Biotechnology looks to bounce back

Stock markets are like elephants. They have long memories. No sooner had Sir Philip Green found himself in a spot of bother over BHS, and having to defend his stewardship of the failed high street chain, then a few older heads mentioned Amber Day, his one and only stint as the boss of a public firm, where he departed amid much acrimony in 1992 after a series of profit warnings.

Those with a few grey hairs about them (assuming they have any hair at all) are also taking a look at the biotechnology sector, possibly with a similarly jaundiced eye. Biotech was hot to trot during 1999-2000 but then collapsed spectacularly as lofty valuations proved unsustainable in the face of drug launches, profits and cash flow which failed to appear as quickly as hoped (if at all). After the fall, fingers were pointed at the formation and bursting of one of the stock market’s latest bubbles.

Growth-starved investors warmed again to biotech at the start of this decade, as the sector and those funds which specialised in it swept all before them for three years in row, leading the performance charts in each of 2011, 2012 and 2013.

And yet the last 18 months have been tougher, if the NASDAQ Biotechnology index is any guide.

Biotech sector has suffered indigestion after its second stunning run in less than 20 years

Source: Thomson Reuters Datastream
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

The question now for risk-tolerant investors is whether to get involved or not, after a sizeable pull-back. Bulls will see this as a potential opportunity. Bears will politely suggest the index’s current price chart looks uncomfortably like the one it offered in 1999-2000, just before disaster struck.

Income-hunters and the risk-averse may simply decide to politely pass but patient seekers of capital appreciation with a strong stomach for volatility do at least have a decent clutch of actively- and passively-run collectives from which to choose, if they feel biotech lies within their risk tolerance and offers a suitable palliative for a low-growth world.

There are four biotech funds, although only two run to this column’s usual five-year trading history, while three have a three-year record.

Best performing biotech-dedicated OEICs over the last three years

Source: Morningstar, for Sector Equity Biotechnology category. Where more than one class of fund features only the best performer is listed.
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

There are four investment trusts. All have a five-year history but three-year data is shown, to provide comparability with the OIECs above.

Best performing biotech-dedicated investment trusts over the last three years

Source: Morningstar, The Association of Investment Companies, for the Biotechnology & Healthcare category
* Share price. ** Includes performance fee
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

There is also one tracker (or exchange-traded) fund which specialises in the sector. Source NASDAQ Biotech ETF launched in 2014 and has compiled just over $100 million in assets.

Keep taking the tablets

It is not hard to make a long-term case for investment in the biotechnology sector, and it is one made not just by funds dedicated to the area, but long-term growth-oriented collectives like Neil Woodford’s Patient Capital investment trust.

It is these trends which helped carry biotechnology onward and upward through 2010 to 2014. However, the going has got tougher since, and the sector has stayed in the headlines, if not always for such uniformly positive reasons.

• First, global demographic trends point to greater longevity and growing populations, so demand for drugs is only likely to increase over time.
• Second, we remain trapped in a low-growth, low-inflation, low-interest-rate world. Any firm which can grow quickly (preferably organically) and has a strong competitive edge which means it has pricing power will be highly prized. Many drug manufacturers fit the bill here and there is also the hope that a drug developer will come up with a highly successful new treatment.
• Third, a wave of merger and acquisition activity is still sweeping the industry, as established, larger firms seek to address holes in their drug portfolios or revitalise their growth and pipeline prospects.
• Certain pharmaceutical firm takeovers failed or were blocked by the regulator, notably Pfizer’s lunge for Allergan.
• US Presidential candidate Hillary Clinton threatened to investigate “predatory” drug pricing in the US, the world’s biggest market, in the event she were to win November’s US Presidential election.
• The share price of Valeant collapsed after a string of high-profile deals, a failed lunge for Allergan, the accumulation of hefty debts and (as yet unproven) allegations of creative accounting.

Valeant share price plunge has hurt sentiment toward the wider sector

Source: Thomson Reuters Datastream.
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Drug pricing

Perhaps the most emotive of these is the second one. Although many will remember how Mrs Clinton’s “Hillarycare” initiative as First Lady in 1993 (or the Health Security Act to use its proper name) came horribly to grief, drug stocks underperformed for a while back then too as her husband’s first term as President saw a big focus on healthcare reform.

