Williams says these type of stocks, which have been a preferred hunting ground of late for FE Alpha Manager Neil Woodford, have seen rapid growth in recent years but may be approaching bubble territory.
“We don't get involved in these types of stocks. If they go into a period where they are going to start generating lots of cash and paying a dividend yield, say next year, then we might buy them this year. But generally we not interested when they are having a long period of negative cash flow with only a potential for a big pay-off at the end,” he said.
“With these stocks you might get a fantastic pay off because of a takeover or because they do a big deal with a pharmaceutical company, but it is a bit of a binary event and what we are looking for is much more than hoping to get lucky in the future.”
“Biotech is particularly a case in point. The reason it has done so well is because the time to market has been shortened by the Federal Drug Administration, allowing more drugs to come to market more quickly which has meant the cost has been dramatically reduced.”
Williams says if a stock is more likely to see its share price rise over the longer term if it has a growing dividend than through the promise of future contracts or being involved in M&A activity.
He adds that while it is hard to say for certain if these stocks are in a bubble, they have undoubtedly risen very rapidly.
Graham Spooner, investment research analyst at The Share Centre, says an expectation of a material uptick in bid activity has boosted the pharmaceutical and biotechnology sector this year.
“M&A has been the buzzword for the sector in 2014, bolstering valuations, but earnings and sales have been under pressure,” he said.
“Pharmaceuticals and biotechnology companies in the FTSE 350 have seen revenues fall 3.8 per cent compared to a year ago, decreasing by £1.9bn. Earnings have been hit even harder, falling by 11.9 per cent to £8.1bn.”
According to FE Analytics, the FTSE All Share Pharmaceuticals & Biotechnology index has gained 18.19 per cent in 2014 compared to a gain of just 1.84 per cent in the FTSE All Share.
Performance of indices in 2014
Source: FE Analytics
While Woodford’s enthusiasm for UK biotech and university spin-out companies is well known it is important to note that they represent a reasonably small part of his £3.7bn CF Woodford Equity Income fund.
However, he has frequently said the sector merits greater financial support from investors and speculation has been rife of late that the manager will launch a specialist investment trust in early 2015 specifically targeting such companies.
Examples of Woodford’s interest in the niche sector include Oxford Nanopore, an unquoted UK bioscience group founded in 2005, and 4D Pharma, which has seen a jump of approximately 150 per cent in share price soon after Woodford’s backing of the firm became public knowledge.
Performance of stock over 1yr
Source: FE Analytics
Woodford (pictured) says he has invested in early-stage businesses – some of which are quoted, others unquoted – because it is an unloved and subsequently undervalued part of the market that he believes has huge untapped potential as a consequence.
“This undervaluation is symptomatic of a simple dynamic: the demand for capital in this area is high, but its supply is very constrained. This reflects the fact that very few investors are willing to embrace the long-term ‘patient capital’ approach required in this sector to deliver successful outcomes,” he said.
“Early-stage companies need nurturing to fulfil their long-term potential. This sits uncomfortably with many investors who take a short-term view and expect their investments to deliver returns within one or two years.”
He says this is largely because early-stage businesses can be demanding and labour intensive to analyse.
“They have the potential to deliver significant out-sized returns over time, but they will often need periodic injections of capital before they become self-sustaining businesses,” he added.
“In this way, they should be viewed as partly-paid investments, where over time more capital is invested as a business begins to fulfil its potential and as pre-determined hurdles are overcome.”
“Although these investments may be small in a portfolio context initially, we expect them to become bigger as they mature.”
A recent FE Trustnet article examined the outlook for the wider biotech sector after noting that investors have become more interested in the area.
Chief market strategist at IG Brenda Kelly warned in the article that valuations are stretched and the wider sector could see a correction in the coming months.
“Markets have been on a very bullish run recently and something as volatile [as biotech] has been lifted along with that, but there is volatility associated with the industry and that is something an investor must bear in mind,” she said.
“If you are going to try and take advantage of the move in it you can probably expect to see a good deal of noise and potential volatility in the coming months.”
