Buy into biotech before prices rise

Biotech stocks had a bad 2016. In the calendar year, the Nasdaq biotechnology index fell by 6.2 per cent after US presidential hopeful Hillary Clinton’s pledge to clamp down on drug prices and US President Donald Trump’s plans to dismantle the current US healthcare system.

Fast forward to October 2017 and the climate is altogether more cheerful. President Trump’s most recent attempts to repeal and replace Obamacare lie in tatters and his latest plan to reform the US tax system could be a boon to biotech stocks. Mr Trump wants to cut the corporate tax code and allow companies to repatriate billions of dollars amassed overseas without incurring a 35 per cent tax bill, handing them a chunk of capital to go shopping for M&A deals.

"Fears around more draconian pricing regulations have subsided and I think there are still expectations for tax reform, which could fuel M&A activity in the sector," says Jason Hollands, managing director at Tilney Group. "There have also been a lot of new drugs approved already this year and the US Food and Drug Administration (FDA) is looking to streamline and speed up the approval process for certain types of treatment. So all of that has led to a more cheery backdrop for biotechnology stocks."

The FDA approved more generic drugs in the fiscal year ended 30 September 2017 than any other, approving more than 700 compared with 651 in 2016.

"The regulatory environment has been favourable to the approval of new drugs and the state of innovation has been excellent too," says Geoff Hsu, manager of the Biotech Growth Trust (BIOG). "This year Novartis got approval for its CAR-T therapy (a pioneering new cancer treatment for a rare form of leukaemia) and we have on deck the first ever gene therapy close to approval by Spark in the US, so we are seeing new modalities of treatment and it really reflects the excellent innovation going on."

Add to that the fact that prices across the sector are still looking less frothy than previous years. The biotech sector remains on a rare discount to the wider S&P 500 index, but the gap is narrowing fast. In the year to date the Nasdaq Biotechnology Index has returned over 22 per cent, far exceeding the 8 per cent return of the S&P 500 index.

But biotech stocks remain a "rollercoaster ride" according to Mr Hollands. "The key issue is that these are very difficult companies to value. You are paying a premium on the expectation that if a drug does get commercialised, it will pay you back over time. It is the same issue that you find with many high-growth stocks."

Young biotech companies are hugely valuable if their drugs pass clinical trials and make it onto the market. But a negative clinical trial outcome can mean the difference between a stellar success story and abject failure and many biotech investments have binary win/lose outcomes. The same is not true of older, more mature biotech companies, but they have their own issues in maintaining growth and competing with newer drugs as their patents run out.

Biotech funds to buy

That makes biotech a good area in which to use an active fund manager. When assessing a biotech or healthcare fund, consider the strategy is uses, how well diversified it is in terms of region, type of stock and market cap and look too at the proportion of speculative stocks that may not yet be generating a profit compared with larger, revenue-generating names.

The Biotech Growth Trust deliberately invests in stocks with binary outcomes in order to get an edge on the market and is managed by a team of medical professionals and scientists, meaning they can take big bets on the outcome of big drug trials.

It is the top performing trust of any in the Association of Investment Companies (AIC) specialist biotechnology funds sector over 10 years and has returned 667 per cent compared with 541.5 per cent for the Nasdaq Biotechnology Index.

"A key part of the fund's strategy is to invest in binary events," says Kieran Drake, analyst at Winterflood Securities. "The management will take an in-depth analysis of a drug approval event, and then analyse the individual drug and its chances of success. The fund also has a diversified portfolio, which is what we look for because it does add a lot of risk when you’re investing in this way."

Mr Hsu, manager of the trust, says more than half of the portfolio is invested in “major biotech companies, which are larger companies that don’t really have binary risk, have real revenues and are more diversified,” but he also holds a higher-risk chunk of emerging biotech stocks.

Those include DBV Technologies (DBV:PAR), a 3.1 per cent allocation in the portfolio. The company is developing a patch for peanut allergies and is expected to report phase three clinical trial data any day now. "If it goes well that would have a sizeable postitive impact on returns, but if it doesn’t the opposite is true," says Mr Hsu.

In recent months, positive data from Vertex Pharmaceuticals (VRTX:NSQ) on a new three-drug cocktail to treat cystic fibrosis boosted performance, as did a high-risk investment in Puma Biotechnology (PBYI:NSQ), whose breast cancer drug was approved this year, sending the stock's share price soaring. It is up 300 per cent in dollar terms (check) in the year to date.