Mrs Clinton is still not certain to win the Presidency, but the threat of US Government intervention in drug pricing (let alone any further proposed takeover deals) is a real one for now.

More encouragingly for would-be biotech investors, talk of a fresh valuation “bubble” in the sector has become more muted, although this may be because that NASDAQ Biotechnology index currently stands some 28% below the summit reached some 11 months ago. The S&P Biotechnology Select index, which features fewer established drug developers and more early-stage firms, stands 34% below its July 2015 high.

S&P Biotechnology Select index has also pulled back sharply

Source: Thomson Reuters Datastream.
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

The big, well-established biotechs – say the 10 largest constituents of the NASDAQ Biotechnology Index – now trade at a discount to the broader US market, at around 13.9 times earnings for this year and 12.4 times for next.

Well-established biotechs trade at a discount to the broader US market ...

Source: Thomson Reuters Datastream
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

However, the air still looks a little more rarified if investors are tempted to look at a basket of younger, up-and-coming biotechs, and the sort of drug developers who populate the S&P Biotechnology benchmark.

Its ten biggest firms are forecast to generate a combined net profit of around $7.9 billion in 2016 and $9.2 billion in 2017.

This sounds impressive enough but all of those profits come from just one of the 10, the well-established Amgen. Of the other nine, just three are expected to make a profit this year and just four next.

In addition, the combined stock market value of the 10 largest S&P Biotechnology Select index stocks is currently $180 billion. This suggests there is a lot of future good news already baked into their share prices – they do trade at a hefty premium to the US market on forward earnings multiples of 22.7 times for 2016 and 19.6 for 2017. In each case, those ratios are dragged down by Amgen’s profitable presence. If Amgen is excluded, then $58 billion of market cap currently buys no profits at all in 2016 or 2017, on aggregate, according to analysts’ consensus forecasts.

... while the earlier-stage biotechs of the S&P Select index still trade at a big premium

Source: Thomson Reuters Datastream
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

All it may take is one those nine fledglings to come up with a blockbuster drug to make that price still look like very good value, even if the other nine fail to come up with anything that is commercially viable.

But there is little margin of safety here as in some cases there is little or no cash flow to support the valuations. If the sector, or markets more generally, take further fright for any reason there has to be a chance start-up stocks such as these – which have done extraordinarily well - witness further profit taking.

Best of British

This is not to say that investors must look overseas if they want exposure to biotechnology. The UK has a blossoming industry here too, and this can be accessed via some of the intellectual property incubation firms or directly via quoted firms like BTG and Circassia.

The latter itself is a spin-off from incubator Imperial Innovations. Allergy and asthma specialist Circassia is still in the clinical development stage and has yet to generate any sales, let alone profits, and has a market cap of £750 million but it does have products which are at the critical Phase III stage, with a study on a cat allergy treatment due this quarter.

Under the guidance its CEO, Dame Louise Makin, BTG has blossomed and profits are expected to rise sharply over the next two to three years. Even so forward PEs of 29x for this year and 22 times next may be a bit rich for some, despite the rapid growth expected by consensus forecasts, as they represent a very big premium to the broader UK market.

BTG and Circassia are two leading UK biotech stocks

Source: Thomson Reuters Datastream
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Bulls will argue that there are still great potential gains to be had on both sides of the pond, given the long-term trends of population growth and longevity and the powerful tailwinds they provide to the biotechnology industry.

Ultimately, investors can decide whether portfolio exposure to this dynamic industry fits with their overall investment strategy, target returns, time horizon and appetite for risk. But the one thing they know in advance is the voyage of discovery is unlikely to be a boring one, even if the larger names do in some cases generate both profits and cash, unlike the start-ups, who may still be developing their first products.

Stock-specific exposure is therefore a route suitable for highly experienced investors only, while even those seeking to get access via dedicated funds will have to be prepared for some lumps and bumps in their quest for portfolio-soothing profits.

Russ Mould
AJ Bell Investment Director