The biotech sector is driven by the consistent fundamentals of demand from an ageing population and supply from accelerating scientific innovation. These forces are unaffected by highs and low of economic cycles, giving the revenue generating companies in the sector an unusual level of predictability and stability of earnings and helping to feed the constant supply of new companies with exciting, innovative products.
The biotech industry has over the last couple of decades branched out, matured and has its own “eco-system” to co-exist with the historically larger pharmaceutical industry. The boundaries are blurred and the whole pharma-biotech complex are highly dependent on each other.
As the biotech industry is relatively stable and growing, the investment cycles are not. Many Biotech investors are sentiment driven and the prices they ascribe to companies are in many cases emotional, not always by true company fundamentals. New innovations often fuel overly optimistic expectations of cures in the near future, triggering a hype that over time has a tendency to fade once those innovations are put to the test and a more realistic view emerges of what and when tangible changes to patient outcomes can be achieved.
While some investors, like IBT, are fully committed to biotech, many investors tend to move in and out of the biotech sector depending on their risk appetite.
This tendency leads to exaggerated highs and lows in the valuations of the sector, creating a type of cyclical environment for investing. We as experienced fund managers have been through several of these cycles, all of them are different but bearing similar characteristics and cyclicality. This time around, the highs have been extreme, mainly driven by an increased focus on the media biotech sector through the Covid pandemic and a rise in retail trading over lockdown. The globally recognised fund flow tracker, EPFR, showed overall inflows into global equity funds hitting a record weekly high in mid March 21 and this was thought to be fuelled by the US lockdown giving retail investors the combination of ample time and access to financial markets via online trading platforms.
Stages in the life cycle
Stage 1 is characterised by depressed valuations which generally don’t reflect the potential of companies. This is often manifested by a portion of companies being valued below their cash position indicating the market ascribing a value to their product of below zero. The analysts that cover the industry tend to follow with downgrades and general bearishness and we see a stand-still in initial public offerings or IPOs. Mainly the industry specialists remain, whereas sentiment driven investors switch to safety out of the sector.
Stage 2 is the start of the recovery phase. The low valuations draw back the ‘cash-rich’ pharma companies looking to replenish their product portfolios with reasonably valued assets. The M&A deal announcements and premia paid act as a catalyst signalling the sector in aggregate is at low valuations and values start to rise.
Stage 3 is usually the longer phase of relative stability, growth and stable valuations with regular M&A deal flow and a steady flow of reasonably valued IPOs. Risk averse investors come back into the sector and support it through this phase and companies find it easier to re-finance on reasonable terms.
Stage 4 is the boom period with prices driven up by the volume of new investors coming into the sector and valuations starting to feel disconnected from the potential of the underlying assets. IPOs increase with relatively high valuations, more private companies take the opportunity to list at an earlier stage of their development and at better terms than an M&A tie up.
Inevitably, Stage 4 is unsustainable and Stage 5 commences. M&A deals dry up as pharma companies look to licencing deals as an alternative to paying hyped valuations for assets. Many of the early stage companies are suddenly considered riskier so, re-financing becomes troublesome and at the same time investors take profits with inevitable price corrections. Disappointed and “late to the party” investors leave the sector and the drought cycle resumes.
The graph below shows the XBI, which is dominated by smaller cap biotech companies, in which you can see that the duration and severity of the current drawdown is longer and more striking than any previous drawdown in the past ten years.
Identifying points in the cycle
Knowing where we are in this investment cycle is key to preserving capital in our Trust. We are committed to investing in Biotech, but we can shift our assets between the less risky cash-flow generating large biotech stocks and the higher beta development stage biotech companies, depending on where we believe we are in the cycle. Moreover, as the Trust is closed-ended, we may use our gearing facility as and when biotech company valuations are depressed.
Back in March of 2021, our blog https://ibtplc.com/investor/blog/meme-theme-and-the-ark-innovation-momentum-machine looked at the hyped valuations and meme stocks resulting from the huge inflow of investors entering the sector through ETFs such as ARK Innovation. This momentum was further fuelled by the renewed focus on the biotech sector as a result of its role in creating solutions to the pandemic.
At IBT, we had taken these factors as a sign that the sector was in Stage 4 and had shifted our focus away from the smaller stocks where we felt valuations were looking frothy, into the lower risk large biotech stocks. We also reduced our gearing. We felt that Stage 4 would quickly turn to Stage 5 as external factors such as rising inflationary pressure, and US political interference in the sector were testing investors nerves and a downturn followed.
Source: SV Health Investors.
As previously mentioned, this cycle has been dramatically accelerated by the Covid pandemic and gone almost full cycle in less than 18 months. As we stand, we believe we see many signs pointing towards us being at Stage 1 again with around 30 companies in the fund’s benchmark, the NASDAQ Biotech index, representing around 16% of the index, trading at negative Enterprise Values, which means they are at valuations lower than the value of the cash they have in the bank. This is the most severe impact on the sector that we have seen in the last 20 years, with only around 11% of companies in the index trading at values below cash in the financial crisis in 2008/9. The investment community is bearish, analysts are downgrading expectations and we are seeing sentiment driven investors selling out of the sector.
We feel the current situation represents an opportunity to buy companies with great science at attractive valuations – both topping up levels in stocks we own and investing in some exciting science that we like but had previously felt was overpriced. To enable us to take advantage of the situation, we have increased our gearing and shifted our exposure towards the smaller, riskier but also the most innovative, earlier stage companies.
What is interesting is wondering how long Stage 1 will last. The duration of the current correction has been longer and harder than previous downturns already. M&A announcements could be the catalyst that the market needs to shift into Stage 2 and we feel that M&A deals that were contemplated prior to the pandemic but shelved due to lockdown can be quickly dusted off and rekindled now that valuations are looking attractive. That, coupled with positive readouts from expected major company news events in the next few months, may be the kickstart the market needs to enter Stage 2. We firmly believe the fundamentals of the sector remain very much intact while the ebb and flow of investor interest is dictated by wider macro concerns over interest rates and the economic cycle. All this considered, we at IBT are buckled in and ready for the ride.