Can Biotech Bounce Back?

Biotechnology stocks have been suffering a months-long decline. But while the sector faces some challenges, attractive valuations and a rapid pace of medical innovation could become difficult for investors to ignore, says Portfolio Manager Andy Acker.

Key Takeaways

  • Biotechnology stocks have sold off in recent months on concerns about potential health care reform, a global economic slowdown and other headwinds.
  • However, the pullback has improved valuations while medical breakthroughs are driving a surge in new product launches and increased merger-and-acquisition (M&A) activity.
  • The combination of attractive valuations and continued innovation could help drive the sector’s growth, regardless of the political or economic backdrop.

Biotechnology is known for periods of volatility, with this year being a prime example. After rising 30% year to date through April 5, the S&P Biotechnology Select Industry Index began a months-long decline, falling by as much as 20% in October.1 The sell-off occurred as legislators introduced drug pricing reform in the U.S. and 2020 presidential candidates called for overhauling the health care system. Uncertainty about global economic growth and trade tensions also created a risk-off environment in financial markets, which weighed on small-cap biotechnology stocks dependent on public markets for funding. In addition, a handful of high-profile clinical trials delivered disappointing results, most notably in Alzheimer’s disease. In short, biotech’s high-risk/high-reward profile appeared to tilt a little too much toward risk.

Valuations Improve, Pipelines Ramp Up

This is not the first time biotech stocks have swooned, and it probably won’t be the last. But for investors with a long-term perspective and the appropriate risk tolerance, we believe the sector’s fundamentals remain as appealing as ever. For one, the recent pullback has made valuations more attractive, with the S&P Biotechnology Select Industry Index trading at all-time low valuations and more than a 40% discount to the market (see Exhibit 1).

Exhibit 1:  Biotech Valuations (Forward Price-to-Earnings Ratio (P/E))

Source: Bloomberg. Data are quarterly from 9/30/92 - 9/30/19.
Price-to-Earnings (P/E) Ratio measures share price compared to earnings per share for a stock or stocks in a portfolio.

 

Admittedly, multiples for some large-cap biotechs have dropped for good reason, as an increasing number of these companies face looming patent expirations, opening them up to generic or biosimilar competition in the coming years.

But exceptions exist. AbbVie’s blockbuster drug Humira, for example, loses its exclusivity in the U.S. in 2023, causing the stock’s forward P/E to drop to as low as 6.8 this year (a blockbuster drug generates sales of $1 billion or more annually).2 But the firm is preparing for this eventuality and recently won Food and Drug Administration (FDA) approval for Rinvoq, an oral therapy for rheumatoid arthritis, as well as Skyrizi, a once-quarterly injectable for psoriasis that is seeing strong patient uptake.

Vertex Pharmaceuticals is another notable exception. In October, the $50 billion biotech received FDA approval for a new medication for cystic fibrosis (CF). The highly innovative therapy dramatically improves the standard of care for 90% of all CF patients and is likely to accelerate Vertex’s top-line growth significantly.

Small- and Mid-Cap Biotechs Drive Innovation

At the same time, some of the sector’s most exciting medical breakthroughs – from life-changing gene therapies to small-molecule targeted therapies for cancer – are being achieved by small- and mid-cap biotechs (companies with market valuations of roughly $10 billion or less). Often, these entities are still developing their pipelines and, consequently, do not have predictable earnings. But in our opinion, they have the potential to become the next “big” biotechs, with today’s market volatility improving the risk/reward equation.

Along those lines, we have seen strong M&A activity. For the year through October 31, nearly $190 billion in deals have been announced in biotech, on track to match last year’s $221 billion record. Many of the acquisitions are being made at substantial premiums.

For instance, in October, Alexion Pharmaceuticals announced it would purchase Achillion Pharmaceuticals for $930 million, a roughly 73% premium (with the potential to pay even more should certain clinical and regulatory milestones be met). Achillion is developing oral small-molecule compounds that target rare diseases associated with the complement system (a part of the immune system), including paroxysmal nocturnal hemoglobinuria (PNH), a life-threatening blood disease. Achillion’s pipeline could help expand and diversify Alexion’s product offering.

Exhibit 2: Health Care M&A Heats Up (Total Volume)

Source: Bloomberg, as of 10/31/19

 

The Alexion/Achillion merger will need approval by the Federal Trade Commission (FTC), which lately has held up several biotech deals on antitrust concerns. The regulatory uncertainty has further weighed on biotech stocks but may not be insurmountable.

For example, Bristol-Myers Squibb, which earlier this year announced plans to buy Celgene for $74 billion, recently sold psoriasis drug Otezla, a divestiture that was required by the FTC. The drug fetched a better-than-expected $13.4 billion and has improved the chances of regulatory approval. At the same time, prospects for the combined company have improved. For one, Bristol-Myers’ immunotherapy, Opdivo, recently delivered positive clinical trial data as a front-line lung cancer treatment. In addition, Celgene has experienced several key pipeline advances, including luspatercept, a product developed with small-cap biotech Acceleron Pharma. Luspatercept has shown a dramatic benefit in managing chronic anemia associated with myelodysplastic syndromes and beta thalassemia, both blood disorders, and is believed to have blockbuster potential.

Scientific Breakthroughs Continue

Despite significantly higher volatility, over the long term biotech has outperformed the S&P 500® Index, and today’s rapid pace of innovation could help fuel future gains. Since 2017, the FDA has approved more than 100 novel therapies, including the first two gene therapies. One of these gene therapies, Zolgensma, addresses spinal muscular atrophy, a leading genetic cause of infant death. In clinical trials, the treatment led to unprecedented rates of survival in infants and rapid improvement in motor functions.

Exhibit 3: Biotech Historical Outperformance

Source: Bloomberg. Data are weekly from 12/31/99 - 10/25/19. Indices rebased to 100 as of 12/31/99. Past performance is no guarantee of future results.

 

Zolgensma is just one of many recent medical breakthroughs. Last year alone, almost half of FDA-approved treatments received orphan drug designation3 and over a third had novel mechanisms of action (the biochemical processes in the body affected by a drug’s action), according to a report by the IQVIA Institute for Human Data Science. In addition, there are now 3,876 immunotherapies under development globally, an increase of 91% since 2017.4

There is no guarantee that today’s flurry of research and development will translate into successful new medicines, but the data suggest innovation is accelerating and looks set to continue regardless of the political or economic backdrop.

 

1Bloomberg, as of 10/9/19
2Bloomberg, as of 8/16/19. P/E is based on estimated, forward 12-month earnings.
3According to the FDA: “The Orphan Drug Act (ODA) provides for granting special status to a drug or biological product (“drug”) to treat a rare disease or condition upon request of a sponsor. This status is referred to as orphan designation (or sometimes “orphan status”). Orphan designation qualifies the sponsor of the drug for various development incentives of the ODA, including tax credits for qualified clinical testing."
4“Immuno-Oncology Drug Development Goes Global,” Cancer Research Institute, September 27, 2019.

S&P 500® Health Care Index comprises those companies included in the S&P 500 that are classified as members of the GICS® health care sector.

S&P Biotechnology Select Industry Index comprises stocks in the S&P Total Market Index (TMI) that are classified in the GICS biotechnology sub-industry. The S&P TMI is designed to track the broad equity market, including large-, mid-, small-, and micro-cap stocks.

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