As IBT’s financial year came to a close at the end of August, we thought it would be helpful to take the time to review how the year has been and what some of the challenges and highlights we have faced will be. Please be aware when reading information relating to the performance of IBT that an investment in our trust is considered to be high risk and capital invested and associated income may go down as well as up. Please remember that past performance may not be indicative of future results.
2021 was still dominated by the Covid-19 pandemic, and the seismic economic change and widespread suffering across the globe is still being felt. In the face of this turmoil, the biopharmaceutical industry stepped up and delivered novel Covid-19 vaccines and therapeutics at an unprecedented pace, helping to bring forward the end of the pandemic and reducing the death toll.
As a consequence, the pandemic highlighted the increasingly important role of the biotech industry in delivering cutting edge healthcare and the scale and speed of innovation this industry can provide. Coming at the end of a decade of continual growth in biopharmaceutical markets, this appeared to lead to an influx of additional investors, positive market sentiment, and soaring valuations for biotech companies.
There is no doubt that after the highs of 2021, the past year has been difficult for our industry. The realisation that many biotech companies had become overvalued, combined with global macroeconomic challenges including geopolitical instability, inflation and rising interest rates, sent biotechnology stocks into a downward trajectory in the later stages of 2021 and into 2022. In order to counter rising inflation, central banks all over the world have raised interest rates. These rises in interest rates, combined with the inflation they are designed to counter, is contributing to a highly uncertain economic outlook that is expected to continue into 2023.
It is against this backdrop that many investors who entered the sector in 2020 and 2021 now appear to have exited. As a consequence, IBT’s comparator index, the NASDAQ Biotechnology Index (NBI), fell by more than 30% since a peak in Autumn 2021, before recovering slightly over the summer of 2022. As an additional barometer of market sentiment, recent analysis from Evaluate Vantage shows that Initial Public Offerings (IPOs) – a major source of cash for pre-clinical and early clinical stage companies that reached unprecedented levels during the halcyon days of 2020 and 2021 – shows biotech IPOs have all but ground to a halt in 2022.
Against this backdrop, although the first half of IBT’s fiscal year ended 28 February 2022 was challenging, the second half saw a rise of 10% in IBT’s net asset value. Although there was an overall outperformance against the benchmark NBI of 7% over the fiscal year to 31 August 2022, the NAV of IBT declined in absolute terms in the course of the financial year. This means that, while the dividend yield will remain constant, the absolute dividend payable in 2023, which is based on IBT’s dividend policy of 4% of the NAV at the close of the previous year end, will be slightly lower than that paid in the previous year.
Innovation in biotechnology remains robust
Despite these significant challenges, the strength of the biotechnology R&D engine remains a major cause for optimism. 2022 bears witness to record numbers of potential drugs in clinical trials as seen on the register of clinical trials in the US at clinicaltrials.gov. Whilst the vast majority of clinically approved drugs are ultimately marketed by large pharmaceutical companies, these drugs are increasingly originating from small biotech companies and transitioned into large pharmaceutical pipelines through direct acquisition or strategic partnership.
This model continues to provide pharmaceutical companies with access to the kind of early stage innovation that ultimately leads to blockbuster drugs and produces returns for players all along the value chain, from venture capitalists and entrepreneurs who found these early stage biotech companies to the large pharmaceutical companies who benefit from the ready-made source of high value drugs they produce. By investing in both the early stage companies that are typically the target of acquisitions and the larger players that are often the acquirers, IBT can be a double beneficiary of any M&A activity in the sector.
While valuations in the biotech sector reduced dramatically towards the end of 2021, it took several months before the anticipated rise in M&A transactions materialised, probably due to unrealistic expectations of the possible exit price achievable at the target companies. However, in 2022, the M&A in the sector picked up and IBT was fortunate enough to have seven companies in its portfolio acquired during its fiscal year ended 31 August 2022.
With fundamental innovation at smaller biotech companies remaining robust but valuations looking attractive, there is a strong chance an M&A buyer’s market will emerge, with big pharmaceuticals and big biotech companies looking to replenish their pipelines of expiring product patents with new innovative products that might have been considered overvalued in the past.
IBT will continue to look to benefit from this activity over the coming period and is particularly focused on companies in the revenue growth area of the market – those with approved products which have yet to turn a profit. These assets seem to be the ones catching the eye of acquirers most frequently.
