Global Perspectives: Why biotech could be embarking on a new decade of growth

Adam Hetts: Welcome back to Global Perspectives. I’m your host, Adam Hetts. And today, we have a fascinating conversation ahead on biotechnology, which is the heart of innovation in the healthcare industry. And if you are already familiar with the biotech space, you are going to appreciate the expertise that this team at Janus Henderson brings to the conversation. And if you are unfamiliar with biotech, with it being a somewhat niche market, well, you are in for a treat.

Here with us we have Andy Acker and Vish Sridharan. Andy has been with Janus Henderson for over 20 years. He is a Portfolio Manager on Janus Henderson’s Healthcare and Biotech strategies, and Andy also leads the Healthcare Sector Research Team.

Vish is a Research Analyst, and on a team loaded with PhDs, he is a bit unique as not being a PhD but actually an MD. And Vish brings a lot of unique perspective, being both an investor within the team and also a physician that’s treated patients.

So, Andy, Vish, thanks for joining.

And Andy, we’ll start with you. Biotech is a unique space. So, can you tell us how you have gone about building a team and your approach to a sector?

Andy Acker: Sure. So, biotech is one of the most complicated and dynamic sectors that you can invest in. And there is really a huge difference between the winners and the losers in this sector. And so, you mentioned the PhDs and the MDs. It’s extremely important, we believe, to have a scientific background where you can actually understand how these molecules work and whether they are likely to be successful or not. So, as you mentioned, we have three PhDs and an MD on our team. Vish is our MD, and you’ll hear from him shortly. But that is really critical, we think, to success.

And we’re also part of a broader team, and each of those analysts are focused on specific sub-sectors within the healthcare sector. And it’s also a highly collaborative process. So, in order to understand biotech stocks, it’s also important to understand, for example, what are the perspective of the payers? What are the pharmaceutical companies going to do? You know, just to understand biotech alone is not enough to really, fully understand how to invest in the sector, we believe.

Hetts: Right, so Vish, usually being just an investor or a doctor is enough for most careers or satisfied parents, but now you’ve done both. So, what’s it like being an investor after having treated so many patients as a physician?

Vish Sridharan: Thanks, Adam. I think being a physician, you have an intuitive sense of what the standard of care is across the entire disease landscape. And in diseases where there is not a standard of care, how to think about what that unmet need is, how you can design clinical trials and develop therapeutics that might fulfill that unmet need, and also, bring the patient along with you every step of the way. Think about, what are the other comorbid conditions they might have? What medications might they be already taking? Who is part of their care team and what are the dynamics of that? What specialists might they be seeing? And keep in mind that there are a lot of ways that you could talk to doctors or forums in which you could speak with them. There are ways in which you could talk to payers, but really, there’s no other way that you can capture the voice of the patient other than being at their bedside. And I think it’s really a unique perspective that’s not available to a lot of generalists in this space.

Hetts: All right, thanks Vish. So, Andy, let’s go ahead and start digging into biotech itself. So, now we’re just coming out of one of the worst drawdowns on record for small- and mid-cap biotech stocks. So, can you recap that sell-off? Just talk us through the drivers of the sell-off, if you’re still worried about those same drivers persisting, or maybe if we are already in the final innings of this thing and closer to recovery mode.

Acker: Sure. So, if we think about that period we had from February 2021 through the middle of ‘22, we had one of the worst drawdowns in over 20 years. The average biotech stock, or the XBI, which is a broad tracking index of biotech stocks, lost almost two-thirds of its value over that 18-month timeframe.¹ So, the first question is, why? What happened? And I think it started with the pandemic period. So, if we remember back to 2020, we got two vaccines approved for COVID-19 in about 10 months, where historically it took more like 10 years to develop a vaccine. So that generated, obviously, a lot of excitement for the sector. And we had wide-open capital markets, many companies going public, high valuations, and a lot of excitement.

I think what many investors forgot, though, is that this is a really challenging sector, where 90% of the drugs that begin human clinical testing never make it all the way to market. So, we started to see some clinical disappointments. I think the market started to recognize not every therapy is going to work and give you over 90% efficacy after 10 months and generate tens of billions of sales [as COVID-19 vaccines did]. That was a huge success milestone, but not every company is going to be able to do that.

We also had a number of other overhangs. So, we started at high valuations, we started to see that sell-off. Then we had the lack of leadership at the FDA [Food and Drug Administration], where there was no commissioner for more than a year. We had some of those clinical setbacks. With the capital markets wide open, companies were not as eager to sell themselves, so we saw a lull in M&A [merger and acquisition] activity. We had some drugs that, again, because the FDA was overwhelmed with COVID, were getting delayed. And then, of course, we had the macro start to exert itself with higher interest rates and especially hurting earlier-stage [drug] development companies. So, all of these factors were weighing on the market, and we saw a substantial sell-off.

