Best foot forward

Anyone with exposure to growth stocks will be aware of the bumpy start that they’ve had in 2022 and those with exposure to technology, in particular, will be acutely aware of their changing fortunes.

We saw a staggering performance for some of the best known technology names during the pandemic – Amazon tripled its previous year’s profits in 2020, and then handed on the baton in 2021 to Apple, Microsoft and Alphabet which delivered 34%, 51% and 65% respectively.

But after finishing last year 23% up, the NASDAQ composite index, perhaps the best known of the ‘tech focused’ market indices, has fallen relentlessly since the start of 2022.

Biotechnology companies, despite seeming to be an obvious beneficiary of the global pandemic and the focus this has placed on healthcare across the world, have fared even worse. Last year the NASDAQ Biotechnology Index delivered just 0.94% and since the start of 2022 the index is also significantly down.

Much of the recent weakness in these stocks stems from the growing threat of inflation. Growth companies in the biotechnology sector typically have higher expenses when it comes to getting their products to market – whether that be the cost of R&D or the cost of setting up new supply chains or capital equipment – and rising inflation causes those costs to rise, eroding margins. At the same time, interest rates going up – to counter inflation – can put a dent in future earnings estimates.

So far, so sensible, but what does that mean for those seeking growth from their portfolio? Given that inflation looks far from ‘transient’ as we were first promised, is it time to abandon the pursuit of growth for the time being?

Quite the opposite, according to the team at International Biotechnology (IBT), who think rumours of the death of growth have been greatly exaggerated.

Biotech investing is by nature cyclical; investor reactions tend to be exaggerated both on the upside as well as downside, but not so the sector fundamentals.  Disease and the requirement for medical treatments along with the pace of scientific innovation continue largely undeterred by economic or political factors.  IBT as a long-term investor has seen this type of stock market volatility in the 2000 dot.com hype, the 2008 financial crisis and again in 2015 when presidential hopeful Hillary Clinton was aiming to curtail free drug-pricing in the US, but, over this period, many new treatments for unmet medical need have been developed, and new, successful, innovative companies have joined the sector.  Most recently, investors have been experiencing the Biotech “Covid correction” and IBT’s managers, Ailsa Craig and Marek Poszepczynski, are hopeful that another volatile investment cycle is nearing its bottom.  

As we discussed in our blog in March last year our view was that valuations for the smaller, early stage and thus interest rate sensitive biotech stocks had become overheated and disconnected from company fundamentals.

We also highlighted the short to medium term risk of inflation, which played out as the global supply chain failed to keep pace with the global economic recovery which created bottlenecks and consequential inflation pressures leading to increased interest rates.

Having shifted IBT’s portfolio to larger cap names in the first half of 2021, characterised by proven sales and revenue track records, they were insulated from the full force of the sharp correction among the smaller cap companies during the second half of the year.

Since then IBT has been taking advantage of increasingly battered valuations lower down the market cap scale, and has shifted the portfolio away from the largest biotech companies, boosting its exposure to smaller companies from less than 5% of the quoted portfolio in January 2021 to nearer 15% a year later.

At the same time IBT, which uses gearing tactically but conservatively, has increased its firepower by increasing its gearing level.  Gearing – money which is borrowed from a bank to add to the funds provided by shareholders – can magnify downside but the obvious intention is for it to enhance any upside, and this stance is a reflection of the managers’ optimism for the year ahead.

“We believe that 2022 represents an interesting entry point and, with valuations falling, we anticipate bigger pharma and biotech companies taking the opportunity to acquire great science at lower prices.”  IBT has seen four companies in its portfolio being acquired since the start of its fiscal year on Sept 1, another signal that the sector is ripe for recovery.

“Taking the XBI index as a proxy for the biotech sector, it is currently trading pretty much back where it was in 2015 and 2018, in spite of the value creating events over that period characterised by significant scientific advancements, new drug approvals and continuing demographic expansion. This brings us to the conclusion that valuations are not, on the whole, currently expensive (and certainly a lot better value than this time last year) and makes us optimistic about M&A on top of our expectation of continued strong fundamental drivers in the sector of innovation and demand for the sector’s products.”

While they are in bullish mode, the team at IBT retains a keen eye on risk controls – which are essential in such a potentially volatile sector. As they’ve moved down the market cap scale they have also increased the number of holdings in the portfolio, which helps to diversify single stock risk.

They are also sticking to their knitting when it comes to reducing exposure to key risk events such as clinical trials. As we have discussed in previous coverage of the trust, the team would prefer to lower their exposure and forsake some of the potential upside from a stock by selling it well before a clinical trial read out and buying back in if it is considered successful.  The propensity for investors to speculate on a trial success tends to drive an anticipatory price rise which IBT can take advantage of, before reducing its position ahead of the news coming out in order to minimise the potential scorching effect a trial failure can have on share prices.

Against this exciting backdrop, the big question remains – what about inflation? The team at IBT has been thinking hard about this, too. Key to their solution is the nature of the companies they prefer – focussing on companies which have moved beyond the cash burning pre-clinical or early-clinical stages, so are less vulnerable to the decay caused by inflation and less likely to have to refinance at unfavourable rates.

“We have been avoiding companies which are at pre-clinical or very early clinical stage, the time point where they require longer studies and carry an intrinsically lower probability of success,” says Marek. “Instead we are focusing on companies that are now in the revenue growth phase, where the majority of capital investment has already been made and the costs have already been borne.”

Biotechnology is a volatile sector, and even more so during volatile periods for the broader market but, in an ageing and richer world with ever more complex health requirements, this troubled time for tech investors could be an attractive entry point in biotech for those who share the team’s excitement about the sector’s long-term outlook.

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