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Six active approaches for a biotech boost

28 July 2022

International Biotechnology Trust’s Marek Poszepczynski and Ailsa Craig explain why using an ETF to track biotech companies might not be best way to get exposure to the industry’s innovative growth.

By Marek Poszepczynski and Ailsa Craig,

International Biotechnology Trust

While the road to a successful drug launch can often be long and arduous, the biotechnology industry continues to rapidly roll out innovative new approaches to tackling devastating diseases.

Abounding scientific innovation continues to fuel the supply of new drugs, while developing world demands for greater access to healthcare – as well as an ageing global population – underpins robust long-term demand for the sector’s products.

Given these resilient growth drivers, investors may be tempted to just select an ETF and simply track the biotechnology index. However, not only is deep sector specialism required to identify true innovative leaders, but active management is also vital in navigating numerous external factors – as biotech valuations are often heavily impacted by interest rate changes, inflation, geopolitics and bouts of global crises.

Below, we highlight the strategies that specialist investment trusts can deploy to aid alpha generation efforts and seek to reduce beta in the biotech space – in both rising and falling markets.

 

Careful curation

The hyped biotech stock valuations seen in the run-up to the sector’s February 2021 peak led to an onslaught of biotech companies floating, many of them at an earlier stage of development than typically seen in public markets. Investors appeared to react exuberantly, but much of the capital driving the hype was flowing into passive ETFs, which are, by definition, indiscriminate buyers of every stock underlying the tracked index. This resulted in many companies becoming overvalued.

To avoid holding companies with inflated valuations, specialist investor managers can hand-pick stocks possessing robust growth fundamentals. Specifically, we look for realistically priced, well managed and financed businesses addressing areas of unmet medical need. Publicly listed biotech firms that have a product close to, or already through, the drug approval stage are also highly attractive, as these naturally display less risk.

Actively managed funds like ours can avoid businesses with no meaningful clinical data or a suite of ‘me too’ products. Carefully curated portfolios will also mitigate beta, as low exposure to overhyped businesses reduces the risk of portfolio volatility.

 

Private positions

Looking beyond public markets is another useful tactic a specialist investment fund can deploy with the aim of generating alpha in the biotech arena.

Investment trusts are especially well suited to this type of investment due to their closed end structure. Exposure to unquoted businesses ensures portfolios are inherently differentiated from the benchmark meaning that positive moves in those companies are mostly alpha generating. While investments in unquoted companies generally carry a longer lead time to profitability, due to their early-stage nature, the growth potential can be far greater.

Additionally, unquoted companies can act as a ballast in a falling market, as valuations are not subject to the volatility induced by the vagaries of public market investors. In this way, unquoted companies can both reduce beta and generate alpha. We subsequently invest 5-15% of our portfolio in unquoted biotech funds.

 

Takeover targets

Specialist biotech investors can seek to capitalise on the biotech sector’s dynamic M&A activity to deliver outperformance over the benchmark. Traditionally, ‘big pharma’ companies have dominated M&A in the biotech and pharmaceutical sectors, as these businesses face constant pressure to acquire new technologies and products before the patent protections on existing drugs expire. Currently the most common targets for M&A are revenue growth companies with assets that have gone through the approval stage but are in an early stage of the roll out to patients.

Allocating to these types of assets poses a compelling alpha generation opportunity, given the significant return on investment that acquisition of a portfolio holding can deliver. An example of this is Biohaven Pharmaceuticals, a company with strong management capability and a solid pipeline of innovations – which included Nurtec ODT, a migraine therapy approved for both the acute treatment and episodic prevention of migraine in adults. Last month, Pfizer acquired Biohaven at a considerable 79% premium. Biohaven was not a constituent of the NASDAQ Biotechnology Index (NBI), so was an added bonus in terms of alpha for Biohaven investors benchmarked against the NBI.

 

Actively allocate

Within the biotech sector, there are several types of public companies – those already profitable, those with launched products but not yet profitable, and early-stage development-stage businesses. In turbulent and declining markets, the profitable companies tend to be more stable than the other groups, and therefore provide a relative safe haven for investors. An active fund manager can exploit these sorts of trends by tilting the portfolio to be overweight in one type of asset and underweight another.

When we anticipated a fall in the markets last spring, we increased our weighting in these companies to enhance the prospects of portfolio protection. Conversely, when a bounce is likely, we increase our exposure to early-stage names, which tend to witness the sharpest gains. We are currently optimistic around M&A activity in the revenue growth category.

 

Gearing

Alpha generation prospects can be improved through the sensible utilisation of gearing. Investment trusts can use gearing to enhance returns in a rising market, and deleverage when a retraction is expected. This is in stark contrast to exchange traded funds, which become forced sellers in falling markets and forced buyers when markets trend upwards.

By actively managing our gearing, we can take advantage of market dislocation, such as what we have witnessed in the space over the past two months.

 

Curbing volatility

Lastly, by trading around situations with a binary outcome, it is possible to reduce the volatility of the portfolio. This is a strategy that we have used to good effect. By reducing our exposure to companies in advance of the sort of binary outcomes that are prevalent in the pre-approval stages of drug development, we aim to protect our investors’ money and curb volatility. We can always buy back the de-risked asset immediately after any positive announcement.

 

The ability of a fund to boost returns and protect the downside through these active management strategies are a good reason that investors may turn to a specialist investment trust over an ETF.

Marek Poszepczynski and Ailsa Craig are co-investment managers of the International Biotechnology Trust. The views expressed above should not be taken as investment advice.

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