Biotech – dependable growth with a cyclical boost

The global biotech sector benefits from several fundamental tailwinds that look capable of driving structural growth for many years, if not decades, into the future. The increasingly complex demands of a growing but ageing population and the emergence of a higher income middle class in many rapidly developing economies, are likely to drive rising demand for healthcare services in general. Meanwhile, the confluence of advances being seen across scientific and technological disciplines is fuelling an unprecedented wave of innovation, delivering a constant supply of new investment opportunities in biotech companies with exciting products that can meet the evolving needs of patients globally.

These are consistent, reliable trends that underpin a secular global growth story in biotech and contribute towards its reputation as a sector that could deliver dependable long-term growth. From a relative perspective, biotech is much less exposed than many other industries to the slings and arrows of the global macroeconomy, but this does not mean that it is completely immune from cyclicality.

A cyclical investment environment

Although the biotech industry is relatively stable and growing, the investment cycles which surround it are not. Some investors like IBT, are fully committed to biotech, but many other investors tend to move in and out of the sector, depending on their risk appetite and prevailing sentiment. Inevitably, this contributes to volatility in observed valuations, and can lead to significant dispersions of price from fundamental value, in both directions. This drives an investment cycle that is illustrated below, which we have seen repeatedly during our long time investing in the sector.

Source: Schroders, 2023

The cycle starts with stage one, which is characterised by depressed valuations that generally don’t reflect the potential of companies. Typically, some biotech businesses will trade at a valuation below their cash position, which indicates the market ascribes zero future value to their products or services. Industry analysts will likely reflect this negativity with downgrades, and initial public offerings (IPOs) will be very rare events. Sentiment-driven investors exit, putting further pressure on valuations. Often only industry specialists like us typically see value at Stage 1, which tends to be fairly prolonged. It takes time for the biotech companies and their Boards to start to accept their rerating and begin discussions on M&A deals at prices lower than the lofty valuations of Stage 4.  The eventual deals then provide the necessary catalyst for the move into Stage 2.

Stage two is the start of the recovery phase. The low valuations, combined with Boards more willing to entertain lower offers, lure in the “cash-rich” pharma and big biotech companies, looking to replenish their product portfolios with bargain priced assets. An increase in merger & acquisition (M&A) activity ensues, typically conducted at a sizeable premium to the still-depressed prevailing share prices. This confirmation of acquirer appetite sends a signal to the market that the sector is, in aggregate, too cheap, and valuations start to rise.

Stage three is usually a longer phase of relative stability and growth, with regular M&A activity and a steady flow of reasonably valued IPOs. Investors with an appetite for risk may be tempted back in this stage, providing positive support for valuations and making it easier for companies to re-finance on reasonable terms.

As stage three gathers momentum, more and more investors become attracted back into the sector by positive performance and the steady stream of M&A. A point will be reached where valuations appear to reflect the sector’s growth potential more rationally, but equilibrium may be fleeting as the cycle progresses towards the euphoria of stage four. This is the boom period in which prices are driven up by the volume of new investors coming into the sector. Valuations start to exceed the potential of the underlying assets. IPOs become more numerous, as more private companies look to take advantage of the abundant capital, listing at an earlier stage of their development and on better terms than the option of staying private with M&A as an exit.

Inevitably, stage four is unsustainable, and it ultimately corrects in stage five. M&A deals dry up as pharma companies look for licencing deals rather than paying for over-valued assets. Many of the earlier stage companies become perceived as riskier, leading to re-financing problems. Investors take fright, leading to inevitable price declines. Disappointed and “late to the party” investors exit the sector, and the cycle returns to the drought of despair.

The interest rate cycle

Another important driver of cyclicality is the relationship between biotech valuations and interest rates. While several valuation cycles have existed over past few decades, investors have seen an incredibly long interest rate cycle, with thirty years of reductions followed by a decade of ultra-low rates. That all changed in 2022, with the return of inflation forcing central banks to aggressively raise interest rates to levels not seen since before the global financial crisis of 2007-09.

The length of this cycle perhaps led to a degree of market complacency about how biotech may be exposed to higher interest rates. As the chart below demonstrates, there is currently a very close inverse relationship between the sector’s performance (the white line, using a smaller cap biotech ETF as proxy) and the US 10-year Treasury yield (the blue line). This relationship was briefly disturbed in March 2023 by the collapse of SV Bank ­– a prominent bank used by many small cap biotech companies – but the two lines have since recoupled. Clearly, many other factors may have influenced performance, but the chart suggests that the biotech sector has been negatively impacted by higher interest rates.

Given the sector’s reliance on financing to develop assets through to approval and profitability, this relationship is not surprising. Debt finance is clearly more expensive now and higher interest rates have also impacted the availability of equity finance. 

