06 JUN

2017

Equities , Rudi Van den Eynde , Topics

Biotech: performance is in the pipeline

After going through a slump in 2016, the biotech sector is expected to gradually renew with better performances , driven by promising new drugs.

Biotech share prices climbed from 2012 until the end of Q3 2015, then fell 35%, hitting their lowest point in early July 2016. Since then, the Nasdaq Biotech Index, which is the most representative of the industry in that most companies in the sector are American, seesawed during the year, subject in recent months to pressure from Donald Trump's plan to scrap Obamacare and fears of government intervention in drug prices.

Is this threat likely to significantly influence the financial strength of biotechs? There are good reasons not to think so. In the US, drugs account for just 10% of healthcare spending and only 45% are reimbursed by government  entities, with the rest covered by private health insurers. Consequently, no matter what decisions are taken by the new US administration, their impact on drug prices will be rather limited. Price setting mechanisms will be virtually unchanged and will pave the way for very attractive margins on products offering a real medical benefit.

Even if, over the longer term, bio-similars (generic versions of name-brand biotech drugs) should ease some of the pressure on healthcare budgets, they will not have the same impact as generics on traditional medications. There are at least two reasons for this. First, biotech products are infinitely more complex than traditional medications, making it harder to “imitate” them. Second, US and European drug supervisors demand highly expensive clinical trials for generics, limiting competition between companies in the biotech industry.

Innovation is the other key variable in assessing the health of biotech firms. From the standard pill to protein-based drugs, technology has significantly evolved, and concepts such as gene therapy or genetically modified cells are now a reality. In the field of cancer treatment, for example, research has advanced from non-specific chemotherapy to highly targeted treatments. As an example, Loxo Oncology has succeeded in identifying the cause of certain tumours and developing a specific inhibitor. The same can be said for Clovis which, thanks to its PARP inhibitor which is capable of inhibiting the repair of DNA damage to cells, has achieved excellent results in ovarian cancer. In both examples, these therapeutic developments boosted the company's share price substantially.

From an investment standpoint, in the wake of the pitfalls of 2016 and more recently the rhetoric spouted by the Trump administration, the valuation of the biotech sector has returned to a very reasonable level - a level protected by a solid floor of M&A deals expected to keep up a steady pace. However, the significant dispersion of performances delivered by sector companies calls for an active stock-picking approach. Given the importance of the “innovation” factor, this approach needs to be rooted in extensive knowledge of the clinical trial process and the ability to assess the potential of drugs in each company's pipeline. That's one of the reason our investment team includes two scientists capable of monitoring and analysing the data flows associated with research and development in the biotech industry.

Strictly speaking, on the investment front, diversification is particularly important given the level of volatility in the sector. Diversification is reflected in the choice of the investment universe and in portfolio construction. The investment universe is as broad as possible and is not limited to one or more therapeutic fields: investments are focused on clinical progress, when it is able to change the treatment paradigm. As for portfolio construction, after an initial filter aimed at eliminating companies with a market cap of less than $100 million, selection is focused on two types of very different stocks. On one hand, large cap biotechs can provide the portfolio with some stability. On the other, companies on the cusp of expansion and boasting large potential are the vectors of strong performance. This discipline applied to stock picking and portfolio construction, combined with a 3-5 year investment period, has been a winning combination so far, as the fund has regularly outperformed its benchmark in an expanding biotech universe.