It is a fact of life that prescription drug usage increases with age. Add to that the demographics of an aging population and you have a prima facie case for investing in healthcare and pharmaceuticals. But restricting one’s investing to the global monoliths is buying into an earnings stream whose rate of growth is slowing. Biotech companies, meaning small research-based companies with minimal current revenues and one to two drugs in development, now account for 50% of FDA approvals. When a biotech company strikes a rich seam, its market value can increase more than tenfold. Once a patent is approved, competition is minimised for 20 years, leading to a long period of high quality earnings. For the long-term investor, such as a pension fund, the sector offers relatively cheap valuations, the possibility of exceptional returns and trading opportunities arising from a lack of research and stock price volatility.
Studies show that biotech companies are more efficient on aggregate in their research and development (R&D) spend than the multinationals. For every $1 of future sales, big pharmaceutical companies pay $5 in R&D, compared with $1 for their smaller biotech brethren, according to a study by the USA Office of Health Economics. But ironically, individual drugs in the pipeline of pharmaceutical giants like Glaxo appear to be more highly valued by the market than entire biotech companies.
US dominance has derived from the 10-year head start the US biotech industry had over Europe. Now, the US accounts for the vast majority of biotech companies globally, and some former biotechs are now big pharmaceutical companies in their own right. But an investor would be wrong to exclude European companies in a nascent stage of development. The argument still stands for investing in top scientific brains who are willing to take the chance on their own rather than stay in the stultifying bureaucracy of a large operation.
Given the specialist nature of the industry, an opening has arisen for independent research houses, which are commissioned by specialist funds to conduct in-depth research on a company’s product stream. Ian White of 1 Research, one such organisation, comments on the conflict between stock market perception of the industry and the long-term outlook, saying “there is a paradox between the volatility of share prices and stability of prescribing. The environment is not changing for drug discovery, yet clearly at the current times it is close to impossible to raise capital”.
But clearly not every biotech company is going to come out with another blockbuster like Enbrel, a treatment for rheumatoid arthritis launched by Immunex in the late 1990s. As White comments “more than 50% of products developed by early stage companies fall by the wayside”, so investing in companies with small immature pipelines is something of a gamble. By hedging one’s bets and buying a portfolio of stocks, losses on the losers should be more than made up for by gains on the winners, on average. And to avoid participating in a lottery, detailed research, down to the scientific detail of each drug in development, is necessary.
A typical biotech fund will contain a number of core positions and some smaller outside ‘bets’. One example, BB Biotech, run by Bellevue Asset Management in Switzerland, aims to have five to eight core holdings, and its four top holdings account for 62% of the fund. This fund has achieved an average annual return of 19.8% since its launch in 1993.
According to White, taking into account the cost of failures, the average drug company spends $500m (E507m) for every drug that eventually reaches the market. A drug company might formulate thousands of compounds for every one that is approved for prescription, but most of these will fail before much money has been spent. Once a drug reaches the first stage of clinical trials the odds improve slightly, to about 10 to 1, but the expenditure increases commensurately. By the last stages of clinical trials, involving sometimes tens of thousands of patients, a company will have probably spent some $40 to $50m on that one drug alone, but will be more than likely to have a marketable product. However, there is still some 20-30% chance of failure at this stage, and it is companies whose most advanced products fall short at this final hurdle that suffer the sharpest setbacks in their share prices.
What drives whether a drug is finally approved is a play-off between the severity of the condition versus the apparent side effects. Although targeting a wide audience with an improved oral contraceptive or mild painkiller might generate the largest eventual revenues, testing is much more extensive, and the penalties for an adverse outcome greatest. A drug to treat an incurable disease which affects a small population would need minimal testing and might provide a more guaranteed level of earnings at less risk. The nature of the disease also influences the length of testing. Drugs designed for progressive diseases require a long period of testing to ensure that the drug has some perceptible effect. Taking all these aspects into consideration, the cost of final stage testing, depending on the nature of the drug, the acuteness of the need, the acceptability of side effects and the amount of data required for the results to be statistically relevant, could be anywhere between $5m (E0m) and $100.
When selecting stocks in the biotech sector, White highlights the expertise, drive and dedication of the scientific team as the key success factor. The company must be focusing its research on some important unmet need where any new innovation in treatment is almost certain to make money. Commercial management and marketing is a less important driver, as White comments: “the industry’s products are geared towards a professional audience, who will prescribe if they can be shown to work”.
The vast majority of the 300 or so specialist healthcare funds are US-based, not surprising given that is where the most companies are created. The mammoth Vanguard Special Healthcare fund dwarfs all the others in the sector at $14bn of assets. The next six largest funds account for between $4bn and $1.6bn under management. All the above have a large to medium cap bias. Rydex Biotechnology is the largest small cap biotech fund at $701m. Other key US names make for a total funds under management devoted to biotech of $31bn. By comparison, UK healthcare trusts are tiny at approximately £400m in total under management. There are German funds of the order of $6bn in total and French of $3.5bn.
