By Marek Poszepczynski and Ailsa Craig, co-investment managers of the International Biotechnology Trust
Despite UK inflation hitting fresh forty-year highs, demand for healthcare is unlikely to drop off anytime soon. As households feeling the pinch differentiate between necessary and optional expenses, pharmaceutical drugs will undoubtedly make the cut. In fact, with an ageing global population and rising incomes across the developing world, the need for new treatments will only continue to expand.
However, the era of rising interest rates that will arise in response to inflation will necessarily impact the biotechnology businesses producing these drugs, as operating costs increase, and stock prices suffer. For investors, it will be important to understand which types of businesses will be affected and how they can take advantage of attractive valuations in the sector.
Assessing the impact
The biotech industry is mature and diverse, comprising companies that have been in existence for multiple decades as well as micro caps engaged in early-stage laboratory work. The extent to which inflation will limit biotech companies will depend largely on where they are in the business cycle and the timing of their future cash flows.
Behemoths like Gilead and Amgen have established products on the market, diversified portfolios, consistent and predictable sales – expected to exceed $25bn for 2022 – and are valued in the multi-billions of dollars. While these companies may have higher input costs due to inflation and may have to trim some activities, they can be considered ‘safe-havens’, as their valuations should not be significantly affected by higher interest rates.
Smaller, younger companies, which are still in the costly and risky development stage of the business cycle, and are still looking to attract investment, do not expect to receive cash flows until far out in the future. This means they will inevitably be hit harder than the larger more mature companies that are receiving cash flows already or expecting to in the near term. In fact, they are already feeling a significant impact from the rise in interest rates. The XBI index, which is dominated by the smaller biotech companies, has fallen 36% YTD [18 May, USD] and c50% since November highs, when it became clear that inflation and consequently interest rates would become a prolonged problem.
While smaller companies may struggle to raise financing, which could mean laying off staff or cutting marginal projects from their pipeline programmes, having fewer, more viable, projects will increase the success rate in the sector. Furthermore, lower valuations may trigger more mergers and acquisitions as larger cash rich companies, which face major patent cliffs towards the end of this decade, try to fill the looming void in sales.
IBT invests across the whole spectrum of biotech companies. We have around 60% exposure in either ‘profitable’ or ‘revenue growth’ companies i.e. companies which have an approved drug selling on the market, and the remainder of the portfolio in smaller earlier stage companies.
While the latter are the most impacted by macro dynamics, they also offer the most exciting potential. We increased our exposure to these businesses in the last year, as valuations have become more attractive to us. Many of these companies are trading at or below cash values, yet this sort of risk-off environment can still yield ground-breaking innovation and tremendous growth. In particular, we are excited about new technologies emerging in oncology and rare diseases – which are less sensitive to price regulations, as they address high unmet medical need.
Nevertheless, because they are higher risk, and by virtue of their smaller size, we hold a diversified portfolio in this space, with a larger number of holdings (c100). By ensuring we carefully select companies with robust financials, we feel we can also reduce the impact of inflation and rising interest rates on the portfolio, while retaining exposure to future potential.
As a closed-ended fund, we can also seek to mitigate downside risks and enhance returns by actively adjusting the gearing of the trust. For example, we recognised a bear market rally in March and were able to reduce our gearing at the peak ahead of the anticipated market slide, leaving us with firepower to redeploy in opportunities as they arise.
We remain excited at the extent of ongoing innovation that could address today’s unmet medical needs. For biotech companies, it takes time, effort, and patience to transform new technologies into drugs that treat patients. While the ebb and flow of the wider economy and shock events will impact these businesses, we are confident the industry will continue to grow due to ever increasing demand.