International Biotechnology

International Biotechnology Trust (IBT) aims to deliver a combination of strong capital growth and consistent dividend income from investing in biotechnology companies around the world. As we discuss in the Portfolio section, the managers believe IBT is exposed to a long-term secular growth theme, but in a sector that trades on less demanding P/E’s than wider equities.

Performance from the trust this year has been strong. Up until July, the sector and the trust performed strongly relative to wider equities, but since then global equities have outperformed. That said, since the summer, IBT has outperformed its benchmark, and calendar year to date, the NAV is ahead of the benchmark by 10.3% (to 02/12/2020).

The team of three, led by Carl Harald Janson, employs a distinctive approach that has enabled the trust to achieve this outperformance. They take a measured approach to investment, backed by identifying clear medical needs and understanding the science behind product research. However, an important differentiator is that the team prefers to reduce risk to specific stock moving events, such as clinical trial results, ahead of its announcement. This risk management tool has helped the team deliver a lower volatility return stream than the benchmark, whilst still enabling IBT to outperform.

Another key differentiator, and a strong contributor to returns this year, is the exposure to private companies. Investments here are led by Kate Bingham, offering exposure to early stage companies with explosive growth potential.

IBT pays a Dividend from capital of 4% of NAV each year (NAV value at end of the previous August). On 15 December 2020, IBT announced an interim dividend of 14.2p per share to be paid on 29 January 2021. Assuming the same amount is paid as a second interim dividend, the shares yield 3.5% at the current price.

The biotechnology sector offers attributes of strong, long-term prospective growth and an undemanding valuation. In our view, this makes it a differentiated growth story to technology stocks which have led the market.

Alongside the secular growth opportunity, IBT has some clearly differentiating characteristics – both in the underlying Portfolio, but also the investment philosophy behind it - which make it attractive from a diversification perspective. These same characteristics have led to its strong long-term performance. Over recent months, the manager’s active management, as well as exposure to unlisted companies, has meant that the NAV has significantly outperformed the benchmark.

With net assets of c. £330m, IBT is in a sweet spot. At this size, it is nimble enough to actively trade the underlying portfolio, but big enough to benefit from economies of scale and has enough market liquidity for most institutional investors to trade in the shares.

In the current environment, where visibility on dividends everywhere is murky, we see the consistency of the Dividend as a key attraction. The fact that the dividend is paid from capital means that it is not subject to the same pressures as dividends paid from current earnings. On a prospective dividend yield of 3.5%, this is attractive relative to that of other equity income sources. IBT remains a solid and differentiated way to get exposure to a sector which has secular growth and appears attractively valued relative to the wider equity market.

International Biotechnology Trust (IBT) aims to deliver a combination of strong capital growth and consistent dividend income by investing in biotechnology companies – both public (listed) and private (unlisted). The team behind the trust is SV Health Managers LLP (SVM), part of SV Health Investors (SVH), a specialist asset manager with long and extensive experience in the space. The unlisted exposure, together with the actively managed approach to public market investments – encompassing large profitable companies as well as smaller ones at a developmental stage – mean IBT is unique in the AIC’s Biotechnology & Healthcare sector.

The US political environment has an important influence on many sectors, and biotechnology (and healthcare) is no different. With Joe Biden’s position as President-elect now undisputed (aside from one person…), we met up with the team to discuss the implications of a Democratic President, the portfolio as it now stands and their outlook. The public equities team at SVH constitutes a team of three dedicated investment professionals, led by Carl Harald Janson. The team believes that double-digit annual returns are achievable from the biotechnology sector over the long term. They take a measured approach to investment, backed by identifying clear medical need and understanding the science and industrial processes behind product research.

As we discuss in the Performance section, the biotechnology sector as a whole has de-rated relative to broader equity markets since its peak five years ago; when Hilary Clinton tweeted on drug pricing during the 2015 election race. The prospect of Bernie Sanders or Elizabeth Warren – who also promised a hard line on healthcare pricing as Democratic presidential candidates - have also held back the market. This has seen the S&P Healthcare P/E fall to a 30% discount to the S&P 500 during 2020, a position it last reached in 2009 and prior to that in 2003. Indeed, the largest capitalization stocks in the benchmark are on P/Es of around half that of the S&P 500. The managers believe that whilst it is still not clear what a Biden presidency will mean for the sector, several factors mean that from a regulatory perspective, the sentiment towards the sector is likely to improve. Firstly, with Congress broadly balanced between the two political parties, yet still in the hands of the Republicans, the chance of a very significant change to policy is less likely. Secondly, the COVID-19 pandemic has illustrated to politicians and the public that, whilst the drug pricing issue hasn’t diminished, there is a need to ensure an environment that stimulates innovation in healthcare.

