Emerging from the biotech bear market in great shape
Following a challenging three years, the biotechnology sector has put in a much more encouraging performance in recent months. With valuations still attractive, balance sheets looking strong and an improving funding environment, we take a look at the multiple reasons to be positive about the outlook for biotech investors in the years ahead…
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Volatility is an inevitable part of investing, and a long-term perspective is required to counter it. Cycles of bull and bear markets, in which periods of strong performance and positive investor sentiment are followed by periods of declining markets and more negative sentiment, have been well-documented through centuries of financial market history and, although enduring them can be uncomfortable, bear markets should be considered as necessary correction mechanisms, eliminating excesses and creating opportunities for longer-term market participants to capture. This is what Austrian economist Joseph Schumpeter called “creative destruction”, the process through which markets can ultimately drive innovation and growth by clearing out inefficient companies and paving the way for new ones.
The biotech industry itself is not particularly cyclical. It benefits from many dependable, enduring characteristics, such as the implications of a global population that is growing older, richer and sicker, the ongoing demand for medical advancements, and an accelerating pace of innovation as the fields of science and technology inform each other to deliver more and better therapies.
Nevertheless, despite the biotech industry’s non-cyclical attributes, investor attitudes towards it are highly cyclical, as we described in our December post, “dependable growth with a cyclical boost”. Some investors, like International Biotechnology Trust (IBT), are fully committed to biotech, but many other market participants tend to move in and out of the sector, depending on their risk appetite and prevailing sentiment. Inevitably, this contributes to volatility in market valuations and can lead to significant disconnect between price and fundamental value, in both directions.
The last sector wide boom period was in 2020 and early 2021 when the value ascribed by the market to smaller, development stage biotech companies rose sharply, as was demonstrated by the XBI Index, a basket of stocks whose performance is dominated by small cap biotech companies, rising by around 150% from its low point to its peak. For much of the period since 2021, when the Nasdaq Biotechnology Index reached a new all-time high, we have been in a down phase of the cycle, with weakening sentiment and investor risk aversion generally depressing biotech share prices and valuations. This doesn’t mean a complete absence of opportunity, but dedicated biotech investors such as IBT were sailing into a headwind from 2021 to 2023, as the index declined from its peak. During this time, which broadly coincides with the first three years since we took over as lead managers of the trust, IBT’s volatility management strategies described in our blog “A specialist biotech investor’s approach to risk mitigation” stood it in good stead and helped IBT to weather the storm better than the index and its peers.
The biotech industry has seen consolidation throughout this period, with many companies undergoing restructuring, mergers or acquisitions (M&A). This has presented opportunities for active investors to add value, and it has contributed to the gradual reshaping of the industry and, encouragingly, the prospect of improved productivity going forward.
Encouraging signs
Following the challenging three years from 2021 to 2023, the biotechnology sector has put in a much more encouraging performance in recent months. Despite the recent rally, however, the Nasdaq Biotechnology Index remains well below the peak it reached in 2021. Valuations also remain attractive, as illustrated in the chart below.
The biotech sector is still cheap as can be demonstrated by looking at the evolution of the sector’s enterprise value / cash ratio (blue line below) which show how the value of the companies relates to the cash the companies have in the bank (orange bars below).
Source: Jefferies Research, 12 May 2024
The small-to-mid-sized biotech sector (which captures companies with a market capitalisation of up to $5 billion) currently trades on an enterprise value / cash ratio (EV / cash) of approximately 2x which means that the value of all the companies in this size bracket is around twice the value of the cash they have in the bank. In the context of history, this looks attractive. Historically, the sector has traded on an EV / cash ratio of 3.0-3.5x for most of the last 20 years. It fell as low as 1.5x in 2022, meaning the average biotech was trading at a valuation barely above the cash on its balance sheet, with the market implying negligible value to development pipelines. With the benefit of hindsight, this was clearly an appealing entry point, and indeed, we would argue that remains the case today.
Importantly in an inflationary environment, cash levels are robust with the average small-to-mid-sized biotech company currently having a healthy cash runway (the time until they would run out of cash at their current rate of spending) of 2.2 years, suggesting the sector is well-financed.
Meanwhile, the recent strength of the funding market demonstrates that investor appetite is starting to return to take advantage of attractive valuations and promising pipelines.
As described in our blog on the cyclicality of the biotech investment environment "Dependable growth with a cyclical boost", the return of biotech initial public offerings (IPOs) is one of the green shoots that we look for to identify when the sector is moving into the most stable Equilibrium stage. In this respect it is encouraging to see that biotech companies have raised $1.7bn so far this year in US IPOs, up 64% year on year, with “dozens” more having submitted confidential filings to IPO in the future. (Source: BioPharma Dive, Financial Times)
This year could be the best year ever for publicly listed companies selling new shares to raise additional follow-on financing, if the rate of issuance seen so far in 2024 is sustained over the year, with the FT reporting in June 2024 that previously listed companies have raised over $16.5bn in 2024, a rise of over 100% compared to the same period last year. This should give investors comfort that biotech companies should be able to access sufficient funding to run the expensive clinical trials required to get their products through the development stage.
Biotech follow-on financing could exceed the peak of 2020 this year
Source: Jefferies Research, 12 May 2024
How to position for the next phase of the cycle
The investment strategy in place for IBT remains focused on identifying companies with innovative technologies, strong intellectual property and solid growth potential. This is a constant feature of our investment approach, but where we find these businesses within the sector can change over time, as can our appetite for risk.
Towards the end of last year, having seen early signs of renewed vitality in earlier-stage small-cap biotechnology, we increased the IBT portfolio’s weighting towards small and mid-cap biotechnology, where we are finding very attractive opportunities with substantial scope for value creation. This has intentionally increased the volatility profile of the portfolio, as we believe having higher risk stocks in the portfolio will prove beneficial to investors in the period ahead as we expect them to offer higher returns in positive markets.
Conclusion
While nothing is ever certain in the world of investment, the demographic shift to an older population, and the sector’s commitment to innovation are beyond question, and so the outlook for the biotech sector – and IBT specifically – looks positive. There are tangible signs that the industry is enjoying more investor interest and innovation continues to thrive. Moreover, companies have worked hard to restructure during the bear market, emerging in much better shape than before.
These are exciting times in the biotech sector, therefore. The sector still looks to be attractively valued and company balance sheets are looking robust. The sector is already enjoying a more favourable funding environment, particularly for public companies and, while some companies have successfully launched modestly sized IPOs this year, there are signs that more will come with a backlog of private biotech companies awaiting the right timing to go public. This should be taken as the next sign of improved investor sentiment towards biotech. Watch this space…
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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.
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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