Beyond vaccines

Eighteen months ago, perceptions of big pharma were very different from today. This was a sector more often hit with allegations of predatory drug pricing than praised for its therapeutic discoveries. A sector directly implicated in America’s opioid addiction crisis. A sector earmarked for reform by US presidential candidates as they prepared for the November election, having topped the political agenda for decades.

But then Covid-19 arrived. And with it, everything changed. As the pandemic wreaked havoc in country after country, the world’s largest pharmaceutical and biotech companies launched into action – repurposing existing therapies, accelerating the development of new treatments and, above all, striving to find a vaccine that could halt the proliferating disaster.

What followed was a demonstration of the power of science, aided by unprecedented collaboration between businesses, academic institutions, governments and regulators.

Within mere months, rapidly trialled drugs were being administered to patients in hospital beds. Moreover, various jabs were approved before the end of the year – paving the way for people to be inoculated against the virus at record speeds. In the UK alone, more than four-fifths of adults have now received their first coronavirus vaccine dose. More than two-thirds have been fully immunised.

Industry validation

Whichever way you look at it, the pandemic has shown just how important medicine is to our daily lives. In turn, it has provided huge validation for an industry previously resigned to negative airtime.

Even as fears mount about more transmissible Covid variants, the, jab-makers have entered the next phase of the virus battle, designing ‘booster’ shots for potential future use. And it’s not just traditional vaccine developers that have had their time in the sun. The crisis has also granted an opportunity for newer, lesser-known businesses to legitimise their innovative technologies on a global stage.

Indeed, two of the leading coronavirus vaccines cleared for use rely on messenger RNA technology, a product brewed behind closed laboratory doors for years but never previously commercialised. Now, mRNA constitutes the key ingredient in injections developed by German company BioNTech (US:BNTX) in partnership with pharma giant Pfizer (US:PFE) as well as by biotech group Moderna (US:MRNA).

Rising healthcare expenditure

True, some of the top Covid vaccine suppliers including US behemoth Johnson & Johnson (US:JNJ) and FTSE 100 company AstraZeneca (AZN) have pledged not to profit from their shots during the emergency phase of the pandemic. And beyond that period, it is hard to say how long we will need repeat doses.

But Covid may have catalysed other beneficial trends for the pharma sector. The virus has highlighted major demographic shifts such as ageing populations and the rising prevalence of cancer and chronic illnesses. Together, those areas of unmet medical need will arguably light a fire under healthcare spending in the coming years.

In the US, national health expenditure is predicted to rise at an average annual rate of 5.4 per cent to $6.2tn (£4.5tn) by 2028 – faster than the pace of GDP growth. That would take the health share of the economy to almost a fifth, up from 17.7 per cent in 2018.

With one in every five dollars spent on healthcare in the US, there could be “vast rewards” for companies that help to ease the burden on society, says Alex Hunter, partner at investment firm Sarasin & Partners.

Complex and varied landscape

Yet healthcare is a huge universe. It cannot be thought of as a single entity. And the sub-segment of pharma is itself a “very heterogenous group of companies”, notes Dr Trevor Polischuk, co-manager of the specialist Worldwide Healthcare Trust (WWH) which is managed by OrbiMed Capital. It comprises “many ‘haves’ and ‘have nots’”.

Adding to the complexity of that landscape, more and more clinical trials are taking place every year. Right now, more than 380,000 studies have been registered with clinicaltrials.gov – almost four times the figure in 2010.

Such pioneering activity is fantastic news for the medical world. But innovation doesn’t guarantee success. Just one in 10 drugs makes it to market, and that is just one step on the long road to commercialisation. Companies must present their efficacy and safety data to regulators, achieve clearance (often in multiple jurisdictions), scale up manufacturing and marketing efforts – all while liaising with health agencies about cost.

Patent battles

And that leads us on to patents; the protective mechanisms that give drugmakers exclusive rights over newly launched products, typically for 20 years. Such protections enable the originator of a drug to name their price (within reason) over a specific timeframe. But when patents expire, non-patented ‘generic’ rivals such as FTSE 100 group Hikma Pharmaceuticals (HIK) are able to enter the fray – making money from high volumes rather than pricing power.

The issue of pharma patents came to the fore just two months ago, when the sector was rocked by the news that the Biden-Harris administration would support a waiver on intellectual property protections for Covid vaccines. The share prices of vaccine makers dropped as investors weighed the longer-term implications for the broader big pharma revenue model.

Despite hopes that such a waiver might encourage a ramp up in vaccine supplies, Biden’s support met a significant backlash. Pharma companies, trade associations and other political leaders pointed to a lack of raw materials, limited scientific knowhow and concern that removing patents might disincentivise smaller biotech companies from taking investment risks on new ideas.

The waiver threat has seemingly waned since May. But the shock was a reminder of big pharma’s reliance on drug exclusivity periods, and of the need to protect, invest in and replenish therapeutic pipelines to keep generating revenues. Some of the sector’s biggest names are approaching major ‘patent cliffs’ this decade and are already having to explain how they will replace lost sales.

Breaking it down

The opportunities within pharma are potentially very lucrative for would-be investors. It is “a fruitful area to invest in because it’s constantly in a state of flux”, says Hunter, who co-manages Sarasin's Global Higher Dividend fund – a vehicle comprising healthcare and non-healthcare stocks. That “state of flux can give rise to anomalies”.

But any positives must be weighed against science’s inherent uncertainty, regulatory risk and politics.

That delicate balance begs several questions: how should shareholders think about the potential rewards of the industry – and its projected cash flows – versus long lead times? Which metrics should they apply to pharma companies, and which valuation techniques are most appropriate? How can investors apply fundamental analysis to big pharma?

