The middle ground is not middle of the road in biotechnology

Biotechnology is an unabashedly growth-oriented sector. And with this in mind, it is often excessively punished in market downturns, usually following a period of basking in the sun.

The market was especially overheated in mid-2021, when the pernicious low-growth environment and the post-COVID lockdown bounce both contributed to a boom time for companies that can be reliant on financing. Since then, it hit lows in May and June 2022.

This is a cycle that the managers of International Biotechnology Trust (IBT), Ailsa Craig and Marek Poszepczynski are well aware of. With over 35 years’ experience in the sector between them, they have each worked and invested through several of these cycles. With that in mind, they approach biotechnology investing with a more skeptical eye than is sometimes applied by the broader market.

In practice, this meant they steered clear of buying innovative assets for the sake of it as the market soared into 2021, when certain companies with products that had not yet even been trialed on humans (and therefore were well shy of being approved and on the market) were attracting valuations in excess of billions in market cap.  

On the other hand, they understand the fundamental value available within biotechnology and have been taking advantage of the sell-off since those toppy valuations tumbled, because, as with all sell-offs, biotechnology’s 2022 was relatively indiscriminate as often is the case for the sector.

It is true that the biotechnology market can contain exploratory, early stage names dependent on financing for testing and bringing product to market. It is also true that it contains large-cap names, that can rely on finance-fueled acquisitions to grow. But, Ailsa and Marek point out, there is a middle-ground of companies, with sound financials and a compelling go-to-market proposition that has been tarred by a similar brush to these industry peers.

Over the past two-and-a-half years, they have increasingly focused their attentions on the mid-cap segment, focusing on businesses with assets that are considered ‘derisked’. This means that these companies’ drugs are approved, have strong growth but are still  yet to achieve their full revenue earning potential which in many instances is in the multi-billion dollar range. Crucially, the established niches in which these drugs are already selling means that these companies have cash flows to invest in future growth, rather than relying on external funding to grow.

A secondary compelling aspect of the mid-cap investment proposition is the potential for M&A. There is a big intellectual property (IP) expiry cliff looming over the next few years, when the patents restricting competition to many larger companies’ flagship drugs no longer apply. The market saw a similar such fall-off in 2012, which fuelled an M&A frenzy as big companies sought to replace the revenues lost from patent expiry. Indeed, Biohaven, Horizon Therapeutics and Seagen were three significant holdings for the trust that have been acquired in the last year.

This acquisitive lens is a factor in the team’s investment decisions. They say that while they are by no means value investors, they are valuation-sensitive, and that if a company is trading at a level that a big pharma company wouldn’t accept, they don’t either.

One example of Ailsa and Marek exercising this discipline was in the case of Biohaven. The company had a migraine drug, a compelling end market, and they liked its story. However, they sold it as they believed its valuation was overwrought. When the company made a licensing deal with Pfizer for European distribution, there was a significant sell-off in its stock as the market interpretation was a no M&A deal scenario, but Ailsa and Marek didn’t see the deal as being as detrimental as the market response suggested. As a result, they rebought the stock and subsequently benefitted from the acquisition by Pfizer which occurred six months after the original licensing deal was announced.

Biotechnology is undoubtedly a risky sector, with high beta and volatility at its heart. However, a diversified allocation to the sector can dampen these risks to some degree. In amongst the noise, there is growth to be found in an increasingly health-conscious world.

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