Leading the pack

The fortunes of biotech companies have been distinctly Darwinian since their glory days in the pandemic. Free-flowing funding sparked a frenzy of investment in early-stage biotech companies but only a select few have justified their initial hype and others have struggled to survive.

A trifecta of dwindling investor appetite, stalling of the IPO market and the end of cheap debt funding has weighed on the biotech sector over the last two years. The Nasdaq Biotechnology Index (NBI) has fallen from its high of almost 5,500 in mid-2021 to settle around 4,000 for much of 2023, in contrast to the one-year gain of more than 40% in the Nasdaq Composite Index.

As a result, the biotech sector is trading at a significant discount to both its 10-year average price-earnings ratio and broader US indices. This shake-out has hit the smaller end of the spectrum particularly hard, with the number of small-cap firms that are trading below their balance sheet cash at historic highs.

Despite these headwinds, seasoned investors may view the downturn as a necessary correction of the heady valuations bestowed on unproven biotech companies during the pandemic. With a drought in equity and debt funding, the fight for survival has prompted a necessary exodus of the weaker businesses, ultimately creating a universe of higher quality companies, well-positioned to exploit secular growth trends.

It’s also worth remembering that the biotech investment environment is, by nature, cyclical and that a dip in valuations can provide an opportunity for investors to position themselves for an upturn. Biotech specialists International Biotechnology Trust (IBT) believe the sector is on the cusp of entering the ‘equilibrium’ stage of the cycle (where valuations rise on the back of an influx of capital) and has recently increased its gearing to c. 14% to exploit investment opportunities. A one-month increase of almost 9% in the NBI (as at 15/01/2024), as well as an increase of 10% over the same period in the small-cap dominated XBI biotech index, supports the managers’ view that the sector is well-positioned for a re-rating in valuation.

Biotech is also a sector that benefits from active management by specialists with the expertise to identify the likely winners in a risky and competitive market. IBT has outperformed its benchmark over one, three and five years, as well as significantly outperforming its biotech focused peers, delivering a five-year NAV return of 39.8% relative to 30.1% for the IT Biotechnology and Healthcare sector (as at 12/01/2024). The trust recently completed its move to Schroders where it is expected to benefit from being part of a broader investment trust platform.

Renewed M&A activity  

Subdued valuations in the biotech sector have prompted an upturn in M&A activity, which is expected to continue as large-cap pharma companies look to save money by outsourcing high-risk, early-stage R&D. With a forecasted $200 billion loss in annual revenue by 2030 due to patent expiries, the pharma giants have built significant acquisition war chests to plug these patent ‘cliffs’.  

IBT continues to benefit from takeovers of portfolio companies, with seven offers in the last calendar year alone. Returns were boosted by two of IBT’s largest holdings, Horizon and Seagen, being acquired at significant premiums of 48% and 35% respectively (to the closing share price prior to announcement). In addition, Novartis paid a premium of 67% on the acquisition of Chinook Therapeutics, bolstering its line-up of treatment for kidney disease.

During the downturn, managers Ailsa Craig and Marek Poszepczynski have focused principally on companies which have already completed the risky and costly clinical trials and have now obtained approval for, and launched, new drugs or have an approved drug on the cusp of being approved for a wider scope of patients. These ‘oven ready’ products are highly attractive to pharma companies due to their shorter runway to profitability and the potential synergies from leveraging development and distribution infrastructure. In anticipation of a stronger year for biotech, the managers are now building out their exposure to carefully selected earlier-stage names.  

The managers have several companies in their portfolio with characteristics which may also be attractive to an acquisitive pharmaceutical company, for example, the profitable cardiovascular company Cytokinetics, the early-stage oncology company Iovance and the revenue growth orphan disease company Krystal.  

Managing risk

As the biotech sector is subject to higher volatility than the broader market, Ailsa and Mark seek to preserve capital and manage downside risk for investors. One such approach is reducing exposure ahead of binary events such as the outcome of clinical trials. The managers are willing to pay a slightly higher price to rebuild their holdings at a lower risk-weighted valuation after positive news, in return for circumventing the potential adverse effect of a failure of clinical trials.

IBT also invests in a basket of companies targeting the same disease to diversify the risks inherent in developing new treatments, with this strategy being particularly important among earlier-stage companies. Portfolio companies Calliditas, Travere, Aurinia and Vera Therapeutics are developing treatments for kidney disease, while Intra-Cellular Therapies, Axsome Therapeutics, Xenon and Karuna Therapeutics are focused on drugs to treat mental health issues. Karuna has recently received a bid from Bristol Myers Squibb at a premium of 53% and several others are also possible acquisition targets.  

As mentioned earlier, revenue growth companies account for the largest share (42% by NAV as at 31/10/2023) of the portfolio, with just under a quarter of the portfolio invested in early-stage companies. There is also a diversified spread of market caps from mega-caps (over $30 billion) to small-caps (under $2 billion). The company has a small number of unquoted holdings, invested primarily in two venture capital funds which offer the potential for higher and differentiated returns to public markets.

The managers also tend to reduce transaction risk by reducing the trust’s exposure after takeover announcements if the price reflects the transaction valuation. This strategy proved beneficial in the case of Horizon and Seagen which faced delays and uncertainty due to scrutiny from regulators on both sides of the Atlantic.  

IBT’s conservative approach to risk management has proved beneficial, with the trust achieving a considerably lower one-year beta of 0.91 than the 1.04 average for the IT Biotech and Healthcare sector (as at 15/01/2024), meaning that the trust’s share price was less volatile than the sector. Ailsa and Marek have also proved their ability to navigate turbulent markets, achieving a NAV total return of 2.31% against a 0.85% fall for the NBI in 2023.

With an ageing population driving demand and ground-breaking innovation in life-enhancing treatments fueling supply, the biotech sector is likely to benefit from long-term secular growth. Although the biotech sector is inherently a higher risk sector, investors may see IBT’s current discount of c. 9% (as at 15/01/2024) as an attractive entry point to a trust which puts risk management at the forefront of its strategy.

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