US drug pricing legislation
The US political landscape has for decades threatened to introduce controls on drug pricing, but has until now never delivered. This changed in 2022 with the passing of significant drug pricing reforms by a narrow margin as part of the Inflation Reduction Act.
The legislation will allow Medicare and Medicaid – the US state health systems – to negotiate lower prices for the biggest selling drugs that lack generic competition a set number of years after they reach the market. It will also prevent above inflation price rises for marketed drugs and will specifically lower the price of medications for major diseases like heart disease and diabetes.
With a possible swing of, at least, the Congress to the Republican party in the US mid-term elections and an uncertain future political outlook, it remains to be seen whether these measures are actually enacted, and their likely impact is up for debate. However, the consensus is this legislation may lead to a single digit percentage revenue fall for large pharmaceutical companies who are, unsurprisingly, not pleased with these changes.
However, this legislation has so far had very little impact upon valuations across the sector. Indeed, despite doom-mongering from investors prior to this legislation’s enactment, valuations for the innovative small and mid-cap biotechnology companies in which IBT is primarily invested appear thus far relatively unaffected. Several factors are likely responsible for this.
Firstly, the legislation has exemptions for drugs produced by small biotech companies, for drugs with generic competition, and for blood-derived products such as cell therapies. Perhaps more importantly, price negotiations (i.e. forced price reductions) will only apply to the biggest selling drugs, only kick-in 9 or 12 years after launch (depending on the drug class), and will only affect drugs purchased through Medicare and Medicaid, which only constituted around 40% of US pharmaceutical sales in 2017. Whilst the percentage of revenues likely to be affected varies from company to company, it is estimated by RBC Group that only 10-15% of global drug revenues will become subject to ‘negotiation’ as a consequence of these measures, with the remainder being unaffected.
Indeed, as these measures will only apply to the biggest selling drugs after a set number of years on the market, by definition, a product has to have been commercially successful for an at least seven years or longer if a biologic product in order to be affected. Consequently, earlier stage biotech companies likely view this as a ‘nice problem to have’, as they will only be subject to price negotiation should their products prove to be huge successes.
With innovation accelerating in the biotech sector, many products are likely to be superseded by a new, more effective treatment before their patent expires and within a shorter timeframe than used to be the case, so the fact the price negotiations will only come into effect after a number of years makes them less relevant in any case.
Finally, this legislation has left drugs manufacturers with the sole rights to set launch prices for drugs, leaving the industry with the pricing flexibility required to make an investment case for an early stage product. As such, we share the view of the US Congressional Budget Office, whose analysis suggested very few future drugs would be lost as a result of this legislation, and the high levels of innovation driving our industry should be largely unaffected.
A positive outlook on the period ahead
Whilst the recent passing of drug pricing legislation in the US through the Inflation Reduction Act may lead to slight reductions in the revenues of future blockbuster drugs, for the reasons outlined above, the legislation has so far had very little impact upon valuations of the innovative small and mid-cap biotechnology companies in which IBT is primarily invested.
With mid-term elections looming, there is always a risk of negative political rhetoric around drug pricing, but we hope the recently approved changes mean there will be less political noise around this subject in the run up to the election. Innovation in biotechnology remains robust, with record numbers of drugs in R&D pipelines and clinical trials. Indeed, there is real excitement that the new modalities recently reaching the market, such as gene, cell and RNA therapies, could transform healthcare across a variety of diseases where there remains significant unmet need.
The current financial turmoil provides an opportunity for knowledgeable investors to make outsized returns on investments in companies that are fundamentally undervalued. Our expertise and experience helps us identify these companies and take advantage of the current market conditions.
IBT continues to be actively managed with a tactical approach to asset allocation and gearing, and a cautious approach to holding investments that have impending binary events, such as clinical trial readouts. This strategy has led to IBT outperforming its benchmark index in the fiscal year ended 31 August 2022 and having lower volatility than the NBI index. IBT’s relative and absolute performance and its relative volatility can be viewed monthly on IBT’s factsheet at www.ibtplc.com.
IBT’s achievements have been recognised by investors on the AJ Bell investment platform, who voted IBT as the winner of the AJ Bell Funds and Investment Trust Awards - Technology/Biotechnology Award for 2022. https://fitawards.ajbell.co.uk/winners
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