Biotechnology sector in 2016

The biotechnology sector has undergone a very hefty correction from the start of 2016. Investor positioning is somewhat to blame as, at least in the US, investors were rather well invested in biotechnology. The very mediatized and polarizing US presidential election campaign with numerous attacks on the level of drug prices in the US acted as the trigger while general liquidity in equity markets (or rather, the lack of it) exaggerated the move. Some green shoots in terms of commodity/energy sector performance started a tentative sector rotation into selected value sectors and names, again compounding the problem.

We see the sell off as hugely exaggerated with the caveat that the political comments on drug pricing will persist for some time but this is to be expected. In all fairness, it has been “open bar” in terms of drug prices for many years hence some reasonable push back is even to be applauded from an ethical stand point. We think that in the end drug prices will remain at levels where investors can make a decent return on the risks they have been taking while funding biotechnology research. No politician, whatever his allegiance, wants to stop the on-going amazing innovation. Do we really want the emerging immune-oncology miracle to stop now that it starts delivering? Will we tell the 70 year old patient who loses his eyesight due to macular degeneration that we cannot do anything for him despite good pipelines? Sensible discussions on drug pricing are needed, not harsh rhetoric. After all, drug prices are only 10-15% of all health care spending and many drugs keep people out of hospital for some time and hence help the system save money.

We think the sector will recover but this recovery will be volatile and any timing is difficult to forecast. Valuations are very interesting, with the mega-cap biotechnology P/E’s well below the P/E of the S&P500 now, something almost unheard of in the history of the sector. Earnings are great and pipelines are full, in fact there is so much innovation that even specialist investors are having trouble identifying the next winners amongst all those interesting drugs. And the FDA is very constructive, with 45 approvals of drugs (many of them biotechnology drugs) during 2015.

How did we react?

We have a higher weighting now than before in the mega-cap biotechnology names like Celgene and Biogen, as those stocks as a group are holding up much better. We refrain from putting meaningful money into those pharmaceutical companies that have a major biotechnology component like Roche or Bristol Meyers, as we find the valuation of many smaller and mid cap biotechnology names extremely low and hence it seems too late, at least on any longer term view, to make the fund ultra-defensive. In this environment of indiscriminate selling, it is almost impossible to stay out of the rain and to differentiate meaningfully. The sector enjoyed a huge performance over the years but has often also undergone severe corrections (this is why we position this as a satellite strategy) but each time it emerged strongly from those corrections. It is odd that this correction happens at a time when innovation is really at its best. The political news flow on drug prices started in 2014 (in fact, those discussions have been around since the 1990’s) and the sector had resisted well until end of 2015. On no new news, the correction seems really aggressive.

Correlation with markets

The biotechnology sector has, over longer periods, always had reasonably low correlation with equity in general. This correlation has recently however gone up and this is in part because the sector is well owned by many generalists in the US. Also, given the success of the sector and the market weight of the mega-capitalisation biotech stocks, their direct influence on the NASDAQ index has risen and again this pushes correlations. This usually happens in terms of general market stress, like in the post 2000 market correction where biotechnology moved in sync with the negative markets for a long time. The sector was then also pretty well owned by generalist investors. During the 2006-2008 commodity bubble biotechnology obviously was overlooked and less correlated, and started to perform once the commodity cycle turned. In the end, earnings drive share prices and, bar extremely restrictive political actions on drug pricing, the earnings picture and long term outlook of biotechnology is strong.

Valuations are very supportive

The 5 mega-capitalisation names in the sector have indeed never been so cheap and once in the commercial stage, biotechnology companies can indeed earn hefty profits and free cash flow. Balance sheets of the big names are in an excellent shape with hardly any debt and in many cases nice surplus cash. Smaller companies are, in general at least, also rather well capitalized compared to earlier sector corrections and for a lot of companies the cash lasts until well into 2017 and even 2018. Because of this, they can continue the progress their clinical programs and gather scientific data that will allow for partnerships or at least will help to overcome the difficult equity market and raise new cash on better terms than what current share prices would allow for.

Conclusion

This is again one of those unpredictable and violent corrections that the biotechnology sector unfortunately undergoes from time to time. Innovation is there and pipelines are great, more drugs get approved than at any time point since 1996. We see an sensible solution to the political debate on drug pricing and valuations are surely not high on consensus data. Our fund is extremely well ranked amongst the peers even on 3, 5 and 10 year timeframes. We strongly believe in the sector and have been expanding the team with highly qualified analysts, a sign of confidence on the long term outlook for the sector.