This means that the managers are cautiously optimistic, reflected in the current positioning of the portfolio. The public equities part of the portfolio represents 89% of NAV, and as the chart below shows, just under half of the total portfolio is invested in large caps – which on a historical P/E basis the managers believe is attractively valued. These companies offer a unique exposure to long term secular growth trend backed by global demographic patterns. Innovation, as measured by the number of drugs in development has continued to increase year on year meaning the pipeline of these companies has never been stronger.

The large cap exposure of the trust is complemented by exposure to private biotechnology investments through a venture capital fund run by SV Health (although there are some directly held investments that will be run off). These investments are at a much earlier stage in their maturity, and offer the potential for explosive growth. As we discuss in the Performance section, this area of the portfolio has been performing very strongly recently amid a fertile investment environment for early stage companies.

Currently IBT’s portfolio has 71 direct investments, of which 65 are publicly listed. The private investments are made by the team led by Kate Bingham. Since September 2016 all new private investments have come through the venture fund – SV Life Sciences Fund VI. Existing direct investments (of which there are six holdings, or 4% of NAV as at 31 October 2020 will continue to be run, and future commitments made to venture funds so that unquoted investments remain within a 5% to 15% range. From a portfolio management perspective, the team tries to maintain exposure to a range of different therapeutic areas, although the exposure to any one area is a result purely of bottom up stock selection choices. Currently the portfolio has the highest exposures to rare diseases (30%), oncology (25%) and the central nervous system (CNS) (18%). The top ten, and their respective subsector can be seen in the table below.

Source: SV Health Managers LLP, as at 31/10/2020

The management team are benchmark agnostic, and only select companies meeting a strict criteria. This includes only those that solve an unmet medical need, have strong pricing power for products, and have experienced management and financial strength. Companies’ intellectual property rights and/or regulatory protection should also be strong. From an investing perspective, the team prefers companies which offer liquidity in terms of the trading of its allocation, but which also make sense from a valuation perspective – which is behind the current high weighting to large caps. Many of the characteristics that the managers target also make these companies attractive targets for M&A. Within the biotechnology sector, M&A has been a persistent tailwind for valuations, and it is a well-established path for smaller biotechnology companies to be taken over by larger ones or by pharmaceutical companies.

A consistent and important differentiator to peers is that the team prefers to reduce exposure to specific clinical trial results ahead of scheduled announcements. As has proven to be the case over time (see Performance section), this risk management tool within the investment process has helped the team deliver a lower volatility return stream than the benchmark but also enabled IBT to outperform over the longer term. A key component of implementing this strategy is that the underlying companies are liquid, or at least liquid enough to allow the team to actively trade the portfolio constituents as discussed above. The trust is in a sweet spot in this regard, with net assets of c. £330m, making it nimble yet not too small for most investors to consider it.

IBT has a flexible multicurrency gearing facility of £55m. When employed, this attracts an interest rate of 1.75% above the relevant base rate. The gearing is used tactically. The team aims to build up gearing after a market pullback and when volatility is high. That said, they keep a macro overview. As the graph below shows, the trust has generally employed a little gearing more often than not. In January, when the team recognised that the virus was likely to evolve into a pandemic, they reduced the gearing to a cash position. Going into the US presidential election, IBT had net cash of 2% (i.e. no gearing), reflective of the team’s desire to avoid binary event risk. Now that we have more visibility on the next US President, it is therefore not surprising to see that IBT is once again modestly geared. The articles of association allow the trust to gear up to a maximum of 30%, but the current facility – if fully drawn – would equate to 16.8% of NAV.

One attraction of the biotechnology sector is its potential to deliver strong capital growth to investors over the long term. The experience of IBT over the past ten years is illustrative (although it is worth noting that the current management team only took over in 2013). As the graph below shows, IBT, the biotechnology sector and the Morningstar investment trusts peer group have outperformed wider equity markets (even the S&P 500) by a significant margin over this time.

