Which biotechs are fund managers buying?

Almost 250 years ago, the English physician Dr Edward Jenner's vaccine for smallpox paved the way vaccinations against disease around the world. A century ago, the Scottish biologist Sir Alexander Fleming discovered penicillin, the world's first antibiotic. Sixty years ago, Francis Crick and James Watson, two Cambridge University academics, announced they had discovered the structure of DNA.

Do you see a pattern here? The most important advances in modern healthcare have repeatedly been made by British researchers and in British laboratories - and this is a trend that Steve Bates, chief executive of the UK's BioIndustry Association, insists continues to this day.

"The UK is one of the best places in the world for life sciences, on a par with premier life science destinations such as Boston, San Francisco, San Diego and Singapore," Bates argues. "We have four of the top 10 universities in the world, 19 of the top 100 universities, one of the world’s three major financial centres, a stable of quality service providers, world-class charitable supporters of the industry and a rich heritage of globally recognised medical research."

Nevertheless, investors in healthcare and life sciences, have a global outlook. While the most successful healthcare funds do have exposure to British businesses, their portfolios tend to be dominated by US companies. This reflects a fact of life: there are vastly more publicly listed US businesses, particularly in the biotech space, but also in the pharmaceutical sector.

There are good reasons why the US investable universe is so much bigger. The US is a bigger marketplace for healthcare, with a population six times as large as the UK's. Also, it has a better developed funding environment - fledgling businesses pursing speculative but potentially lucrative ideas find it easier to attract growth capital in the US than anywhere else.

However, Bates's flag-waving is not misplaced. Britain does have a life sciences sector that is generating tremendous excitement about both the healthcare advances it is making and its commercial potential. Moreover, British companies are benefitting from the same global trends in healthcare as their American cousins.

Above all, says Sven Borho, a partner in OrbiMed Healthcare Fund Management, the pharmaceutical sector is currently benefitting from a more exciting pipeline of new drugs and treatments than at any time in living memory. US-based OrbiMed manages the portfolios of two UK-based closed-ended funds, the Biotech Growth Trust and Worldwide Healthcare Trust, and both have just enjoyed a stellar year, posting returns of around 40% over 2014 thanks to that pipeline.

The quantity and the quality of the new medicines coming through in several different areas is incredibly exciting"David Pinniger

"Last year was the year of the biotech blockbuster drug launch," says Borho. "We are now seeing the innovation we’ve always known of in this sector really coming through - eight out of the top 10 selling drugs in the world next year will be derived from biotechnology".

At Polar Capital, whose top-performing funds include Polar Capital Healthcare and Polar Capital Biotechnology, fund manager David Pinniger is also thrilled by the recent breakthroughs seen in healthcare - and the potential for new advances in the months and years ahead. "The quantity and the quality of the new medicines coming through in several different areas is incredibly exciting," Pinniger says. "When the human genome was mapped 15 years ago, it prompted a huge wave of investment in health and biotech and that is now beginning to pay off."

Pinniger points to advances in immunotherapy as especially rewarding - this new technology has seen the development of new drugs to combat cancer that target the disease specifically, a huge advance on the chemotherapy that is standard treatment today, which kills healthy cells and cancer cells alike. He is also impressed by developments in the area of fibrosis, where new drugs for patients with problems in both the lungs and the liver look promising, and with a number of advances in the battle against rare genetic diseases.

It was these sort of advances that propelled valuations in the healthcare sector last year, both directly and because the breakthroughs helped trigger a wave of M&A in the sector as the large pharmaceutical companies jockeyed for position in each new area of interest. Add in the effect of "skyrocketing healthcare spending in emerging market countries", says Sven Borho, and you can see why the sector performed so strongly. The MSCI World Healthcare Index rose by 19% during 2014, while the MSCI World Biotechnology Index was up by more than 40%.

Linden Thomson, manager of the AXA Framlington Biotech fund, shares this sentiment. "While remaining conscious of the risks, particularly those inherent in research and development, we continue to remain bullish on the sector into 2015," she says. "Maintaining current valuation multiples suggests we could see 20% plus growth for the sector through the year."

So which British businesses are best placed to benefit? Well, the good news, says David Pinniger, is that the environment for innovative healthcare companies in the UK is improving rapidly, with institutional investors increasingly keen to provide the sector with the funding it needs to develop. "I think the window for UK biotech companies can open up over the next couple of years," he says.

