychotic drugs, and Biohaven (US:BHVN), which recently inked a $1.2bn (£890mn) deal with Pfizer to commercialise its oral treatment for migraines.
Clearly, share price declines across the sector show sentiment has dropped considerably. So have valuations. According to FactSet, the Nasdaq Biotech Index trades at 3.4 times’ consensus book value forecasts, down from a multiple of 4.9 a year ago. But analysts at Stifel note that historically, the biotech sector has tended to strongly rebound the year after a heavy sell-off. Whether a similar inflection is near is hard to say, though risks are unlikely to have dissipated. In fact, for all its promise, the sector has been a perennial underperformer against other growth markets; Stifel points out that over the past five years, tech stocks and the wider market have outperformed biotech by 111 and 66 percentage points, respectively.
As ever, however, investors should focus on what’s ahead. Berenberg is one investment bank expecting a rebound in the sector. "We think the fundamentals supporting healthcare's secular growth story remain compelling and so generally look favourably on recent price weakness in the context of a longer-term view," its biotech team argued in a client briefing published last month. Against most metrics, the analysts noted, expenditure on healthcare is increasing year on year and inefficiencies within the systems offer opportunities.
The biotech sell off could also trigger a wave of corporate activity with major pharmaceutical companies and big biotech firms looking to buy up smaller companies to expand their drug development pipelines. As of January, Berenberg calculated that top pharma companies had over $135bn cash at hand and argued that a pick-up in M&A activity is likely to act as a catalyst for rising share prices at the sector’s junior end.
Craig and Poszepczynski have responded in kind, by increasing exposure to names that they think are “fundamentally very sound with attractive valuations”, which “would be able to reach their full potential more easily in the hands of larger companies”. While corporative activity stalled in late 2020 and early 2021 owing to high valuations and lockdowns, Craig cites two drivers behind a possible increase in takeovers this year: cheaper valuations, and the need for big pharma companies to replenish their pipeline of new drugs as older patents expire. In normal times, notes Craig, takeover premiums of 60 to 70 per cent are common.
While biotech stocks have performed poorly recently, there might be more bumps ahead. A sharper-than-expected monetary policy tightening in the US, where 95 per cent of IBT’s assets are based, could continue to rattle growth stocks, and particularly biotech companies with light or non-existent sales and profits. For this reason, Craig and Poszepczynski have been cautious about backing companies with weak balance sheets and long and costly development timelines. As the Financial Times reported recently, certain biotech firms are burning through cash and face an uphill struggle to raise fresh funds after “tourist” investors who snapped up their shares during the pandemic abandoned the sector.
Biotech stocks are also politically sensitive, and with US mid-term elections coming up later this year, there is a risk that renewed scrutiny of drug pricing will raise sector volatility. However, analysts at Berenberg argue “the political environment seems to move in favour of the biopharma sector”, and that recent activity suggests antitrust concerns have dissipated.
IBT itself has relatively high fees, as is often the case with specialist investment funds. But this is a sector where it probably pays to delegate stock-picking. Reflecting a pickup in investor expectations in recent weeks, the fund itself now trades at a slight premium to net assets, after being priced at a 7 per cent discount in January.
While that volatility is unlikely to subside, IBT looks like one of those rarities in the investment trust world: a high-yielding fund with attractive long-term capital growth potential.
|Fund name and ISIN||International Biotechnology Trust (IBT)|
|AIC sector||Biotech & healthcare||NAV||663.7p|
|Fund type||Investment trust||Price premium to NAV||1.30%|
|Market cap||£277mn||Ongoing charge*||1.34 per cent (plus performance fee)|
|Source: Winterflood 31 Jan 2022 *AIC **Manager's note|
|Fund/benchmark||1 year total return||3 year cumulative total return||5 year cumulative total return|
|IBT share price||-18||21||44|
|Nasdaq Biotechnology Index||-22||14||27|
|Source: Winterflood, 14 Feb 2022|
|Top 10 holdings (%)|
|Source: IBT factsheet, 31 Dec 2021|
|NAV by therapeutic area (%)|
|SV Fund VI||5.0|
|Source: IBT factsheet, 31 Dec 2021|
|NAV by headquarter location (%)|
|Rest of world||2.0|
|Source: IBT factsheet, 31 Dec 2021|