Generating dividend yield from biotechnology M&A activity
31 January 2019
Even though the biotechnology sector thrives on merger and acquisition activity, the recent level of deal making has been particularly high. While all investors in this sector will benefit from the capital gains of deals, only an investment trust can convert that profit into dividend income.
In December GlaxoSmithKline agreed to acquire the US cancer specialist Tesaro. Bristol-Myers Squibb stunned the market at the start of the year by announcing a $74bn merger with Celgene. Four days later, Eli Lilly announced its plans to buy Loxo Oncology on 7th January.
Doing deals is standard practice. Large pharmaceutical and biotechnology firms acquire smaller rivals to access innovative new drugs which have significant sales potential. Volumes have remained pretty constant over the last decade, irrespective of the current economic cycle as demand for medicines is immune to these trends.
Over the last two decades there has been in an increasing bifurcation in the activities of the whales and the minnows. The behemoths focus on the final stages of drug development along with global marketing and distribution. The small fry are more nimble and better able to find drugs which address unmet patient need.
That’s why approximately two-thirds of new drugs in 2018 were initially developed by small companies while two-thirds of these drugs were commercialised by large companies.
Deal-making is a symbiotic process. Mature companies use their acquisitions of smaller firms to inject growth into their product portfolios as their existing drugs lose their patent protection. The synergies derived from a marketing and distribution machine make such acquisitions accretive to the acquirer. And the smaller firms get access to the giants’ cash and high-quality clinical development and marketing teams, enabling their discoveries to reach their full potential.
While M&A always thrums along, it will tick upwards when market prices move down. That’s because short-term corrections make it even more economically attractive for larger companies to enter into deals. This has helped to spur the recent spate of activity.
The pressure on established corporates not to increase the cost of their drugs has provided another incentive to look for new, high-margin products which will boost earnings and cash flow. This could result in higher levels of M&A activity over the medium term.
From an investor perspective, these M&A transactions can immediately boost portfolio returns, with companies paying an average premium of 62% for acquisitions.
Every time there is an acquisition of a large company which makes up a significant proportion of the index, this activity will underpin the valuation of the whole sector. That’s because investors tend to reinvest their bounty back into other biotechnology stocks.
While an open-ended fund invested in medium-sized firms can benefit from both the buoyant valuations and the capital gain of these deals, only an investment trust can translate this into dividend income.
Growth sectors, like biotechnology, usually have their returns skewed towards capital growth because of the high level of M&A activity and most companies in the sector pay no or low dividends. But International Biotechnology Trust (LSE:IBT) can deliver a more balanced total-shareholder return to its investors.
It uses its capital reserves to pay a dividend. In essence, the Trust converts part of the capital growth of the biotech sector into dividend income for investors. It currently offers a competitive yield of around 4%.
The Trust further capitalises on the high level of M&A in the sector by investing in the type of mid-sized firms which are most likely to be snapped up by larger organisations.
But the Trust’s motivation to acquire a stock is not based on whether it will be an acquisition target. Assets are allocated to those companies with the best long-term growth potential. This happens to be the same criteria used by those firms looking for smaller companies to acquire.
Areas of particular interest for acquisition include the treatment of cancer, the central nervous system and rare diseases. As these areas offer the best long-term growth potential and are relatively resistant to pricing pressure, given the increased level of unmet need, the Trust currently has over 60% of its assets in these areas.
For further information on International Biotechnology Trust, please visit the website at ibtplc.com
Why an investment trust works well for a biotechnology allocation
5 December 2018
While the benefits of investment trusts are well-understood, it’s less obvious why these vehicles are a particularly good fit for an allocation to the biotechnology sector.
That’s because the structure of an investment trust gives stability to a sector which can experience sharp market fluctuations. A trust can access a broader investment universe, provide an attractive dividend, can be geared and can better weather a volatile market.
Closed-ended shareholders can buy and sell their shares on an open market, without having a direct impact on the manager’s day-to-day investment strategy, but unitholders in an open-ended fund can redeem their funds directly with the manager. This means open-ended fund managers can be forced to sell at a loss when markets correct or can end up cash heavy and having to rush into overvalued investments when markets are hot.
As a result, when the long-term performance of open- and closed-ended funds is compared, the latter usually does better because its portfolio is more stable.
Investment trusts and companies have on average outperformed rival open-ended funds over one, three, five, 10, 20 and 30 years, according to analysis commissioned by the Association of Investment Companies (AIC).
But that’s not the only advantage an investment trust brings to an allocation to biotechnology and healthcare. It can give investors access to initial stage developments. International Biotechnology Trust includes an investment in a venture capital fund.
Allocating to these companies allows the trust’s shareholders to access returns from the initial phase of drug development. Pharmaceutical and biotechnology companies are often willing to pay significant sums for these early stage compounds, especially if it looks like they can address significant unmet medical need.
In contrast, the requirement for instant liquidity in an open-ended structure precludes it from investing in this more illiquid asset class.
Another advantage is that an investment trust can offer a more balanced total shareholder return than open-ended structures because it can convert capital growth into a source of dividend returns.