Biotech trades inversely with the US interest rates

US long-term bond yields rose from 3.5% to 5% in 6 months, then fell back to 4%.

Source: Bloomberg, December 2023 . Past Performance is not a guide to future performance. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. Exchange rate changes may cause the value of any overseas investments to rise or fall.

Where are we now?

It may be too early to declare a decisive victory in the battle against inflation, but financial markets are beginning to conclude that we are reaching a peak in the current interest rate cycle. The Federal Reserve, European Central Bank and Bank of England all held interest rates after their most recent meetings, and inflation on both sides of the Atlantic has declined meaningfully in recent months.

While nobody knows precisely what will happen to inflation and interest rates in the months and years ahead, the relationship between the biotech sector and bond yields demonstrates why it is important for investors to focus on the financial strength and funding needs of individual biotech investment opportunities.

Dedicated biotech investors are able to find very well-financed businesses, built on terrific innovative technology, with enormous potential for the future. Importantly, these opportunities are currently available at attractive valuations, in part because of where we are in the biotech investment cycle.

Key to preserving capital, is knowing where the sector currently sits in this investment cycle. Investors who are committed to investing in biotech can shift between less risky, cash flow-generating, large biotech stocks, and higher beta development-stage biotech businesses, depending on where they believe they are in the cycle. Moreover, closed-ended Trusts like IBT can borrow money to invest in further investments, known as gearing, when biotech valuations look depressed.

The good news is that our analysis suggests we are currently well-placed in the investment cycle. The increased M&A activity in recent months provides strong evidence that the cycle has progressed through the stage two recovery phase and is on the cusp of entering stage three. The equilibrium stage is usually a relatively stable part of the cycle, so we have redeployed some of the recent profits from portfolio takeover activity and the additional funds borrowed in our gearing facility into development stage companies, that are often smaller and younger. We have seen a 34% rally in the development stage company dominated XBI index in the seven weeks to the 18th December in response to renewed optimism about the trajectory of interest rates. Even after this rally, the index remains half the value it was during the highs of 2021. With long-term secular growth trends currently being supported by cyclical investment tailwinds, we feel the current situation represents an attractive time for the biotech sector. The biotech sector's fundamentals remain strong, and we believe that IBT is well-positioned to capture its incredible long-term potential.

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International Biotechnology Trust plc Risk Considerations

Capital risk / distribution policy: As the Company intends to pay dividends regardless of its performance, a dividend may represent a return of part of the amount you invested.

Concentration risk: The Company's investments may be concentrated in a limited number of geographical regions, industry sectors, markets and/or individual positions. This may result in large changes in the value of the Company, both up or down.

Currency risk: The Company may lose value as a result of movements in foreign exchange rates, otherwise known as currency rates.

Gearing risk: The Company may borrow money to make further investments, this is known as gearing. Gearing will increase returns if the value of the investments purchased increase by more than the cost of borrowing, or reduce returns if they fail to do so. In falling markets, the whole of the value in that such investments could be lost, which would result in losses to the Company.

IBOR risk: The transition of the financial markets away from the use of interbank offered rates (IBORs) to alternative reference interest rates may impact the valuation of certain holdings and disrupt liquidity in certain instruments. This may impact the investment performance of the Company.

Liquidity risk: The price of shares in the Company is determined by market supply and demand, and this may be different to the net asset value of the Company. In difficult market conditions, investors may not be able to find a buyer for their shares or may not get back the amount that they originally invested. Certain investments of the Company, in particular the unquoted investments, may be less liquid and more difficult to value. In difficult market conditions, the Company may not be able to sell an investment for full value or at all and this could affect performance of the Company.

Market risk: The value of investments can go up and down and an investor may not get back the amount initially invested.

Operational risk: Operational processes, including those related to the safekeeping of assets, may fail. This may result in losses to the Company.

Performance risk: Investment objectives express an intended result but there is no guarantee that such a result will be achieved. Depending on market conditions and the macro economic environment, investment objectives may become more difficult to achieve.

Share price risk: The price of shares in the Company is determined by market supply and demand, and this may be different to the net asset value of the Company. This means the price may be volatile, meaning the price may go up and down to a greater extent in response to changes in demand.

Smaller companies risk: Smaller companies generally carry greater liquidity risk than larger companies, meaning they are harder to buy and sell, and they may also fluctuate in value to a greater extent.

Valuation risk: The valuation of some investments held by the Company may be performed on a less frequent basis than the valuation of the Company itself. In addition, it may be difficult to find appropriate pricing references for these investments. This difficulty may have an impact on the valuation of the Company and could lead to more volatility in the share price of the Company, meaning the price may go up and down to a greater extent.

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