Biotechnology stocks have been the asset class to own since the dark days of the financial crisis with many funds and investment trusts focused on biotech seeing returns of upward of 500 per cent over this period.
Of course this has come with significant volatility but could a recent downward trend indicate that a substantial slab of those returns are heading for the scrap heap?
According to FE Analytics, over the past 10 years the NASDAQ Biotechnology index has returned 577.31 per cent – vastly eclipsing major developed markets – with much of this gain made in the past few years.
Performance of indices over 10yrs
Source: FE Analytics
However, in recent months the market has started to fall for the first time in more than year having lost about 12 per cent over the six weeks since the end of March, although the index has started to climb back a little since.
Performance of indices since 19 March 2015
Source: FE Analytics
It is unclear what has caused the weakness in the stocks but David Madden market analyst at IG believes investors are getting nervous about an expectation of rising interest rates in the US.
“There have been quite a few M&A stories dominating the headlines and that has been fuelling the stock prices which is why they have been trading so high. If you look at the NASDAQ Biotechnology index it has pretty much doubled in comparison to the broader NASDAQ index over the past 15 years,” Madden said.
“Over the last number of years you have really seen big pharmaceutical corporations who are very cash rich and a very low interest rate allowing for quite a lot of issuing of debt and leverage buyouts. This just compounds the issue with these large companies racking up large amounts of debt.”
He says this presents a potential worry for companies as interest rates rise which is almost certainly likely to mean higher borrowing costs.
“[From] an era when it was easy and cheap to borrow on the debt markets, we are now in a scenario where there is a bit of a wobble and pullback from the moves we’ve seen in recent years. There has been lots of M&A activity thanks to cheap debt but a lot of the stocks are potentially overvalued with lots of stocks trading at premiums to the price they were taken over.”
“There is fear that it is overdone and now that we are edging toward an interest rate rise in the US people are going to look at which sectors have been overheated and have benefited from low interest rates. The biotech sector is clearly a hot one to take cash off the table or even one to go short.”
One investor who has recently begun to short the stocks is top-performing City Financial manager David Crawford, who believes biotechnology is likely to go through a period of underperformance.
“We have some shorts in technology companies and biotech companies – both areas where we think the market is expecting a lot and may actually be disappointed,” he told FE Trustnet recently.
Anna Hauguard (pictured), fund analyst at Brewin Dolphin, meanwhile says a correction could lie ahead but that certain parts of the market look more susceptible than others.
“There are certainly expensively valued stocks and sub-sectors in the group – particularly small caps – and more corrections probably lie ahead in those areas, which is why selectivity and active management is important,” she said.
“We do think large-cap biotechs are very different this time around – many are profitable fairly mature companies with large and growing addressable markets. Although biotech stocks remain toward the higher end of the range of their historical valuations, they are not more expensive than they were a year ago. Much of the stock price appreciation in the sector can be chalked up to increasing revenue and earnings expectations rather than pure sentiment.”
“Looking at long-term valuations going back to the technology bubble, we are not close to that level of market hype. It is nearly 15 years from when Tony Blair and Bill Clinton announced the discovery of the human genome – so what was essentially hype – is now commercial.”
OrbiMed, which manages the Biotech Growth Trust, admits there are signs of overheating in the small-cap biotechnology space but says the outlook for the sector as a whole is positive due to a number of “new, innovative” drugs in the pipeline and “a positive regulatory backdrop and consistently high merger and acquisition activity”.
FE Alpha James Thomson, who heads up the £560m Rathbone Global Opportunities fund, bought several biotech stocks for the first time about a year ago with his portfolio currently overweight the sector and no plans to sell down exposure.
“We still have exposure to biotech – about 6 per cent of fund – but we don’t want to own the early-stage companies with just one or two products in the clinic. We own companies like Amgen and Gilead that are already profitable and have multiple approved products plus exciting pipeline opportunities,” he said.
Russ Koesterich, BlackRock’s global chief investment strategist, recently warned that ‘momentum stocks’ such as biotech were starting to see greater volatility due to worries over rising interest rates.
“This style – buying whatever goes up the most – has been extremely effective for most of the past several years as a low-volatility environment favors this style. But over the last few weeks, many segments of the market that have most benefited from momentum, such as biotech and social media companies, have been the hardest hit,” he said.
“As volatility is still below the long-term average, and we are still in the early stages of the market adjusting to a more normal interest rate regime, this process is likely to continue. This suggests investors may want to reduce their exposure to momentum strategies and increase their position in more value-oriented parts of the equity market.”
Just before the biotech sector started to lose some ground Royce Associates’ Lauren Romeo told FE Trustnet that she was staying clear due to bubble concerns.
“It has hurt being out of that sector but we still feel like it is good to stick to our discipline [as] valuations are getting into bubble territory. It feels like that time in terms of the euphoria in terms of what has been going on in that space. We are wary of this sector,” she said in late February.