The healthcare sector accounts for some 11-12% of global stock market capitalisation, and two thirds of this is in the area of innovative therapeutics. MP Asset Managers, a specialist biopharmaceutical asset manager and adviser based in New York, invests in more than 300 companies in this field worldwide, ignoring HMO’s and services companies. MP’s Viren Mehtra’s view on industry prospects extends beyond mere stock market valuations, as he explains: “innovative therapies will have a greater impact on society and quality of life over the next generation than did IT in the last generation. Industrialised countries today spend about 1% of GDP on innovative therapeutics, and their expenditure going to rise to at least 2% of GDP. Currently, lifetime medical spend is skewed heavily towards prolonging the last few days of life, whereas in future therapies will impact on health at an earlier stage”. In Mehta’s opinion it makes sense to invest in this important sector as a separate global allocation and benefit from specialist expertise, rather than have exposure fragmented between regional general equity managers. Mehta looks for a combination of industry expertise, scientific background and financial acumen in the management of pharmaceutical and biotech companies globally to stay abreast of the evolving critical success factors and to benefit from resulting investment opportunities, highlighting the stark difference between success and failure in this industry.
Orbimed, a New-York-based healthcare fund manager, advises six funds with different operating mandates and jurisdictions. Although adding in service companies and devices adds diversification to the profits stream, Orbimed focuses solely on the 600 publicly listed pharmaceutical and biotech companies worldwide, investing mainly in some 36-48 names, selected after a process of comparing values across the different market capitalisation sectors. When considering the top 8% of companies, with a market value of $5bn or more, the emphasis is on market share and pipeline. For the newer companies, scientific and financial strength are key. Proportions in small and large cap companies vary by the mandate of the fund. The UK-listed Finsbury Worldwide investment trust has a large cap mandate and invests 60-80% of its money in big pharmaceuticals, whereas for the small cap US-based Caduceus fund the percentages are reversed. In the opinion of Sam Isaly, founder and CEO of Orbimed, the most exciting opportunities at present are in a selection of around 30 profitable biotech companies with long patents, whose earnings are likely to grow at 20% pa, and which are currently trading at low valuations.
In recent market falls, biotech stocks have suffered particularly badly, declining to valuations last seen in 1998, despite the more advanced state of the industry in terms of drug pipeline, cash reserves and commercial management. As June Scott, manager of the Sagitta Healthcare and Salix funds, and former manager of the $800m Activest Bio Pharma fund, remarks: “if one deducts cash balances from the stock market capitalisation, the prices of some stocks are not factoring in any technology value. Historically this has been a good time to buy.” Being mostly traded on the NASDAQ index the sector shows correlation with technology stocks, although product demand drivers are quite different. Big pharma stocks, deemed defensive, are trading on a p/e discount to the market, as analysts are factoring slower future growth rates. Scott tips Acambis, a producer of vaccines against biological warfare, and Transkaryotic Therapies, whose product to combat Fabry’s disease, which affects only 3,000 people annually, is slated for FDA approval in September.
Leaving aside general stock market turbulence, there are some fundamental reasons for biotech companies to trade cheaply at present. US legislative changes have made it a tough year to gain patents and created uncertainty about the lifetime of patents granted in future. There has been a greater than average frequency of late stage failures which has also weighed down the sector. Isaly however anticipates success rates to improve by 2005.
For the larger stocks, the panacea to slowing growth rates appears to be more mega-mergers. New drug discovery comes with talent and innovation, but marketing and development are strengthened by size. A key industry trend is for biotechs to license their discoveries to the big pharmaceuticals once they enter clinical trials, because of the heavy investment required at this stage.
Although the industry is global, no suitable global benchmark exists, indices being calculated by market or region. No index appears to fully reflect the sector’s diversity, by geography, market value, currency, product mix and technology. MSCI global biotech and pharmaceutical indices were criticised for a lack of coverage. The FTSE global pharmaceuticals index contains only the 30 largest healthcare companies, so excluding stocks less than $6bn in size. NASDAQ and Neuer Markt indices contain only stocks in those markets, and the Bloomberg indices operate by region. MP Asset Managers finds that its investments are most closely represented by a combination of about half the performance of the MSCI global pharmaceutical index and half the NASDAQ biotech index, although this excludes any European-based biotech names. None of the managers interviewed closely track an index, because index weightings would force concentration in the biggest industry names, such as AmGen, which makes up 16.35% of the NASDAQ biotech index.
Some of the managers interviewed run hedge funds as well as long only funds, and have found that the ability to short has protected performance in the market downturn. Aside from selling individual stocks short, funds can go short the Biotech Holders Trust and the Pharmaceutical Holders Trust, investment companies that own the 20 largest companies in the sector on NASDAQ. Sagitta operates two funds on the same investment principles, a long only Healthcare fund and the long/short Salix fund. Since inception the Salix fund has fallen just 3.09%, versus a drop of 31.3% over the same period for the Healthcare fund. MP Asset Manager’s equity long/short fund also suffered some fall in NAV given the typically 60% long bias. By contrast its market neutral fund has gone up in value in the year to date.
With both financial ratios and operational valuation tools showing the sector at its cheapest for a decade and some names at 40-year lows, Mehta is convinced that the sector will outperform on a five-year view. Changes in discovery methods should lead to a higher “hit rate” and the creation of more effective drugs that treat the cause rather than simply alleviate symptoms.
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