One of the few winners on the back of the Covid-19 pandemic, the case for investing in biotechnology is a strong one.
These companies are helping us live longer by bringing new drugs to market to tackle the likes of cancer, heart disease and obesity.
The tailwinds are immense – biotech companies differ from pharmaceuticals in that they focus on the innovative side of healthcare, with the sector now responsible for the top 10 selling drugs globally.
Covid has brought the sector centre stage, but in reality the pandemic has been a catalyst for highlighting the longer-term growth in biotech.
From 2011 to 2021, the Nasdaq Biotechnology Index more than trebled in number to 373 US-listed biotechnology companies valued at more than US$1.65tn from 119 companies with a combined capitalisation of US$355bn.
Detractors say biotech is heavily driven by sentiment and tends to move in quite extreme cycles, depending on whether it is in favour or not.
Drug pricing tends to be a constant political football that comes up every few years (around US elections) and can dent the whole sector.
For this reason biotech funds can be volatile and tend to be high-beta vehicles – although there can also be periods where their performance differs greatly from the wider stock market.
We have seen this in the past couple of years when the sector has significantly underperformed global equities (2 per cent versus 15 per cent).
Will 2023 be a strong year for the sector?
But there is hope on the horizon in 2023 as attractive valuations, coupled with strong data and an improving regulatory environment, offer support to these longer-term tailwinds.
Janus Henderson portfolio manager Andy Acker says biotech delivered a significant amount of positive clinical trial data in 2022 for diseases such as Alzheimer’s, pneumonia and dry age-related macular degeneration – a leading cause of blindness in the elderly.
He says this could feed into a stronger 2023 – we could see a number of new approvals and launches – with the Food and Drug Administration having some 75 potential new drug approvals pending this year.
“One thing that we did see last year was that because we had just been through an 18-month bear market in biotech, many of the valuations in this sector were extremely depressed.
"And so then, when a company came out with positive clinical data and investors could appreciate the market potential of those drugs, we saw very substantial stock reactions.
"Because the valuations were so depressed and because the innovation was so high, I think that made for a very attractive risk/reward," he says.
To put this into context, a drug typically goes through three trial phases before being considered as an effective medical treatment.
The average probability of success (to approval) is about 10 per cent at phase one; around 20 per cent at phase two; and around 50 per cent at phase three – however there are marked difference in each therapeutic area.
It is also important to note that regulators like the FDA have sped up the approval rate – for example, Moderna’s vaccine was able to progress from understanding the genetics of the virus to human trials within a record 63 days – it historically takes around four years.
More than just high risk/high reward
Importantly, the sector is evolving to the point where investors could look to it as more of a core holding in the future.
In addition to blockbuster drugs, more recently we have seen the likes of advanced therapeutic modalities, such as RNA-based drugs, as well as gene and cell-based therapies investigated with a reasonable amount of success.
This blossoming of the sector has also seen its construction change significantly.
Back in 2018, around 80 per cent of the industry consisted of companies with a market cap of less than $1bn (£14.8bn), many of which were relying on a single drug being approved to survive.
Now there is a number of large-cap lower-growth companies, which are both highly profitable and cash generative, as well as a number of mid-caps, which are either at/approaching profitability and are strong commercial entities.
AXA Framlington Biotech manager Linden Thomson says that alongside growth, the sector also offers a number of defensive characteristics.
She says: “Commercially they are typically less dependent on economic cycles, as there will always be a need for medicines and healthcare as well as breakthrough drugs to treat existing or new conditions.
"We are seeing this now as biopharma companies report robust quarterly financials in more challenging economic conditions.”
There is also a level of intellectual property protection – if a drug does pass testing it is patented, meaning it rarely faces competition at launch.
The other point I would highlight is many large pharmaceutical firms have started looking in more detail at these firms with a view to potential merger and acquisition activity.
It is hard to ignore the positives. The long-term trends of ageing populations and a rising middle class mean new drugs will be both in demand and affordable in the future.
The sector is also showing signs of maturation – making it a more attractive core holding in challenging periods. There will be major opportunities for talented active managers.
You could argue there are some similarities with the tech sector in the past. We will see companies fail and there will be challenging periods – but ultimately, if you can stomach the risk, the long-term rewards are there: a 730 per cent return over the past 20 years is testament to that.
Funds to choose from
AXA Framlington Biotech – the sector specialist
While the sector is evolving at a rate of knots, it continues to be led by high-end science.
It requires a specialist, focused team with skills, experience, and a network to keep up with these changes. That is exactly what manager Linden Thomson and her team offer.
The final portfolio will typically consist of around 50 stocks across the market cap, with a focus on quality/later-stage opportunities that have a greater chance of making it to market.
Polar Capital Global Healthcare Trust – the diversified approach
This trust invests in healthcare stocks from around the globe.
These companies will predominantly come from four sub-sectors: pharmaceuticals, biotechnology, medical technology, and healthcare services.
The portfolio is split into two segments: growth and innovation with a circa 90/10 split.
The growth element is made up of predominantly larger companies, whereas the innovation pot will invest into medium and smaller companies that have the potential for greater growth in the long run.
Scottish Mortgage Investment Trust – the stock picker
The managers of this trust aim to identify businesses that have the potential to disrupt their own industries, with sustainable business models in excess of five years.
As a result, the portfolio tends to have a relatively high allocation to technology and healthcare companies.
The trust currently has biotech firms Moderna (9.4 per cent) and Illumina (3.6 per cent) among its top five holdings.
Darius McDermott is managing director of Chelsea Financial Services and FundCalibre
