After a disappointing performance in the first half of 2018, healthcare stocks headed north in the third quarter and the Nasdaq Biotechnology index gained 11.2 per cent.
The life sciences tools and services, medical technology and healthcare services sub-sectors were particularly strong performers.
The index rally, however, was followed by a severe drawdown in October, erasing all of these gains and more, before a bounce at the start of November brought prices back to where they were at the end of June.
Prior to that volatility, the third quarter saw innovation leaders in the drug industry benefit from new regulatory guidelines. US regulators are increasing their oversight of trading partners in the pharmaceutical supply chain, and Wall Street (or biotech stocks at least) welcomed the news.
There was a positive flow of capital into the biotech sector during the third quarter, after at least a year of outflows. Renewed investor appetite encouraged initial public offerings and secondary placements.
Yet most investors in the sector continued to show a preference for short-term investment strategies. Positive news events precipitated brisk upward trading, whereas arguably minor setbacks led to even sharper downward moves. Employing a longer-term, value-based strategy, coupled with continuous portfolio rebalancing, is a wiser bet in our view.
New ideas
Next-generation drugs offer a host of compelling investment opportunities, which means it might make sense to look more closely at small and mid caps rather than large caps. It is in this area that novel treatment modalities and approaches are more common.
Such investors are gradually shifting their focus from classic pharmaceutical chemistry and recombinant protein therapies to sophisticated antibodies, RNA-based therapeutic agents, and gene and cell-based therapies. Some of these novel treatment avenues have shown lasting benefits that improve treatment outcomes and produce greater economic value relative to older methods.
We anticipate significant growth for RNA-based drugs in a manner that could transform the drugs industry. Janssen’s recently announced huge investment in Arrowhead Pharmaceuticals’ RNAI technology supports this claim.
Also of increasing interest to the market are firms specialising in neurological disorders that are seeking to treat conditions affecting large patient populations.
From the perspective of our own portfolio, longstanding holdings such as Celgene, Gilead and Novo Nordisk have made an outstanding contribution to portfolio performance over the years, but looking ahead these bellwether stocks are likely to relinquish their status as pre-eminent growth drivers.
As a result we used the third quarter to focus on profit taking, and opted to reinvest the proceeds in small and mid-cap stocks in line with what we believe will be a shift in market dynamics. The total number of stocks in our portfolio now stands at 34.
Outlook
Despite the recent indiscriminate sell-off, we believe that selected names can continue to attract the interest of investors during the final quarter of 2018 and well into 2019. Part of the reason for this is that multiple, late-stage clinical trial results and product approvals are expected to take place over this period.
Separately, as the market capitalisations of large pharmaceutical companies grow, merger and acquisition activity may well pick up again. These giant businesses are likely to only acquire best-of-breed biotech firms, in a bid to establish themselves in these areas of the market.
Daniel Koller is head of the investment team at BB Biotech