Currently Mr Hsu says he is finding better valuations among the larger-cap, revenue-generating companies than smaller, speculative stocks and as a result is holding a greater portion of large-caps now than in recent years.

International Biotechnology Trust (IBT) also invests strictly in biotechnology companies but, according to Mr Drake "prefers to avoid binary outcome stocks". According to Kepler the trust sells out of stocks before key clinical trial events in order to minimise risk. It has not performed as strongly as BIOG over 10 years. But in five years it has beaten that trust, having returned 209.4 per cent against the Nasdaq Biotechnology index, with a return of 191.4 per cent.

The trust does also invest a portion of the portfolio in private equity companies. This part of the portfolio is managed by a separate manager. It means that the trust has access to some potentially high-growth names, but also adds risk. However the bulk of the portfolio is invested in large, revenue-generating biotech names such as Celgene (CELG:NSQ) and Gilead (GILD:NSQ).

These stocks are in a phase of lower growth now and have been buying their way to innovation by snapping up young companies bringing out new drugs. Recently IBT's returns have benefited from Gilead’s $11.9bn acquisition of Kite (KT5:STU). Kite currently has no drug on the market but is developing a cutting-edge cell therapy cancer treatment, which Gilead has paid a hefty premium for.

International Biotechnology’s share price has also been heavily influenced by its decision to start paying an income earlier this year. Biotechnology stocks are not natural income payers due to the high-growth nature of the market, which requires high levels of investment and long periods of time before companies generate earnings.

But since 2012 investment trusts have been able to take income from capital growth, meaning they don’t have to rely on the natural income of their portfolio. International Biotechnology Trust started paying a dividend in January 2017, committing to paying out 4 per cent of the trust’s net asset value (NAV) as at the last day of the preceding financial year (31 August), paid in two instalments throughout the year. The trust’s share price discount to NAV has narrowed significantly since and is now trading at a discount to NAV of 4.5 per cent. But committing to paying income out of capital growth means potentially eating into capital growth over the long term.

"We were cautious when the dividend policy was announced given the volatility of the sector, and one of our concerns was that typically if you commit to paying out a percentage of your net asset value (NAV) you might end up paying it out at a low point in the cycle and then you don’t benefit from the bounceback in the market," says Mr Drake. "However it has been well received by investors and the discount has narrowed. There is clearly a big demand from income investors, but we are still a little uncomfortable with it."

Another route into biotech stocks is to buy a broader healthcare-focused fund. Unlike biotech funds these are able to invest across the sector and buy hospital and healthcare equipment companies too, which can be less volatile and spreads the risk among a wider variety of companies.

Top performers in this group include Worldwide Healthcare Trust (WWH). Over 10 years, WWH has returned 484.68 per cent compared with 253.45 per cent for the index.

Currently WWH's largest exposures are to biotech stocks and it also takes on speculative healthcare risk by investing in stocks with binary outcomes. In the past it used to hold large hospital stocks, but in the past year manager Sam Isaly has jettisoned all hospital stocks from the portfolio due to concerns over the impact of President Trump’s repeal-and-replace policy aims and concerns over lower hospital utilisation in the US.

"Biotech funds are higher risk, but also potentially higher return than healthcare funds," says Mr Drake. "Worldwide healthcare is the largest fund in this area. It has an unconstrained mandate and has a bias towards biotech companies."

Mr Isaly is underweight large pharmaceutical companies such as GlaxoSmithKline (GSK), which he believes are in a period of slow or ex-growth, preferring to generate the growth in his portfolio from a bucket of stocks growing earnings at 15 per cent a year or more. 

Darius McDermott, manager of Chelsea Financial Services, likes Polar Capital Global Healthcare Opportunities (IE00B3NLDF60). This is a diversified healthcare fund but has a heavy weighting towards biotechnology companies compared with the MSCI ACWI Healthcare index. It is also overweight managed healthcare companies and healthcare equipment companies – the fund has 15.3 per cent of its portfolio in that sector compared with 1.3 per cent for the index. Over five years it has returned 188.5 per cent compared with 130.7 per cent for the index.

Mr McDermott says: "The manager of this fund and the team have been adapting the portfolio to move it into better value areas. They have seen opportunities in European biotech and in particular in smaller-cap stocks and have tilted the portfolio away from areas that have been bid up and are now looking expensive."

Performance of biotech funds 

Source: FE Analytics, as at 10.10.2017, *The AIC, ** Morningstar, as at 10.10.2017