We take two approaches to valuation. The first is a bottom-up strategy for companies yet to turn a profit where we assess the profit potential for the drugs in a company’s portfolio. For those companies generating sales and profits, we consider valuations in terms of multiples of price to sales or earnings.
The recent fall in the biotech sector has prompted some investors to fear that a valuation bubble had arisen. But sector valuations are reasonable. At the end of August, the US biotech majors were trading at a price-to-earnings ratio of 21 times compared with the S&P 500 multiple of 16. This premium to the broader US equity market is more than justified by the sector’s double-digit earnings growth.
The recent fall in the value of biotechnology stocks should be welcomed by investors. The tumble was caused by worries that, if elected, US democratic candidate Hillary Clinton would look to reform drug pricing.
However, we believe that these concerns are overblown. There is no mechanism in the US to introduce a pre-determined drug price as there is in many European countries. This is also somewhat of a red herring. The more important influence on US drug prices is the recent consolidation of the healthcare insurance companies which makes them better able to negotiate better prices with drug manufacturers.
This is an issue which we monitor closely and why we ensure to factor in realistic prices to our investment models.
Even with these significant changes in the US market, the current valuation does not look over-stretched. That’s because we are on the cusp of a productivity revolution in the biotechnology sector. Recent scientific advancements are just starting to manifest as a plethora of innovative drugs.
The number of new drugs entering clinical trials is growing. This will result in strong sales potential that will be matched by growing demand for new treatments from an ageing population. The long-term growth prospects for this sector remain extremely robust.