Meme, theme and the ARK Innovation momentum machine

The media frenzy surrounding the Robin Hood and Reddit crowds has dominated headlines worldwide. It has had a tangible impact on U.S. stock markets and we expect continued effects for the foreseeable future. In light of this, we thought we would share our perspective of the phenomenon, the lessons learnt, and how International Biotechnology Trust (“IBT” or “the Company”) navigates this environment.

With more people staying at home, having increased money to spend and with the introduction of free trading, RobinHood and its peers created the perfect brew for what was subsequently unleashed on “short investors” (an investor who borrows a security and sells it on the open market, planning to buy it back later for less money). The target companies were carefully selected, favouring low liquidity and highly shorted names. The Reddit “army” moved in - creating a massive buzz in certain stocks which in turn created even more uncontrolled buying, with Game Stop being the poster child (please refer to Figure 1 below).

Figure 1: Game Stop share price graph – 6 months ended 28 February 2021.

Source: Bloomberg

What does this have to do with biotech, and how does it affect IBT?

Within days, biotech companies with similar characteristics were targeted and their share prices started to spike. Although, the buzz faded relatively quickly, another and more impactful trend has emerged, with a much greater impact on the biotech sector – the so called theme ETF/fund hybrids. A theme fund is one that invests predominately or exclusively in securities representing a single theme. For example, it may invest only in energy stocks, securities related to real estate, or in investment vehicles that conform to a set of ethical standards. There are many such funds available on the market, but the most prominent ones, which in our opinion have had the biggest impact, are ARK Innovation/ Genomics ETFs.

What is ARK Innovation?

Founded by Cathie Wood in 2014, Ark Innovation is an actively managed ETF focused on investing in companies with a “disruptive technology”. The company came into focus last year when its underlying holdings skyrocketed. Names such as Tesla and Teladoc Health had strong positive moves in share price and, as a consequence, money inflows to the Ark ETF spiked. Many of Ark’s holdings are unprofitable, high-risk biotech companies. Inflows into the ETF and its subsequent investment into its portfolio companies, meant that it became one of the largest holders of certain of its underlying stocks, making the portfolio companies very susceptible to inflows and outflows at the ETF (please refer to Figure 2 below).

Figure 2: Ark Innovation ETF/ Ark Genomic Revolution ETF market capitalisation (USD bn) – 18 months ended 28 February 2021

Source: Bloomberg

The February ebb and flow

Similar to the tech companies invested in by Ark Innovation, the biotech names are early stage. Their technologies are exciting and cutting edge, but their pipelines have not yet been proven safe and efficacious in clinical trials. It is these unprofitable companies that are most exposed to risk-off and interest rate fluctuations and in February 2021 we saw how quick and impactful such swings can be. Long-term bond yields started rising and investors began selling those stocks.

Ark Innovation’s focus is to find the true market disruptors with the greatest potential. There are many areas of great potential in the biotech sector, but with the caution that the implied risk is as high on the upside as it is on the downside. With massive inflows to ETF funds like the Ark Innovation/Genomics ETF, the momentum trade becomes self-fulfilling, causing ever higher valuations which, in many cases, become detached from the true underlying fundamentals of the stock. During the first half of February 2021, we saw huge price increases driven by money flows into some of these earlier and higher risk companies, as they fit the characteristics that investors were looking for. These names further benefited from the boom era of Ark Innovation and we began seeing bubble-like valuations in some early-stage companies. Towards the end of February 2021, the reverse has also been true with outflows from the ETF and a consequent sharp sell-off in these names.

Impact on performance and portfolio composition

In building a biotech investment portfolio, we always strive to own an anchor of solid cash-generating companies, a portion with high growth prospects which, hopefully, will generate the next generation of blockbuster drugs, as well as finding the next paradigm-shifting companies that can truly change how diseases are treated. This has meant that we have largely avoided the early-stage companies without clinical data that have been subject to the highs and lows generated by the types of activity discussed above.

The Company´s Investment Management Team has been around long enough to experience a number of market ups and downs. In all markets, we have always been keen to stick to investments which we believe have strong fundamentals and are valued reasonably. This has meant that in some periods we have abstained from participating in run-ups not supported by solid underlying fundamentals. We have strong conviction in the underlying holdings within the Company and will continue with our strategy of investing into quality, fairly valued biotechnology companies for the long term.

Appointment of Joint Lead Investment Managers

On 15 March 2021, it was announced that Carl Harald Janson had decided to step back from his role as the Lead Investment Manager after seven years at the helm. Responsibility for the management of the Company has passed to Ailsa Craig and Marek Poszepczynski as Joint Lead Investment Managers. Following a handover period, Carl Harald will remain as a Senior Adviser to SV Health Investors and the Company. Kate Bingham will remain the manager of IBT’s unquoted portfolio.

We would like to take this opportunity to thank Carl Harald for all his years of service to the Company and the wider SV Health team. Together we have led the Company from a broad discount to NAV with a need for regular share buybacks to a premium to NAV with the ability to issue new shares. We have seen the Company reach all-time highs during 2020, introduced the dividend and restructured our unquoted portfolio. We have really enjoyed working alongside Carl Harald and have benefitted greatly from his leadership and insight. We wish him well in the next chapter of his life and look forward to staying in touch with him through his role as Senior Adviser. We are excited about this next chapter for the Company and will continue to build on Carl Harald’s legacy, striving for strong investment returns from a cautious approach to stock selection with a focus on risk mitigation.