The short answer is that each stock requires its own approach. “We don’t often try and ‘make the case for big pharma’, but rather attempt to deduce the investment rationale for individual companies that represent our best ideas within the sector,” says Polischuk.

Spotting therapeutic innovation, let alone innovation that will be commercially successful, is no easy task. That’s even true of fund managers. Polischuk says he team’s portfolio meetings can sound “more like a doctor’s office or a science lab than a group of investment professionals”. Such knowhow isn’t easily replicated.

Peter Hughes, manager of the AXA Framlington Health Fund, is even more blunt: “The odds are stacked against things working.” But as scientists develop a better understanding of what causes disease, including ever-more promising leaps in genetics, those odds could improve.

Beyond the science

This doesn’t mean ordinary investors are all alone. “If you can get over the science complication,” Hughes says, “then you’re getting into more familiar territory in terms of supply and demand for consumer products.”

Knowledge of the size of a market and what similar drugs in that market sell for can tell you a lot. “You can generally model relatively well what you think the uptake of that drug will be and how quickly that will occur and how long they’re going to have that opportunity to make cash flows from that asset,” Hughes adds.

At the Worldwide Healthcare Trust, Polischuk’s team considers numerous factors, ranging from a company’s early and late-stage pipelines and its current product portfolio to sales growth, cash flows and capital deployment. Consensus forecasts are also important: “How are we thinking differently than other investors about a company or stock? Where is the share price and where do we think it will go? What are the key catalysts on the horizon?” 

To Hunter, the science and a drug’s marketplace are just two parts of the pharma investing equation. Investors also need to contemplate the regulatory and political environments.

Regulatory events

The nature of drug trials and the regulatory approval process mean pharma investors are rarely short of potential catalysts.

For example, some drugs receive ‘breakthrough designation’ from America’s Food and Drug Administration (FDA). This is a process designed to expedite the development and review of therapies intended to treat serious conditions, where early clinical evidence suggests substantial improvements over current available medicines.

“I would feel more confident about drugs that had so-called breakthrough designation. That to me would be an indication that the regulator has looked at the early data and sees something that’s really interesting there,” says Hughes. “That opens up a lot more dialogue between the company and the regulator.”

At the International Biotechnology Trust (IBT), joint lead investment managers Ailsa Craig and Marek Poszepczynski try to reduce their exposure to clinical events by trading down their positions as they lead into them and then choosing whether to add again afterwards.

This was exemplified when the group responded to the ongoing deliberation about Biogen’s (US:BIIB) much-discussed Alzheimer’s treatment, Aduhelm. IBT has owned Biogen on and off for at least the past decade.

Given the company’s $50bn market capitalisation and weighting in the Nasdaq, when IBT reduced its risk exposure to Biogen it took a neutral position – deciding to neither add nor trim. This means the holding in the portfolio would be around the size of what it is in the index. For a smaller company, the trust might sell out completely.

Biogen’s share price slumped in 2019 when it looked as though trials hadn’t produced the desired results for Aduhelm (also known as aducanumab). But subsequent messaging – and the regulatory and public perception – were mixed, prompting a rollercoaster ride in Biogen's market value. Fast-forward to June this year, and Aduhelm was cleared by the FDA as the first new Alzheimer’s treatment in almost 20 years. The shares soared in response.

It has been “very difficult sitting in our seats as investors to predict these events”, says Craig. “If you could guess something works then we wouldn’t need clinical trials. Not only is there that sort of risk to investing in this industry, but then politics is obviously at play here as well.”

IBT hopes to balance this with exposure to what Craig calls “decent long-term returns”, propelled by the secular trends of more people getting sick and older populations demanding more drugs.

Valuation deliberation

With pharma stocks driven by scientific progress, regulatory change and individual drug pipelines, it follows that valuations can vary widely. “Currently, the most expensive company in the [sector] universe trades over 300 per cent the most inexpensive company,” notes Polischuk.

Moreover, different investors will have different interests, risk profiles and ways to value stocks.

Alex Hunter at Sarasin favours a discounted cash flow (DCF) model, a valuation method used to determine the value of an investment based on its anticipated future cash flows.

His fund focuses on larger companies versus early-stage biotech, which can be particularly volatile. This includes exposure to newer drug ideas via a holding in FTSE 250 constituent Syncona (SYNC), which owns 11 portfolio companies. Syncona, which was set up by the health research charity Wellcome Trust in 2012, offers “many shots on goal in many different areas” says Hunter, aided by a balance sheet “that will fund the good part of the development”.

Some specialist healthcare vehicles look across a broader spectrum of company stages, tailoring their valuation approaches accordingly.

At IBT, which sees itself as a healthcare growth specialist, Craig cites a “cross-section of risk profiles”. Thirty per cent (on a NAV level) is invested in profitable pharma companies. The trust's largest holdings tend to be profitable, although this is not a must. Thirty-eight per cent (by NAV) of the trust was invested in companies in the revenue growth stage of development as of June, while 32 per cent was invested in early-stage companies.

While IBT also uses a DCF model for profitable large holdings, growth companies are valued against their five-year prospects. “Then, you know, normal price/earnings (PE) valuations do not apply,” adds Poszepczynski. Instead he points to peak sales potential and multiples of peak sales potential.

For innovative platform technology companies – those firms with a discovery that can address many different diseases, such as the now-acquired cell-based therapy specialists Kite and Juno – Poszepczynski says investors need to “pay an entry ticket”. Valuation metrics like future cash flows are complicated by a lack of clarity over the number of projects and sales that can emanate from a certain platform. Classic valuations simply don’t apply, Poszepczynski argues.