Now, by the middle of 2022, however, we had gotten to what we believed were really extreme levels of valuation. In fact, there were hundreds of companies trading below the levels of cash on their balance sheets. That’s a highly unusual situation. And many companies that had what we believe were real innovation, addressing high, unmet medical needs, that were also trading at substantially depressed valuations. And so we did start to see a recovery in the second half [of 2022], and I think that was driven by both positive clinical data addressing high, unmet medical needs, as well as a resurgence, I would say, in M&A activity. And as the enthusiasm for the sector swings, that pendulum swings, we went from extreme depression back to a little bit of a period of optimism that, oh, maybe this sector actually can bring new products to market that will excite investors.

Hetts: So, thanks Andy. Vish, part of that recovery kicking over is that, later last year, in 2022, the market stopped throwing the baby out with the bathwater and actually started rewarding the biotech companies that had positive clinical results. So, as somebody who has treated so many patients, what’s some innovation on the horizon that you’re personally most excited about?

Sridharan: Yes, absolutely. The pace of innovation in this sector is rapidly accelerating. So, I’ll give you several examples. One of them is Alzheimer’s disease. So, in this country [the U.S.], there are six million patients that suffer from Alzheimer’s disease, and there’s an enormous need for therapies in this space. And last year, there was one such therapy that showed positive phase 3 results and showed that it could slow down the progression of disease in these patients. And I’ll never forget, when this trial succeeded, the son of one of my patients, whose dad suffers from Alzheimer’s disease, texted me about this result even before I had heard about it. And it goes to show how desperate patients and families are for innovation in this space.

Another example is in something called NASH, or fatty liver disease, which is rapidly becoming the leading cause of liver failure in this country. There are about 10 million patients that suffer from NASH, and last year, two separate companies made substantial strides in making a difference in this particular disease. There was one oral therapy in a phase 3 trial, and when it succeeded, that stock was up over 200%. And then there was another company in a phase 2b trial that we think could be an even more potent therapy. And on the day, back in September, when that trial read out, the broader market was down 1,300 points, the biotech index was down 5%. This stock was up 135%.

And lastly, even outside of Alzheimer’s and NASH, which are huge markets in and of themselves, there is substantial innovation happening in obesity. There are about 100 million U.S. adults who suffer from being overweight or obese; that’s about one in three adults. And 750 million such patients globally. And for the first time ever, we have therapies that can allow these patients to achieve up to 20% or more weight loss. And this is the kind of weight loss that you see with bariatric surgery that was never possible with drug therapies before. And keep in mind that obesity correlates with just about every disease that you can think of – cardiovascular disease, of course, but also inflammatory diseases, cancers. And so, having these therapies will really change the course of health for these patients for decades to come. And the last thing I want to say here is these are not pie-in-the sky ideas. These are real innovations that are making patients feel better, function better, and survive longer.

Acker: Yes, and obesity is one of those markets we think has the potential to be the biggest market that we’ve ever seen. It’s not even crazy to think this could be a $50 billion to $100 billion market because not only can you make the patients feel better, but you can also save costs for the system. These are extremely expensive patients to treat. They cost over $20,000 a year, more than double the cost of other patients to treat.

And then there’s other … this is going to be a year of really incredible new product launches. Just recently we got approved the first treatment for dry AMD, or geographic atrophy, which is a leading cause of blindness in the elderly. And we already have treatments for the wet form of AMD, where you have leaky blood vessels in your eye that block your vision in the retina. That’s already a $10 billion market, but there has been nothing approved at all for the dry form of AMD, which is just as prevalent. And now, just recently, we got the first approval, and we could have a second approval later this year. So, these are enormous market opportunities.

And then, this could be a year of, really, the first-ever gene therapies. We could have the first gene therapy for hemophilia A, which is by far the most prevalent for of hemophilia. We’re talking about a single injection that could treat a patient potentially for five to 10 years or longer without any need of additional treatments. Up until a few years ago, these patients needed an infusion; they needed to do an IV injection three times a week and still had very poor control. Many of these patients were ending up in wheelchairs.

So, these are incredible new therapies. And probably one of the ones we’ve been the most excited about is the potential first disease-modifying gene therapy for muscular dystrophy. Patients that have muscular dystrophy have a defect or a missing protein called dystrophin, which is the shock absorber for the muscles of these patients. And so these children end up in wheelchairs in their teens, and they generally die in their 20s because all of their muscle just turns into scar tissue. And here you have a gene therapy that could be disease modifying that could be approved before the middle of this year. So, that’s another one that we’re really excited about. And these are just a few of the ones that could be coming this year that get us really excited about the sector.

Hetts: Yes, a lot of amazing optimism there. Speaking of enormous markets, just asking for a friend, is a cure for baldness or hair loss anywhere on that list for next year?

Sridharan: We’ll let you know if we find one, right after I patent it, how about that Adam.

Hetts: Thanks, I’ll pass that news along to that friend of mine. Okay, so Andy, we talked about drawdown mode and maybe one of the catalysts for kicking out a drawdown mode was that resurgence in M&A activity that you mentioned. So, going forward, how are you feeling about the M&A environment and what that means for the biotech sector?