This enables International Biotechnology Trust’s shareholders to receive an annual yield of 4% of net asset value despite the trust operating in a low yield sector.
An investment trust can also use debt to take advantage of volatility in the sector by borrowing extra money to increase investments in companies when valuations are attractive.
Those who favour investment trusts tend to be more cautious investors and may baulk at investing in the biotechnology sector which is perceived as a volatile sector.
While the sector has matured – and stabilised – considerably over the last two decades, it’s still possible for companies to see high levels of volatility when a drug’s development reaches certain milestones.
International Biotechnology Trust takes active steps to manage this risk by taking advantage of investor optimism and the consequent rise in share price. But that position is reduced just ahead of key binary announcements, locking in the anticipatory price rise for investors while reducing risk to their capital.
Sometimes it’s worth buying back the shares after the event, even if the price has risen. That’s because there is greater certainty over the outlook for the company, which justifies a higher valuation.
The trust supplements this risk mitigation with more standard strategies. For example, appointing a team of sector experts to manage it and only investing in companies that have been through its rigorous investment process.
The SV team which runs the International Biotechnology Trust is led by Carl Harald Janson, a medical doctor who has spent 13 years managing healthcare investments. He is supported by a team of experts at SV, in both finance and healthcare.
The team meets often with management of prospective portfolio companies, digging deeply into the science before deciding to invest in them. The trust’s investments are also diversified across large, medium and small caps, with no single holding exceeding 10% of the portfolio.
The sector also offers investors protection against any further Brexit-related sterling weakness. As the majority of biotechnology stocks are located in the US, most investments are dollar-denominated which equates to favourable translation effect if the pound were to weaken further against the US dollar.
International Biotechnology Trust provides investors with an exposure to the full spectrum of investments in the biotechnology sector, manages risk in the face of volatility and provides both capital growth and income.
For further information on International Biotechnology Trust, please visit the website at ibtplc.com
How investing in biotechnology can provide capital growth and income
31 October 2018
Some investment rules are considered immutable. For example, an asset can either deliver high growth or provide high income. But that’s not always the case – it is possible to receive both.
A standard open-ended income fund will typically select companies which provide high dividends, such as utility stocks. These tend to be low growth stocks so returns are skewed towards income and away from capital appreciation.
At first glance, it seems impossible that a biotechnology investment could be a source of income. This sector has performed well over the last decade delivering considerable compensation for growth investors. But these returns have been skewed towards capital growth as most companies pay no or low dividends.
The International Biotechnology Trust (LSE:IBT) offers a solution to the income versus growth conundrum by using capital reserves from accumulated profits to top up dividend payments. In essence, it converts part of the capital growth of the biotech sector into dividend income for investors. International Biotechnology Trust currently offers a yield of 4%.
The Lead Investment Manager, Carl Harald Janson said, “We are confident International Biotechnology Trust can maintain this level of dividend payment. Over the last 20 years, the NASDAQ biotechnology index has appreciated by 12% a year. Even paying out 4% of this growth as a dividend leaves 8% capital growth for the investor.”
There are good reasons to feel confident about future growth prospects. Changing demographics are increasing the need for medicines. Populations are ageing in the developed world while the middle class in the emerging markets is growing.
Both of these trends will drive demand for drugs. Companies will be able to meet this need as their ability to innovate has become more effective and the regulatory approval process has become easier to navigate.
This should translate into a continued double-digit appreciation of the sector over the next decade which will provide an ample margin for International Biotechnology Trust to maintain its target 4% dividend.
But while the Trust’s managers are confident, they are not complacent. Investing in biotechnology can be a risky business. A company can spend millions with no guarantee of success.
When a drug’s development reaches certain milestones, there is a high risk of share price volatility. International Biotechnology Trust has a strategy to avoid sharp price corrections.
In the run up to a significant news event announced by the company, the Trust will take advantage of investor optimism and the consequent rise in the share price. But it aims to reduce its position just ahead of that announcement.
Carl Harald explains “Sometimes it’s worth buying back the shares after the event, even if the price has risen. That’s because there is greater certainty over the outlook for the company, which justifies a higher valuation.”
This risk mitigation is supplemented with more standard strategies. For example, International Biotechnology Trust only invest in companies its managers understand.
That entails meeting often with management before deciding to include them in the portfolio. The Trust’s investments are also diversified across large, medium and small caps, with no single holding exceeding 10% of the portfolio.
The portfolio also has a 5-15% allocation to unquoted companies which are not affected by stock market volatility.
Not only does this help to better manage the risk in the portfolio but it also gives income investors access to a part of market which is usually only available to venture capitalists. International Biotechnology Trust’s shareholders can benefit from the full life cycle of a drug – from the moment of inception to potential global sales.
A biotechnology investment trust which manages its risk well and offers a consistent, sustainable dividend policy is a good way for an income investor to participate in capital growth while enjoying a decent yield.
For further information on International Biotechnology Trust, please visit the website at ibtplc.
The Trust’s latest monthly factsheet is available – click here
These articles have been written by International Biotechnology Trust for publication on citywire.co.uk