As we discuss in the Portfolio section, the managers believe that now is a good time to look at this sector. With the uncertainty of the US election now over, large cap biotechnology stocks are trading at historically low P/E multiples relative to the wider equity market (represented by the S&P 500 ETF in the graph below). IBT’s managers believe that this will set them up for a strong period of relative returns in coming years. This is illustrated in the graph below, showing the Nasdaq Biotechnology ETF (representing an investable equivalent of the biotechnology sector) and IBT having lagged the S&P 500 over five years. That said, IBT has outperformed its benchmark, having delivered an NAV total return of 61.6% (to 02/12/2020), compared to the iShares Nasdaq Biotechnology ETF return of 47.9%. We view comparing returns against Morningstar’s sector average as not particularly meaningful, given it is dominated by two very large trusts with very different risk and return objectives (Syncona and Worldwide Heathcare).

As we discuss in the Portfolio section, IBT is exposed to a long-term secular growth theme, but in a sector that is trading significantly cheaper on a P/E basis than wider equities. In our view, it is these characteristics that have enabled the trust to outperform wider equity markets since the market lows. We show the performance during 2020 in the graph below. Aside from being the start of the broad recovery, April was significant because it was when Joe Biden became the presumptive Democratic nominee (Bernie Sanders - seen as more likely to take a harder line on healthcare reform - suspended his campaign). In a strong market for equities generally, it is notable that the biotechnology sector outperformed, and since August IBT has pulled strongly ahead of the benchmark. A contributor to returns over this period has been the unquoted portfolio, which saw a 16.6% valuation gain in the SV Fund VI over the quarter to 31/08/2020 (incorporated in the trust’s NAV as at 18/11/2020). The SV Life Sciences Fund VI was c. 7% of NAV as at 30/10/2020. Its average investment has a currency-adjusted internal rate of return (IRR) of 21.0% per annum, as at 31/08/2020 and since inception of the fund.

In our view, IBT’s strong performance relative to the broad market this year needs to be seen in the context of the previous five years, which has seen the sector lag over this period. This ties in with the managers’ view that the sector is undervalued on a relative basis as well as its own history, and is perhaps due a period of catch-up. Certainly its attributes of strong, long-term prospective growth and an undemanding valuation make it, in our view, a differentiated growth story to the technology sector which has led the market over so many years.

As we discuss in the Portfolio section, the managers aim to reduce the inherent volatility in the sector through diversification, but also through reducing stock-specific risk ahead of a stock moving event such as the results of a clinical trial. This means that over time, active management has enabled IBT to demonstrate lower volatility and beta than the Nasdaq Biotechnology Index, whilst providing higher returns, as illustrated in the table below.

Source: Morningstar, five years to 24/06/2020

IBT’s dividend was introduced in 2016, with the first payment being made in the 2017 financial year. The board has committed to paying 4% of NAV each year as a dividend from capital, and so the distribution will vary in accordance with the capital value of the trust. The 4% is calculated on the NAV as at the last day of the preceding financial year (31 August), through two semi-annual distributions.

So far, as shown in the graph below, the dividend has seen a positive growth trajectory (other than in the last financial year). This is purely a result of mathematics, given that it is based entirely on the NAV at a single point in each year. It is therefore worth noting that if the NAV in any August is below that of the previous year, then shareholders should expect a lower dividend in that year. With regard to the current year, the board announced on 15 December 2020 an interim dividend of 14.2p per share to be paid on 29 January 2021. Assuming the same amount is paid for the second interim dividend, this represents a yield of 3.5% at the current price.

The consistency of the dividend remains a key element of the attractions of IBT, in our view. As this year has shown, the fact that the dividend is paid from capital means that it is not subject to the same pressures as dividends paid from current earnings. Secondly, the level of the dividend is attractive relative to other equity income sources and gives investors who require an income a very different underlying exposure than the usual equity income funds. As such, IBT offers such investors valuable diversification, without the need to accept a lower income.

SV Health Managers LLP (SVM) is the manager of IBT, and is part of SV Health Investors (SVH), a specialist asset manager which is focussed entirely on the healthcare sector. SVH has offices in London and Boston, and has assets under management of $2.4bn as at 30 June 2020, overseen by over 55 investment professionals. A large part of SVH’s mandates are aimed towards unlisted companies. The public (listed) equities strategy is helped by the experience and depth of medical and scientific knowledge within the unlisted team, which SVM sees as a key edge over the competition.

