Concentrating on US healthcare reform has led many analysts to overlook other positives in the biotechnology sector
For the past year, debate about biotech investment has been dominated by concerns over US healthcare reform, particularly given that a large proportion of the global biotech industry is based in the US. The point missed by many commentators is that reform is likely to be a net positive for biotech. Going forward, there are several secular reasons why biotech investments should perform well, including growing demand and merger and acquisition (M&A) activity.
At the time of writing, the US healthcare reform bill was undergoing final revisions. Because of the uncertainty surrounding the terms of the bill, investors over the past year shifted their focus to other sectors of the economy and remain underweight healthcare. We would expect them to increase their exposure once the outcome of reform has been determined.
If a public healthcare scheme is established to address the nearly 50 million Americans currently without medical insurance, it would create a large new market. Thus biotech companies stand to benefit from a significant increase in demand. The threat of an NHS-type central buyer has receded, so the anticipated pressure on drug prices will not be as serious as some had feared. In any case, biotech companies are less vulnerable to pricing pressure since many of their products are unique therapies for diseases. As part of the proposals, the period of market exclusivity for biotech products is set to be extended from five to 12 years.
From an investment perspective, biotech is considered a defensive sector, especially during economic downturns. The predominantly protein-based nature of biotech drugs makes them harder for generics manufacturers to copy.
However, to make too much of a case for biotech’s defensive characteristics is to ignore the sector’s growth potential. Currently, valuations are at historic lows due to the Nasdaq Biotechnology Index underperforming the broader market in 2009 and there is considerable upside potential.
Over the long term, global demand for medical treatment can only increase. Populations in developed countries are not just ageing but growing richer and choosing to spend a higher proportion of their wealth on healthcare. Many emerging markets are also becoming increasingly affluent with middle classes who can afford more medicines.
Another secular trend driving returns is M&A activity. Transactions in this sector tend to occur at a substantial premium to the share price, netting a handsome return for investors. In May 2008, for instance, Kosan Biosciences was acquired at a 233% premium by Bristol-Myers Squibb for $190m. Then in January 2009, Tepnel Life Sciences was acquired at a 125% premium by Gen-Probe for approximately $100m. Pharmaceutical companies need to offset upcoming revenue losses from patent expirations as they approach the anticipated ‘patent cliff’ in 2012 and 2013, so there are no signs of M&A activity abating.
UK-based investors considering an allocation to biotech should also take currency considerations into account given the predominance of US companies in the sector. Returns in 2008 were enhanced by the dollar/pound exchange rate dynamics, but this is not always the case and investors may wish to hedge their currency exposure.
The Nasdaq Biotechnology Index strongly outperformed the broader market during 2008 and then experienced a volatile 2009 as reform concerns created headwinds. Going forward, short-term performance may be volatile but over the longer term, the industry’s growth prospects are undeniable.
Geoffrey Hsu, investment manager, The Biotech Growth Trust
