The changing face of biotechnology

If you ask twenty investors what they think of a particular sector, you are likely to be greeted with twenty different responses. The role of the stock market is to find a consensus from that range of views, and its ‘invisible hand’ then sets prices accordingly.

We live in an ever-changing world, however, and sometimes industry dynamics can change faster than investor perceptions, creating opportunities for active investors to capture.

In the case of biotechnology, there’s a fair chance that such an investor survey would be smattered with phrases such as “high octane”, “early stage”, “funding dependent”, “binary outcomes” and “distant cashflows”. Some investors would be attracted to the high risk, potentially high reward, opportunity that is reflected in such statements. Others – arguably, the majority, given current sector valuations – would likely run a mile.

It is fair to say that the history of the biotech industry has influenced such views, particularly in the UK. But a key question for investors to consider is, are the current perceptions that are reflected in biotechnology sector valuations still relevant? Or has the industry matured positively in recent years, without investors really noticing?

The birth of biotech

From ancient Egyptian fermentation practices to the genetic experiments of Gregor Mendel in the 19th century, the roots of biotechnology can be traced back through many centuries. The 20th century saw crucial breakthroughs such as the unlocking of the secrets of DNA, and in the 1980s, biotech emerged on the stock market with the arrival of businesses such as Genentech and Amgen in the United States.

The origin of the sector as a stock market phenomenon involved a collection of very small companies coming to the public market to progress their cutting-edge drug discovery programmes. As the science was relatively new, the failure rate of these businesses was initially high and there were many high profile blow ups, mainly in the US but also in the UK. Undoubtedly, these early disappointments will have scarred many market participants, and to a large extent, modern investor perceptions are still influenced by those negative outcomes.

It is fair to say that, to this day, the failure rate remains high in early stage biotech, but as the industry has matured, success stories have become more frequent. Advances in technology, a deeper understanding of biology and improved research methodologies have all contributed to a steady decline in the failure rate over time, as has the evolution of regulatory frameworks, which provide clearer pathways for drug development. 

Biotech companies have taken over from “in house” R&D at big pharma companies.  IQVIA reported that less than 25% of the global drug pipeline was being developed in pharmaceutical companies in 2022, with small biotech companies responsible for over two thirds of new drugs¹ Pharmaceutical companies now plug their distribution pipelines with acquisitions of and licencing deals with biotech companies. 

Many of the original pioneers, including Amgen and Genentech (now part of Roche), have gone on to become very successful scaled businesses, with highly profitable drug franchises and their own distribution networks. And the share price appreciation they have enjoyed as their development pipelines have delivered has been extraordinary.

From a UK investor’s perspective, this evolution of the biotech sector may come as something of a surprise. That’s because the vast majority of the success stories have been concentrated in the US. Indeed, the Nasdaq Biotechnology Index (NBI) as a whole turned cash positive back in 2007, which demonstrates the very significant change that has occurred in US biotech over the years.

Regional differences

Part of the perception problem stems from the fact that, outside of the US, success stories have not been so numerous. The UK still does not have a poster child of a scaled commercial biotech business. Europe has seen some successes, such as Novo Nordisk and Genmab from Denmark, but the fragmented nature of the European market has made it hard for it to fully develop the ecosystem that is required to provide young biotech companies with everything they need to mature into scaled, commercial enterprises.

By contrast, the US has developed this infrastructure and know-how. It still takes time, but with thriving innovation hubs in places like Boston and the San Franscisco Bay area, the US has built the necessary financial, technical, scientific and human resource ecosystems to be able to support young biotech businesses through to maturity positively. In biological terms, the US biotech industry has developed the muscles for success.

Indeed, on many occasions, UK and European biotechs have felt compelled to migrate to the US to improve their chances of success, either through merger & acquisition (M&A) activity or through listing. For example, Cambridge-based GW Pharmaceuticals originally listed on London’s Alternative Investment Market (AIM) in 2001, and in 2013 it dual-listed on Nasdaq in the US. This gave it access to significantly more equity capital and the increased demand resulted in a valuation uplift of c. 30%. In 2016 it announced it would cancel its UK listing and, in 2021, it was acquired by Jazz Pharmaceuticals.

