After two years of high flying, biotech stocks have ricocheted up and down in 2014. With senior policymakers raising concerns about valuations, can investors expect more triple-digit returns?
US Federal Reserve chair Janet Yellen last week told Congress biotech valuations, among other asset classes, appeared to be “substantially stretched, despite a notable downturn in equity prices for such firms early in the year”.
The MSCI ACWI Biotechnology index soared by 174.9 per cent between 15 July 2011 and 24 February 2014, according to FE Analytics (see table). The index subsequently took a dive from that high, losing 17 per cent in less than two months. It has since regained most of the lost ground.
Biotech and healthcare managers think the growth will continue at the same breakneck pace.
Axa Framlington Biotech fund manager Linden Thomson says “stellar, above-consensus” profit growth helped the biotech sector push past macro drags to offer strong performance in the past two to three years. However, she says a shift in investment focus has hit the sector in recent times.
“Earlier this year, there was a broad move from a growth to a value investment style across the market that negatively impacted the biotech sector,” she says. We also saw some profit-taking, which is unsurprising given the performance.”
Thomson says the sector is susceptible to interest rates because many companies use discounted cashflow methods that would devalue future earnings as the risk-free rate rises. She expects volatility in the sector to continue but says the tailwinds will continue for some time due to an ageing population and the growth of obesity.
Mergers and acquisitions fell away last year – perhaps due to high valuations among the small- to mid-cap names – but are likely to remain a cornerstone of the industry, she says.
“Smaller companies are being given greater support from shareholders to retain a larger share of research and development pipelines, leading to better leverage longer term but fewer earlier-stage acquisitions,” says Thomson.
Pipelines remain attractive to acquirers, she adds, with Merck making a $3.9bn (£2.3bn) bid for Idenix at a 250 per cent premium. The Massachusetts-based laboratory is in the process of developing a hepatitis C treatment.
Schroder Global Healthcare manager John Bowler says the huge upswing in value was simply the revaluation of intellectual property that had essentially been written off by the market.
After the financial crisis, the “tech value” of prospective biotech companies – the difference between cash on the balance sheet and market cap – was almost nothing for many of them, he says, adding: “These companies don’t generate cash, they consume cash.”
Bowler says since the crash investors have recognised the value in the pipelines, creating a massive re-rating.
He says: “It’s a revaluation of the intellectual property, the pipelines, and that’s benefited all of them but now it will come down to picking which of the pipelines are best.”
Hermes Fund Managers European equities team member Tim Crockford says the wash of cheap money around the world has filtered through to all asset classes, making everything essentially overvalued.
“There’s nowhere to hide; it’s trying to find the best of an over-valued bunch,” he says. “We’ve been increasingly positive about healthcare. It’s the largest overweight in all the strategies; the largest and most powerful theme in play.”
The industry is being enlivened by the rise of biologic drugs – enzyme-based medicines – which are beginning to displace chemically formulated pills. Biologic drugs comprise just a fifth of the market but almost 60 per cent of the medicine pipeline, says Crockford.
Because of the more intricate development process, they are much harder to replicate by generic drug manufacturers, which have to put up massive capital investments before even applying for regulatory approval, with a high risk of rejection, he adds.
That creates a massive barrier to entry and means an extension to the 25 years’ exclusive business provided by patents and more resilient profits.
In the past few months, Crockford has opened a position in German laboratory equipment and processing manufacturer Sartorius. He says the market is “oligarchistic” with only a few players and Sartorius is in a good position to make money from increases in biologic drug development.
The Biotech Growth investment trust manager Geoffrey Hsu, of Orbi-Med, says: “Six of the top 10 best-selling drugs are biologic and that’s reflective of the fact that these drugs are effective and difficult to standardise”.
The £321m investment trust has boosted its net asset value by 246 per cent to £339m in the three years to 16 July. Despite such astronomical growth, Hsu says this year is likely to be “the dawn of the biotech mega-blockbuster” as many new treatments reach peak earnings.
As well as hepatitis C, multiple sclerosis and tumour remedies are set to be big earners for the sector, he says. Looking further ahead, immunotherapy for cancer is just one
market that could yield more than $10bn in revenue annually.
“We’re quite excited about the state of the sector,” Hsu says. “We think there are a lot of interesting drugs in the pipeline right now.
“We don’t think that valuations are super-stretched and we’ve had some positive data through this year. A variety of biotech companies have reported clinical data that has been positive.”