Nor is it only the minnows for whom the prognosis is encouraging - Britain's giant pharmaceutical companies remain much in demand with investors. Take Neil Woodford, the much-followed star manager, who last year left Invesco Perpetual to set up his own investment business. Its flagship fund’s top 10 holdings include both GlaxoSmithKline and AstraZeneca - the latter is Woodford's single biggest holding, accounting for more than 7% of the portfolio.

AstraZeneca's impressive pipeline

Woodford's chunky allocation to AstraZeneca reflects his belief in the long-term potential of the business - he was a notable opponent of Pfizer's bid for the British company last year.

"Some people haven't liked AstraZeneca for years," Woodford said at the time. "People were calling the management lunatics for the level of spending committed to research and development, but I didn't think they were lunatics and now it is paying off. The key to the valuation of AstraZeneca is its pipeline of new drugs. People talk about technology companies, well AstraZeneca is immersed in technology, but people don't regard it as a technology stock because it doesn't have a bloke in jeans and a T-shirt representing it."

The pipeline Woodford points to very much reflects some of the themes that fund managers such as Borho and Pinniger are so excited about. Not least, AstraZeneca has a world-leading immune-oncology portfolio, with 13 drugs already in clinical trials and another 16 at the planning stage.

The key to the valuation of AstraZeneca is its pipeline of new drugs"Neil Woodford 

With a market capitalisation of around £60 billion, AstraZeneca is a huge business - second only to GSK in terms of size in the UK pharmarceutical business - but there are potential opportunities further down the scale too. "As the sector is less developed in Europe than in the US, companies with similar positive attributes often appear to be valued quite differently and there are a number of large biotech companies that have only just begun to gain traction with investors," argues Martin Wales, an equity analyst at M&G Investments. "One example is GW Pharmaceuticals, a UK-based biotech company that develops and commercialises cannabinoid medicines.”

Currently valued at around £1 billion, GW Pharma is far smaller than AstraZeneca, but still a sizeable business. It's a specialty pharmaceutical company best known, as Wales suggests, for its work developing drugs based on a range of chemical compounds extracted from varieties of the cannabis plant. These drugs include Sativex, which already has approval for use in much of Europe as a treatment that can alleviate some of the symptoms of multiple sclerosis. But GW also has other drugs in development - including a promising-looking treatment for childhood epilepsy.

Further down the scale still, David Pinniger points to Alternative Investment Market-listed Summit as one to watch. The business, spun out of Oxford University, is active in the battle against genetic diseases and has begun clinical trials of a new treatment for muscular dystrophy.

Pinniger rates Summit's chief executive, Glyn Edwards, particularly highly. "Investors may feel differently because Edwards is best known as the former boss of Antisoma, which collapsed when its drug trials failed," Pinniger concedes. "But those failures weren't down to the chief executive, and Edwards has proved himself to be a highly competent manager capable of bringing in the capital a business such as Summit needs."

Another British business worth mentioning is Oxford Immunotec. Founded by Peter Wrighton-Smith in 2002 - basically in a spare room of his home - the business is now a world leader in tests for latent tuberculosis, for which the global market is immense, though British investors may be less aware of the demand, since TB is rare in this country. Listed on NASDAQ, the stock has a rising investor fanbase.

Among the unquoted biotech companies, industry insiders tip a number of British firms closing in on an IPO over the next year or so - and worth considering once they announce. These include drug discovery group Heptares and Immunocore, which has done promising work on activating the body's immune system so that it can kill cancer cells.

Finally, for investors who prefer the collective approach, Britain boasts several world-leading funds which offer exposure to the sector. They include Money Observer Rated Funds AXA Framlington Biotech and Worldwide Healthcare Investment Trust. Another in the former stable is AXA Framlington Healthcare, which splits investments across themes such as healthcare services, pharmaceuticals, devices, biotech and pharmaceutical specialities.

Last but not least, there is Neil Woodford to consider. Woodford has become such an evangelist for British biotechs that he now hopes to launch a specialist closed-ended fund later this year that will invest in unquoted companies in the sector. And while he has limited experience running such a specialist fund, or investing in unquoted businesses, few would bet against him given his track record.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.