Acker: Yes, so M&A is always important to biotech, and this is because you have the large biopharmaceutical companies that generate a lot of free cash flow but generally don’t have enough innovation to continue to grow without help. And especially as we look later in this decade, the major pharmaceutical companies are facing a gigantic wave of patent expirations. In fact, many of these companies are going to lose or face generic competition for between 20% and over 50% of their current sales today. So, they need to replace those, and where do you go? As Willie Sutton once said, “Why do you rob banks? Because that’s where the money is.” And in this case, why do large biopharmaceutical companies buy small- and mid-cap biotech companies? Because that’s where the innovation is. In fact, two-thirds of the new products in development today are being developed by small- and mid-cap biotech companies. And roughly two-thirds of the new products that reach the market were initially developed by these companies.

So, Pfizer, for example, that has publicly stated that they need to acquire $25 billion of revenue by 2030. And Pfizer was very active in the last year; they made three acquisitions for between $5 billion and $12 billion each at premiums of between 80% and 130%. And that was just a few of the acquisitions that we saw last year, and those really started to pick up in the second half [of 2022]. We ended the year with the biggest deal, a $28 billion acquisition for a company that had developed a treatment for thyroid eye disease, another huge, unmet medical need. So, we would expect M&A activity to continue. These companies have an estimated $500 billion in cash on their balance sheets. So, they’re cash rich and yet they need more innovation. And so, we would expect these types of deals to continue. And the kind of companies that get acquired are generally the ones that are developing new products for high, unmet medical needs that represent large market opportunities.

Hetts: Okay, so Vish, we’ve got this optimism around the M&A activity, we talked about the bargains that come after a historical sell-off, the innovation ramping up. So, can you put this all together as an investor and explain how today ranks as an entry point for the biotech sector?

Sridharan: Absolutely. So, to start off, as you were mentioning, we’re still really recovering from the biggest drawdown in the sector, the biggest the sector has ever seen. And so, the valuations are still extremely attractive. There are 200 small- and mid-cap companies that are trading at or near cash. And keep in mind, the level of innovation is only accelerating, as Andy and I mentioned. And so, last year was really a year of great data, and looking forward, this year we think could be a year of great product launches. And unlike other areas, when these drugs launch, they don’t just drive growth for a year or two; these are 10-year product cycles that drive revenues and cash flows and provide up to a decade or more of growth for these companies.

In summary, you’re in the sector now that has still-depressed valuations, rising levels of innovation that’s accelerating, and we’re at the very early innings of a new product cycle. And so, I think it’s extremely attractive to invest in biotech at this time.

Hetts: Okay, so Andy, maybe we can wrap up with where the rubber meets the road – as an active manager, what do you think is unique about security selection in biotech compared to other sectors and traditional equity markets?

Acker: So, biotech is actually, of every sector, by far the least efficient sector in the entire market. And when I say that, when we look at the top performers and the worst performers in the sector, over the last 10 years, the top-five performing biotech stocks were up 287% in a year. So, they nearly quadrupled, while the worst stocks in the sector lost almost 80% of their value.² So, that is a 17-fold difference between the winners and the losers in this sector. And it’s really driven by the extreme nature of drug development. It’s something that we call the 90/90 rule. So, again, 90% of the drugs that begin human clinical testing will never make it to market. So, you have to try to identify the one out of 10 that has everything lined up correctly to make it.

And then once a product actually gets to market, in our experience over the last 24 years of investing in the sector, the consensus estimates for new product launches are wrong about 90% of the time. Some of these products that were estimated to do a few hundred million [dollars] in sales can go on to become some of the biggest blockbusters.³ A very famous example is the drug Lipitor, which became a multibillion-dollar blockbuster; it was originally expected to be a couple hundred million dollars. And then on the other hand, you have drugs that were expected to do well, maybe to become a blockbuster product, that never return their cost of capital and never really take off. And so that drives these extremes in stock price performance.

It’s an extremely complex and dynamic sector, where understanding the nuances of science can actually drive differentiated returns. So, I think it is a sector that really lends itself to an active management approach. And I think when you have a dedicated team of specialists, when you have a disciplined process of investing in a sector, when you have tremendous innovation and also combine that with the unbelievable inefficiencies of this market, it’s a set-up that allows value creation over many, many years.

Hetts: Okay, so we’ve had a historical drawdown and now historical bargains in the least-efficient sector in the market, which is now poised for historical innovation over the next decade. I think that’s pretty good. So, thanks Andy and Vish for the update on biotech.

Acker: Thanks, good to be here.

Sridharan: Thanks for having us.

Hetts: And thanks to our listeners for joining. And if you haven’t already, you can find more Global Perspectives on Spotify or iTunes or wherever you listen. And, of course, check out the Insights section of the Janus Henderson website for more of our views.

Thanks again, we will see you next time.

¹ The XBI is the SPDR S&P Biotech ETF, which is designed to correspond to the performance of a modified equal weighting of the S&P^® Biotechnology Select Industry^TM Index. The drawdown period was from 8 February 2021 to 11 May 2022, with a total decline of -63.9%. (Source: Bloomberg)
² Based on the Wilshire 5000 Index, from 2013 to 2022.
³ A blockbuster drug is defined as having $1 billion or more in annual sales.