Carl Harald Janson leads the public equities team at SV Health Managers LLP. He took over management of the trust in September 2013, and is supported by Ailsa Craig and Marek Poszepczynski. Kate Bingham leads IBT’s investments in unquoted businesses. Carl Harald is a qualified medical doctor who practised for four years. He has a PhD in immuno-oncology and has run biotechnology portfolios for 15 years, meaning that he brings relevant experience from the medical profession, research field and investment management to the role. Carl Harald has a personal investment in the trust, as do other members of the management team, which we think adds ‘stickiness’ to the management structure.

The team place a high emphasis on direct contact with target companies and existing investments’ management teams, and as a rule of thumb insist on interfacing with the management of portfolio companies at least once a year. This is usually done by directly arranged teleconferences or face-to-face meetings, the majority of these meetings taking place in the US, Europe or the UK.

The introduction of a dividend has led to significantly improved demand for IBT’s shares and encouraged a more diverse shareholder base. As we discuss in the Dividend section, IBT offers income investors an attractive level of dividend, but also an overall exposure very different to that offered by most equity income funds or trusts. Since 2016, when the dividend policy was introduced, IBT has regularly traded at a premium. This has enabled IBT to issue shares, helping to reduce the OCF, as the fixed costs of running the trust are spread over a wider asset base. As a result of new shareholders investing in the trust, no single investor (or investment group) owns more than 10% of the shares. Notably, the percentage of the trust owned through retail platforms has increased, and as a result the liquidity of the shares (as measured by the average daily trading volume) has increased.

The graph below shows the history of the discount and premium, compared to the peer group average. As we highlight in the Performance section, comparisons with the AIC peer group average are not particularly meaningful given the dominance of Syncona, which trades at a significant premium to NAV and so skews the average. That said, IBT offers an exposure to the biotechnology sector without a hefty premium to NAV attached. The risks of paying a significant premium are illustrated in Q1 2020, when liquidity in the entire investment trust market dried up, and saw significant discounts appear. During the volatility, the board did make some purchases of shares, marking the first period of buybacks since September 2016. We believe that this is encouraging and shows that the board remains engaged in protecting investors (in as much as it is able) from discount volatility. Since then, the shares have regained their poise, and IBT has been a regular issuer of shares since the start of October 2020.

IBT has ongoing charges of 1.3%, in line with the sector simple average of 1.32%. We believe that this cost should be considered within the context of the unique investment strategy which encompasses an unquoted exposure, which typically attracts higher fees.

In common with most trusts in the sector, there is a performance fee. On the quoted stocks, the managers are entitled to 10% of the outperformance of the Nasdaq Biotechnology Index, with a hurdle of 0.5% p.a. above the index. Any underperformance is carried forward for three years and set off against any fee payable in those future years. On the unquoted portfolio, 20% is payable on the net realised gains less unrealised losses. There is a cap of 2% of net assets on the overall performance fee payable in any one year, as well as a high watermark provision. A double layer of fees is not charged on the investment in SV Life Sciences Fund VI.

IBT’s most recent KID RIY figure is 1.90%, including 0.15% of historical performance fees.

ESG considerations are an increasingly relevant factor for fund investors. We understand that the managers do not currently take ESG elements into consideration in the investment process. This (perhaps) shows up in the Morningstar Sustainability Rating, which is “below average”. As such, for strict ESG investors, IBT is unlikely to appeal to them.

That said, from a top-down thematic perspective, the biotechnology sector is clearly in the forefront of research and development to alleviate illness or cure sick people. This is a clear positive for society. The healthcare sector in general has an implicit contract with policymakers and consumers. Periods of patent exclusivity incentivise the industry to find new drugs which treat unmet needs but, once those patents expire, these new therapies are often available as low-cost generic drugs in perpetuity – providing a long-lasting legacy for society as a whole. As we discuss in the Portfolio section, the types of company that the team invest in are very far from the relatively few ‘gougers’ who attract much of the negative headlines in this space. It is also worth noting that the team do not tend to invest in cosmetics (Botox and similar) or animal products, and they have avoided companies in the Fentanyl/Opioid universe. As such, from a thematic view, an investment in IBT arguably leaves the world a better place.