Playing to each region’s strengths

So, while US biotech has matured into an established market, the UK biotech sector remains early-stage and higher risk. With a strong academic pedigree and a history of innovation, the UK is exceptionally good at early-stage biotech and has a deserved reputation for cutting edge drug discovery in the global biotech ecosystem, but has not been able to convert early-stage promise into scaled, commercial reality independently.

UK investor perceptions are, inevitably, shaped by what’s on our doorsteps and what we hear about and read about in the domestic media. This potentially means that UK investors are less aware of the compelling biotech investment opportunity that has unfolded – and continues to unfold – in the US. In turn, this perhaps makes them more risk averse than they need to be when it comes to investing in biotech.

A potential solution for investors perhaps revolves around a strategy that harnesses the best of both worlds. As managers of International Biotechnology Trust plc (IBT), we would point to the important clue in its name. As the graphic below illustrates, while IBT is a UK listed investment trust, the vast majority of IBT’s assets are invested in the US, the clear epicentre of the biotech industry and the location of the vast majority of its historic success.

Where we are exposed to other parts of the world, it tends to be to attain exposure to particular parts of the biotech universe. For example, our venture fund investments account for less than 10% of IBT’s net asset value and are designed to provide broad exposure to earlier-stage unquoted biotech innovation. In this part of the portfolio, the geographic balance is very different, with nearly 50% of assets exposed to the UK, due to the UK’s world-class capabilities in early-stage biotech.

Source: Schroders as at 31 January 2024

Diversity of opportunity

To further illustrate the scale and diversity of US biotechnology, below we have sliced up the IBT portfolio into different market cap segments. Investors may perceive a biotech investment proposition as being dominated by small, lab-based companies, but clearly that is not the case. Indeed, when we talk about ‘small cap’ biotech, we are talking about businesses with a market cap of anything up to $2bn.

We believe it is worth having some exposure to exciting early-stage drug discovery through the venture portfolio, but this should be balanced by exposure to opportunities at a more advanced stage of development too. This allocation is not set in stone – as active investors, it can and does change over time as the opportunity set evolves.

The IBT portfolio currently has a sizeable exposure to small cap biotech, but almost two-thirds of it is invested in companies with a market cap of more than $2bn, most of which have an approved product on the market. Nearly a fifth is invested in what we categorise as “mega caps”, with a market cap in excess of $30bn. This segment includes the likes of Amgen and Gilead, which started small but are clearly now very substantial and successful businesses – shareholders have enjoyed that journey of long-term value creation.

Source: Schroders as at 31 January 2024

Conclusion

In the UK, investor perceptions of the biotech sector seem out-dated. It would perhaps be wrong to say the whole world has moved on, but without doubt, part of it, namely the US biotech sector, has changed beyond recognition over the last 20 years.

As professional investors, dedicated to the biotech sector, the opportunity set that we see today is more diverse than ever. We can still access smaller, early-stage drug discovery businesses, but we can also invest in very substantial, cash generative businesses. And there is a diverse spectrum of opportunity in between.

We divide the market into three categories of relative maturity – early stage (companies with drugs in development), revenue growth (companies whose drugs are approved but not yet turning a profit) and profitable, as illustrated below. Our intimate knowledge of the industry allows us to change the composition of the portfolio to suit where we are in the biotech investment cycle. If we become concerned about the outlook for the sector, we can shift emphasis towards the large, less risky, profitable biotech companies. Alternatively, when the outlook appears more benign, we can increase exposure towards higher-beta opportunities earlier in their drug development journey in the early stage and revenue growth categories.

Source: Schroders as at 31 January 2024

Importantly, we are currently tilting the portfolio towards the higher-beta, smaller biotech companies, because we are excited about what lies ahead in 2024 and beyond. With long-term secular growth trends currently being supported by cyclical investment tailwinds, we are confident about the outlook for the biotech sector, particularly in the US. As it has matured, the fundamentals of the US biotech investment proposition have continued to strengthen, and we believe that IBT is well-positioned to capture its incredible long-term potential.

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References

1 - Global Trends in R&D 2023 - IQVIA

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.

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