Interactive Investor

Time to invest in Biotech?

21st July 2016 12:06

Marina Gerner from interactive investor

Drug prices pose an ethical dilemma. On the one hand, treatments should be affordable to those who need them, but on the other, companies will have to finance many failed drug development attempts in order to uncover the successful few, so each life-saver may carry a hefty price tag.

While pharmaceutical companies tend to deal with well-known generic drugs, biotech companies focus on developing new drugs made from living organisms, aimed at treating conditions and diseases that have no cure as yet.

US innovation

For a drug to be approved on the US market - the largest in the world - it has to go through three phases of clinical trials, as set out by the Food & Drug Administration (FDA).

Phase one tests a drug's safety on healthy volunteers, looking at dosage and side effects. Phase two assesses effectiveness, and phase three involves large-scale trials.

Biotech firms burn through cash on research and development (R&D), but only around 8% of drugs make it through the clinical trials to achieve FDA approval. Accordingly, biotech has never been an investment for the faint-hearted.

The majority of healthcare innovation still comes from the US, where most biotech firms are based.

"US consumers pay more for drugs than the rest of the world, and that subsidises the R&D to develop these drugs. The rest of the world benefits from that, without having to pay those high prices for the exact same drugs," says Geoff Hsu, manager of Biotech Growth Trust.

In his book Bad Pharma, the academic Ben Goldacre criticises pharmaceutical companies for spending a large proportion of their budget on marketing rather than on R&D. Does the same apply to biotech?

Hsu says that in contrast to pharma, biotech companies deal with more niche drugs, such as those to treat "orphan diseases" (conditions that affect fewer than 200,000 people). As a consequence, they focus their resources on R&D rather than marketing and sales.

Biotech companies tend to have one lead drug that drives the bulk of their value, so pharmaceutical companies are keen to incorporate innovative biotech start-ups in their business. Mergers and acquisitions are a regular feature in the sector, pushing up prices during the sector's growth periods.

From 2010 to July 2015, the biotechnology sector had a remarkable bull run. The NASDAQ Biotech index surged by 350% during that time.

Drug pricing scandals

It was drug pricing that precipitated the trouble that began in September 2015, when hedge fund manager and pharmaceuticals executive Martin Shkreli acquired HIV drug Daraprim.

He raised the price of a tablet from $13.50 to $750 (£10 to £564), increasing the cost of treatment for patients to hundreds of thousands of dollars.

Gilead, which produces hepatitis C drugs, was also taken to task for its high drug prices. In response to the scandal around Daraprim, presidential candidate Hillary Clinton tweeted in September: "Price gouging like this in the speciality drug market is outrageous. Tomorrow I'll lay out a plan to take it on."

Clinton's tweet was seen by many analysts as a turning point for biotech fortunes.

Sentiment was further dampened by the share price collapse at Valeant, a highly acquisitive drug firm laid low by its debts and (as yet unproven) allegations of accounting irregularities. As a result, investors lost confidence and the NASDAQ Biotech index crashed by 35%.

It could also be argued that the sector was ripe for a reversal because valuations had run so far ahead of reality, and Clinton's comments merely provided investors with an excuse for the pullback. In addition to outflows in 2015, biotech saw another large drawdown in 2016.

This was due to general market weakness, China's slowdown and the falling price of oil, says Hsu, "even though, when you think about it, biotech has nothing to do with growth in China or the price of oil". Managers pulled out of biotech to reduce risk.

M&A optimism

Now, investors need to make a call on whether to return to a sector that is so intricately related to US policy.

Despite the very public discussion around drug pricing in the run-up to the US presidential election on 8 November, Hsu does not expect any major legislative changes to happen given Republican control in the US Congress is likely to continue.

However, he expects M&A activity in the second half of 2016 to help turn the sector around. "We've already seen some hints of that: Pfizer just acquired Anacor at a 55% premium; Sanofi is in the midst of making a hostile bid for prostate cancer drug company Medivation."

His optimism may not come as a surprise - after all it is counter-intuitive for fund managers to talk down the prospects of the assets they manage.

To what extent do other fund managers echo his optimism for the sector? David Coombs, head of multi-asset investments at Rathbones, holds biotech giant Amgen in his medium-risk fund and the Biotech Growth Trust in his higher-risk fund.

Coombs likes biotech because it is not cyclical, which means the sector can perform well in a low-growth environment. In the run-up to the US presidential elections biotech stocks might continue to fall, but Coombs sees that as a buying opportunity.

Jake Robbins, manager of Premier Global Alpha Growth fund, points out that the more mature businesses in the sector such as Gilead, Amgen and Celgene, which already generate huge profits from successfully developed drugs, "now all look extremely attractively valued".

"Strong cash flow generation enables these companies to invest in many potential new drugs, whilst also offering the investor reasonable dividend yields in the meantime as their pipelines mature."

Up-and-coming stocks

The well-established biotech firms, including the 10 largest constituents of the NASDAQ Biotech index, trade at a discount to the broader US market, at around 13.4 times earnings for this year and 12 times for next. "Up-and-coming" biotech stocks with drug development still at early stages, however, are a different matter.

And, given the ageing populations of the West and developments such as antibiotic resistance, biotech is likely to remain a productive area of healthcare for many years to come.

Stock and fund picks for exposure to biotech

Daniel Greenhough, investment manager at Lumin Wealth Management, likes the Polar Capital Biotechnology fund: "The lead fund manager is a specialist in this area and supported by a particularly strong team.

"We currently hold the less speculative Polar Capital Healthcare Opportunities fund, run by the same team, in our model portfolios."

Currently 29% of Woodford Equity Income fund, 26% of Jupiter European and 23% of Threadneedle European Select are invested in this area.

Carl Harald Janson, lead investment manager at International Biotechnology Trust, has some tips for those looking for direct equity exposure.

He says good areas to invest in are businesses that "are exposed to strong top-line growth such as Genmab (which recently co-launched a new drug, Darzalex, for the treatment of cancer of the bone marrow), and companies that could be taken over such as Medivation, which is in the middle of such a process".

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.