The healthcare and biotechnology sector has some natural tailwinds: ageing populations, rising emerging market wealth, innovation and rising healthcare utilisation. However, while pharmaceutical companies have been stable, biotechnology has been hit by poor sentiment and rising interest rates. Nevertheless, there are signs of recovery.
The sector is diverse. Funds such as Polar Capital Global Healthcare (PCGH) are more focused on large and mega cap pharmaceutical giants, with Eli Lilly and AbbVie among its largest holdings. This has generally helped performance over the last year, allowing the trust to benefit from the excitement around GLP-1 drugs for obesity. It has seen the strongest return in the sector, with a three-year annualised return of 13.2%.
But a lot of the trusts are focused on biotechnology. These have suffered amid a tougher period for the sector, particularly for trusts with higher weightings in unquoted assets. Ailsa Craig, manager on the International Biotechnology Trust (IBT) says; “A number of factors have conspired to leave biotechnology a forgotten sector. There were bubbly valuations during the pandemic – people got over-excited and there were a lot of arm-chair investors. There was a bit of a correction after that.”
However, she says the sector was then “whacked” by interest rate rises. “These companies don’t have debt, they use cash raised through equity, but they are long-dated assets. Therefore, increasing rates will hit valuations.” The third factor to take money out of the biotech sector was obesity. Everyone got excited about the obesity space, and that was dominated by pharmaceutical giants Eli Lily and Novo Nordisk, rather than the biotechnology groups.
Woody Stileman, managing director at RTW which manages the RTW Biotech Opportunities trust, says: “From Feb 2021 to October of last year, we’d seen the second worst biotech bear market ever. These businesses require a huge amount of capital. And if capital markets are closed, there are practical implications for biotechnology companies.”
This has been painful for the biotechnology-focused trusts. IBT is the only trust to have delivered a positive annualised return over three years (2.5%). The higher risk trusts, such as Syncona, which focuses on earlier stage biotechnology ideas, have been particularly hard-hit.
However, there are signs of a change in the environment, with a recovery in performance over the past nine months. Craig says: “The sector moves in fits and starts. Sometimes, there’s a lot of excitement around a new innovation and a lot of money comes into the sector. Then it consolidates for whatever reason – perhaps there are no stories, or the macroeconomic environment moves. We have been quite defensive, but now we are doing the inverse and embracing more risk. That speaks to where we think we are in the cycle.”
Rising optimism
That optimism has a number of drivers. Merger and acquisition activity has helped galvanise the whole sector, but biotechnology in particular. Stileman says: “There were a some very large deals last year. This year has seen more bolt-on deals. The fundamental driver for M&A hasn’t changed. Large pharmaceutical companies have significant patent cliffs (many products coming off patent, which tends to lead to a dramatic drop in revenue) and they need to replace them with new drugs.”
Equally, there is plenty of innovation. In big ticket areas such as obesity, biotechnology is bringing out alternative options. Stileman says: “Lily and Novo have led the way on GLP-1s, but second wave will come from biotechnology.” He points out that there is room for improvement, with the drugs still having a number of side-effects.
He also points to developments such as ‘antibody drugs conjugates’ or ADCs. These combine an antibody with a radiopharmaceutical isotope, for example, or a chemotherapy to give a double-hit on cancer. “This is a remarkable technology,” he says.
IBT also has a significant weighting in ‘orphan’ diseases. These tend to treat genetically driven childhood diseases, will command high prices, but are transformative for the patients involved. The trust is also looking at innovation in the treatment of central nervous system disorders. For example, anti-psychotics have nasty side-effects and companies are now looking at different mechanisms that don’t come with these problems.
James Douglas, a manager on Polar Capital Global Healthcare, says there is also innovation in the diagnosis and delivery of treatment. Outsourcing clinical trials, for example, is becoming more common. “It’s not just drugs, it’s insurance, medical devices, life sciences and tools. It’s a broad spectrum. There is real disruption in the delivery of healthcare. Can I treat a patient not in a hospital? That accelerated during Covid and we think that might be durable.”
The election?
With interest rate cuts (or at least no future rises) the likeliest outcome in the near-term, the biggest barrier for the continued recovery in the healthcare and biotechnology sector may be the US election. This is more a problem for the large pharmaceutical companies than it is for the biotechs, but the US remains the largest market and any disruption would be felt across the healthcare ecosystem.
Stileman is watching closely, but doesn’t believe that drug pricing is likely to be the issue it has been in previous elections. He says: “The electorate appears more focused on other things. During the Hillary Clinton versus Donald Trump election, drug pricing was a major issue. The Inflation Reduction Act had a drug pricing component in it. It takes a lot of political capital to get those things over the line, so they don’t happen often. We don’t think something of similar magnitude will follow.” IBT adds that pharmaceutical spending is a relatively small part of the overall US budget.
Long-term
Ultimately, the long-term factors driving healthcare are not going away. Developed market economies have ageing populations, while increased wealth in emerging markets is also driving healthcare adoption. Douglas points out that patient utilisation has increased post-Covid. “The volume of people going to see their physicians and using the healthcare system is accelerating. There may be some durability to this growth.”
Interest rate cuts would undoubtedly help sentiment. Biotech is a long duration asset, so inherently interest rate sensitive. Equally, both IBT and RTW have unquoted holdings, so will benefit from any shift in sentiment on this part of the market.
Craig says the market may be heading towards a sweet spot, where sentiment towards the sector has improved, but investors are still discerning on individual companies. Stileman agrees: “Good companies are getting funding, but earlier stage companies, or companies without great data are struggling. That’s a great environment for a stock-picker.”
The generalist healthcare trusts such as Polar are the right option for those investors who want diversified access to the healthcare sector. They have proved stable during a relatively uncertain environment. However, there may be more scope for capital growth among the biotechnology-focused trusts. These have struggled amid higher interest rates and weak sentiment, but a combination of stabilising monetary policy, M&A and a new round of innovation may prompt a recovery.