During the spring of 2014, the biotechnology sector hit some turbulence and prices fell sharply. The column piece ‘Sticking with biotech’ (9 May 2014) suggested investors keep their nerve and, if underweight, buy. The sector bounced and we have travelled a long way since. However, recently, the sector has been somewhat volatile and yet lacklustre, despite its exciting potential – this in large part being because the larger companies have seen a de-rating. But this de-rating masks the robust health of the sector’s smaller companies. The time has come for these companies to pick up the torch. We are about to see a change in sector leadership which should benefit the patient investor.
Strong fundamentals
The sector’s outlook remains extremely favourable given the strong fundamentals, but it is currently undervalued on a range of metrics. Recent figures suggest the 2018 estimate of the price/earnings ratio for the MSCI World Healthcare Index presently stands at around 16 times – which compares with its 1996-2018 average of 19 times. And within the index, the biotechnology sector compares favourably with a number of the larger companies on a cheaper rating still.
The sector continues to offer tremendous potential over the longer term. The DNA discoveries of Watson and Crick in 1953, the sequencing of the human genome, and the falling cost yet increased power of computer technology, has transformed the potential and efficacy of the biotech companies – these developments are particularly helping the smaller companies compete on more equal terms.
Meanwhile, an emphasis on innovation, and managements reinvesting strong cash flows into R&D, has increased the number of drugs both approved and in development in the US – in 2017 there were 46 new drug approvals in the US, the highest for 20 years. Furthermore, demand for healthcare is growing fast, with various estimates highlighting the extent to which demographics globally are changing – the US Census Bureau suggesting the numbers of those over 65 years of age will double over the next generation.
However, recently, sector sentiment has been negatively impacted by the larger biotech companies undergoing a de-rating courtesy of slowing revenue growth and pricing pressures as product cycles mature. These companies have been very successful but have, somewhat naturally, now reached a size which makes it more difficult for them to achieve high growth – generic threats and a less favourable pricing environment proving headwinds.
And yet many smaller companies continue to exhibit strong innovation and therefore offer good growth potential – the sector is still in a strong ‘innovation cycle’. This is especially the case when it comes to developing drugs for un-met medical needs, such as cancer and dementia. Indeed, importantly, many of the new drug approvals are now originating from these smaller companies, and this should translate into good top-line growth for those involved.
Cancer is a good case in point. According to the World Health Organisation, the disease is the second largest cause of death. Recent figures suggest the number of cancer drugs in clinical trials has increased over 40 per cent over the last 10 years. Furthermore, new mechanisms of delivery, including immunotherapy, have emerged that have improved patient outcomes.
Lung cancer treatment is an example. In 1996, there were just four drugs being administered via one therapeutic category – chemotherapy. Twenty years later, there were 19 drugs approved in five therapeutic categories. Combinations of these mechanisms are displaying good results, with Merck having recently announced that a combination treatment of chemotherapy and immunotherapy has improved overall survival.
Other developments should also be supportive of these smaller companies. For example, they are likely to disproportionately benefit from further mergers and acquisitions, as the larger cash-rich yet pipeline-poor pharmaceutical companies continue to circle – a trend that will be reinforced by recent US tax reforms. Meanwhile, the regulators have been speeding up the process for drug approvals.
The risks from investing in smaller companies are naturally higher as cash flows are less predictable. However, some investment trusts are looking to reduce this risk by favouring companies that have seen drugs recently approved, rather than just in trials. Furthermore, risk is also being reduced when investing in unquoted investments by increasing exposure via pooled funds that offer a better spread of exposure while being easier to access than individual companies.
The fly in the ointment in the short term could be the mid-term elections in the US. However, all levels of government and the Supreme Court are run by the Republican Party which, historically, has been industry-friendly. Listening to fund managers, their view is sanguine in believing very little will change – the market should continue to set prices and there will therefore be the usual winners and losers from the resulting competition.
Finally, one should also remember this is a sector that should ultimately help society, provided science is not stifled by prejudice, dogma or vested interests. As ever, the investment journey will not be a smooth one, but volatility should continue to be seen as an opportunity.
Portfolio changes
During June, the Income portfolio added to its existing holdings in Scottish Mortgage Trust (SMT) and International Biotechnology Trust (IBT).
SMT was added to when standing on a small premium to net asset value (NAV). There are those who believe trusts should not be bought on a premium, but if this rule was rigidly followed then opportunities would be missed. Markets often recognise – and therefore price in – excellent long-term performance. Accordingly, the eight portfolios on the website www.johnbaronportfolios.co.uk, including the two covered in this column, will continue to accumulate such trusts provided their remit and record are appropriate and that portfolio balance is maintained across a spectrum of valuation metrics. By way of illustration, SMT was first introduced to this portfolio at £4.34 in March 2018 when standing close to NAV.
IBT’s objective is to achieve long-term capital growth through investment in biotechnology and other life sciences companies – both quoted and unquoted. Speaking recently with Carl Harald Janson, he has been reducing exposure to companies with a market capitalisation exceeding $10bn in favour of smaller companies in the $1bn-$10bn range, in order to “stay in the sweet spot of growth”.
Meanwhile, IBT has started distributing a dividend equivalent to 4 per cent of its NAV as at the end of each August, which is paid bi-annually in January and August. This is a welcome development for those portfolios seeking income as well as capital growth. The dividend has also helped reduce the trust’s discount – the other key factor being the outperformance achieved by Carl since becoming the lead manager in 2013.
Otherwise, there were no changes to the Growth portfolio during the month.
John Baron waives his fee for this column in lieu of donations by Investors Chronicle to charities ofhis choice. As these are live portfolios, he has interests in all of the investments mentioned.
