By Marek Poszepczynski and Ailsa Craig, co-investment managers of the International Biotechnology Trust
The biotechnology sector has, in our view, rarely been cheaper. Approximately 30 companies in the NASDAQ Biotechnology Index, which represent roughly 16% of the benchmark, are trading at negative enterprise values. This is the greatest sector discount in 20 years, with only about 11% of companies in the index trading at negative enterprise values during the 2008 global financial crisis.
However, the sector is far from flawed – in fact, it possesses solid long-term fundamentals. The expected doubling of over 65s during the next 50 years, in combination with developing economies demanding greater access to healthcare, underpins robust demand for the space moving forward. Meanwhile, on the supply side, scientific innovation is expanding exponentially and with tremendous pace.
These forces are largely unaffected by macroeconomic conditions. Instead, investment in the biotech space is heavily sentiment driven. Announcements of new innovative treatments often fuel overly optimistic expectations of future cures, triggering hype that tends to fade once innovations are put to the test and a more realistic picture of their potential emerges. In addition, many investors move in and out of the biotech sector depending on their risk appetite.
This means the current sell-off poses an opportunity to tap into compelling innovation at attractive prices. Nevertheless, investors must understand the sector’s distinctive cyclical nature and where we are in the cycle to make the most of it.
Follow the cycle
Biotech investing is characterised by the following five stages. Stage one is distinguished by depressed valuations that generally do not reflect the underlying potential of companies. Bearishness follows, leading to a stand-still in new public offerings. The industry specialists remain, but generalist investors tend to move their money elsewhere.
Step two brings recovery. Low valuations draw back ‘cash rich’ pharmaceutical companies looking to replenish product portfolios. The M&A deal announcements and premia paid act as a catalyst, and valuations start to rise.
The third stage is usually a longer phase of relative stability and growth, with regular M&A deal flow and a steady stream of reasonably valued IPOs. Risk averse investors return to the sector, while companies find it easier to re-finance on reasonable terms.
Finally, stage four is the boom period. The volume of new investors entering the sector drives up stock prices, causing elevated valuations to feel disconnected from the underlying value of assets. With high valuations, IPOs increase and private companies take the opportunity to list at an earlier stage of their development.
Inevitably, stage four is unsustainable and quickly gives way to stage five. At this point, M&A deals dry up as pharma companies look to licencing deals as an alternative to inflated assets. Many early-stage companies are suddenly considered risky, re-financing becomes troublesome, and investors take profits, leading to inevitable price corrections. The investors ‘late to the party’ then exit the sector, and the cycle resets.
All about timing
Knowing which stage the biotech investment cycle is in can allow investors to shift assets in a timely fashion between larger, less risky biotech stocks and higher beta development stage players.
The Covid-19 pandemic dramatically accelerated the cycle, which appears to have completed a near full revolution in less than 18 months. Presently, several signs indicate we are back at stage one – the investment community is bearish, analysts are downgrading expectations and we are seeing sentiment driven investors fleeing the sector.
As such, we are taking advantage of what we believe to be cheap valuations to top up stocks we already own and invest in exciting innovations we previously felt were overpriced. We have increased our gearing and shifted exposure towards smaller and riskier – but also highly innovative – earlier stage companies. In particular, we are seeing interesting opportunities in companies that have had de-risking events last year and traded higher on positive data and have since retracted
Moving forward, M&A announcements could be the catalyst that shifts the market into recovery. With valuations once again attractive, deals contemplated prior to the pandemic but shelved can be dusted off and rekindled. This, coupled with potential positive clinical trial results from major innovators in the next few months– may kickstart the market into stage two. Investors would be wise to take a cautious, diversified approach, but for those seeking biotech exposure at the current market dip, rewards could be just around the corner.