With the US Federal Reserve and Bank of England both having paused in their rate hiking cycles, is it time to take another look at growth sectors like biotechnology?
Interest rate increases tend to be bad news for ‘jam tomorrow’ sectors – such as innovative biotech companies, which may be many years from bringing drugs to market, let alone making a profit from their efforts – as financial models for valuing stocks are based on higher discount rates that decrease the net present value of future cash flows.
This has had a noticeable impact on the benchmark Nasdaq Biotechnology Index (NBI), which, having surged by c 75% between the start of the Covid-19 pandemic and the beginning of tightening cycle in Q42021, is now back at the level of May 2020, and has barely moved year-to-date.
Daniel Koller, manager of the CHF2.3bn Switzerland-based closed-end fund BB Biotech, says the sector is “still a bit in no-man’s-land” given the macro headwind of a higher-for-longer rate environment. With strong momentum continuing in obesity drugs (which Koller sees as “more of a consumer product”) and artificial intelligence, the manager says that “the generalist investor population has taken a lot of money off the biotech table”.
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However, while the main ETF tracking the NBI has seen net outflows of $1.6bn year-to-date, in recent months flows have turned slightly positive, with a net inflow of $92m since June 2023.
As well as pressure from higher rates, the mainly US-based biotechnology and healthcare industry has also faced political headwinds, with a key plank of 2022’s Inflation Reduction Act being a focus on controlling Medicare drug costs. From 2026, there will be mandatory price negotiations on drugs with significant Medicare spending, beginning with a list of 10 treatments and rising to 100 by 2031.
While this will mainly affect ‘big pharma’ rather than the earlier-stage biotech companies, some large players such as Amgen (not a BB Biotech holding) are likely to be affected, says Koller.
However, while generalist investor sentiment, the macro environment and political noise can tend to dominate the discourse around biotechnology, Koller argues that innovation, commercialisation and valuation are much more fundamental to long-term success in biotech investing.
BB Biotech invests across the market capitalisation spectrum, although where it has larger-cap positions, these tend to have been held since they were much smaller. (An example is Moderna, which was a tiny private company when the fund first invested in Q118, but is now the fifth-largest of the 268 stocks in the NBI, thanks to its mRNA-based Covid-19 vaccine.) Its core holdings tend to be in the mid-cap space, with over half the portfolio in the $5-30bn bracket.
See also: Are US equities overvalued, or are valuations just high?
Koller sees attractive upside in mid-caps, given undemanding valuations and solid fundamentals. He points to the example of Neurocrine Biosciences ($11bn market cap), which recently announced positive top-line data in a Phase III trial of its drug crinecerfont for congenital adrenal hyperplasia.
While good news on clinical trials is often the cause of significant upwards share price moves, Koller says Neurocrine’s share price went up by less than 10%, “which is far from what it should be given the potential contribution to the P&L”. Neurocrine is currently BB Biotech’s fourth-largest position, at 8.5% of the portfolio.
So what will trigger an uptick in the sector? Deals are being done: analysts at Winterflood Investment Trusts recently pointed to three IPOs in the portfolio of fellow biotech investor RTW Biotech Opportunities as “clear signs that market sentiment towards [the gene therapy] segment and biotech more generally may be past its nadir”. Koller also mentions acquisitions, such as that of Horizon Therapeutics by Amgen (which had been held up by antitrust objections from the Federal Trade Commission), and partnerships like Generation Bio’s recent tie-up with Moderna.
While there have been no acquisitions of companies in BB Biotech’s portfolio in the last 12 months, Koller says the attractive valuations in the mid-cap space could see some bids being made. Meanwhile, in smaller and micro-caps, many stocks are trading below the value of the cash on their balance sheets. “People are just looking for [clinical] catalysts as a clear path forward,” the manager says.
With many smaller companies so out of favour, BB Biotech is increasingly participating in capital raises, rather than simply buying shares in the secondary market. “For example, Black Diamond has had some attractive data from a small sample in its molecule targeting EGFR mutations [in lung cancer] and did a $75m capital raise – we participated in that as it will help the company to invest in long-term growth, rather than just buying undervalued shares from other shareholders,” Koller explains.
Biotech may sit at the more extreme end of the risk-reward curve – particularly in earlier-stage situations, financial outcomes can be as binary as clinical results. But as Koller argues, at an aggregate level, many of the headwinds are unlikely to worsen, with rates more likely to fall than rise in the medium term, limited further political risk given a Democrat US government tends already to be the ‘worst case scenario’ for drug pricing concerns, and emerging signs of a turn in the tide of generalist investor fund flows.
Added to this is the lower-than average level of valuations across the market cap spectrum. “Technologies, pipelines, progress and success all look very good, so that leaves us puzzled as to why interest rates are such an overarching theme – we are positive on the fundamentals,” the manager concludes.
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