This month marks the third anniversary of the UK’s first Covid-19 lockdown, which came amid widespread stock market declines and a distinct ‘risk off’ shift. But while the health ramifications of the pandemic were felt across society until well into 2021 as the vaccination programme was rolled out, the healthcare sector saw a more rapid bounceback, buoyed by the swift sequencing of the Sars-CoV-2 genome that enabled vaccines to be developed.
The S&P Biotech ETF (XBI), which tracks an equal-weighted version of the bellwether Nasdaq Biotechnology index (NBI), hit an all-time high in early 2021 while the UK was still in its third lockdown. But as life normalised for the majority of people throughout 2022, healthcare and biotech stocks once more fell victim to risk aversion, as soaring inflation and interest rates swung the market pendulum from growth to value sectors.
The arguments for investing in healthcare and biotechnology are well rehearsed and pretty compelling:
- – Ageing populations globally as people live longer – and therefore need more healthcare,
- – Rising prosperity in the developing world – where access to good quality healthcare may depend on the ability to pay, and
- – Scientific innovation – driven by better understanding of disease processes – meaning many previously life-limiting diseases can be effectively managed or even cured.
But, although the underlying business of medicine is not particularly sensitive to the wider economy, sentiment towards it can be highly cyclical, leading to short-term volatility of returns.
Stages of investment
Ailsa Craig and Marek Poszepczynski, co-managers of the £326m International Biotechnology Trust (IBT), see the cycle of biotech investment as having five distinct stages, although these may vary in length – indeed, the pandemic saw a whole cycle compressed into just two years, when it would typically last at least twice as long.
In the first stage, which is the point of maximum pessimism, company valuations are very depressed. The second stage is the beginning of a recovery, when M&A transactions restart and valuations begin to tick up again. The third stage is arguably the sweet spot – companies are fairly valued, growth is stable and there is a steady stream of deals.
However, at this point money begins to flood into the sector, as generalist investors catch up to the returns on offer, and this feeds into the fourth stage – hyped-up valuations and a boom in undercooked IPOs – inevitably ending in the fifth stage – the ‘bust’ to match the ‘boom’ – where generalists flee the sector and the M&A deals dry up.
Craig explains that the key to avoiding the worst of the boom and bust is to be able to spot both the fifth and the first stages of the cycle. “If you can do that then you’ve got a good edge,” she says, although Poszepczynski adds that while the duo correctly called the Covid-driven market overheating, they were early to reduce risk, meaning the trust did not fully participate in the ‘boom’ phase.
The fact that IBT currently ranks second in its AIC sector for one-year performance suggests that avoiding the ‘bust’ has been just as important, however.
The managers see the current point in the cycle as being firmly in the second stage. “There were two lows in the market last year, and it will be largely down to macro factors as to whether we see a third, although we have had a nicer recovery than technology since Q4 2022,” says Craig.
IBT has already benefitted from an uptick in M&A activity, with two portfolio companies – Biohaven and Horizon Therapeutics – bid for by Pfizer and Amgen respectively in recent months.
The managers have been recycling proceeds into companies with products on the market that are not yet profitable (reflecting the high cost of developing new therapies, which is then recouped over future years of sales). This should help offset the effects of a looming ‘patent cliff’ in the middle of this decade, when many currently profitable products will reach the end of their exclusivity periods.
Prolonged period of improving returns
For investors seeking exposure to healthcare and biotech, the closed-end space offers greater choice than the open-ended sector, where there is little outright biotechnology exposure and many of the funds are index trackers.
As shown in the table below, performance has been mixed across the AIC Biotechnology & Healthcare sector, with an average 12-month share price return of 5.4% masking a dispersion from -9.1% for RTW Venture Fund to +26.5% for Polar Capital Global Healthcare (perhaps the most broadly diversified fund in the group).
Both RTW and Syncona have seen a de-rating in line with the wider private equity space, given their focus on earlier-stage unlisted companies where price discovery is more challenging. IBT also has exposure to unlisted stocks selected by its current management group, SV Life Sciences*, which make up 10% of its portfolio, while Biotech Growth Trust has made some investments in ‘crossover’ situations, which are unquoted stocks where there is a clear expectation of listing in reasonably short order.
If IBT’s managers are correct in their assessment of the cycle, then investors could enjoy a prolonged period of improving returns from the biotechnology and healthcare space before the market once more begins to overheat. Arguably this is one sector in which specialist management is paramount, given the potentially distorting effect of generalist investors in the latter stages of the cycle.
Biotech and Healthcare Funds
|Total Assets £m||1y%||5y%||10y%||Discount %||Yield %|
|Bellevue Healthcare Trust||1,058.7||1.0||73.0||N/A||6.6||3.6|
|Biotech Growth Trust||416.8||5.9||24.8||158.2||7.5||0.0|
|International Biotechnology Trust||326.4||19.9||42.6||306.4||6.6||4.1|
|Polar Capital Global Healthcare||461.4||26.5||80.5||181.2||4.6||0.6|
|RTW Venture Fund||346.2||-9.1||N/A||N/A||23.3||0.0|
|Worlwide Healthcare Trust||2,377.5||7.6||34.5||250.4||9.1||0.8|
*SV Life Sciences has served notice to the board of IBT as it wishes to concentrate on its earlier-stage investments. It is expected that fund managers Ailsa Craig and Marek Poszepczynski will continue to manage the trust under a new management group, although no further announcements have yet been made.