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Tech vs biotech: Is it time to look beyond the Magnificent Seven?

21 March 2024

The biotech sector offers attractive valuations and strong secular growth trends.

By Jo Groves,

Kepler Partners

It would be fair to say that the past year has been dominated by the so-called Magnificent Seven, with investors enjoying stellar gains from the likes of NVIDIA, Meta and Amazon.

But, away from the madding crowd, the biotech sector has been quietly bouncing back to health, as evidenced by the Nasdaq Biotech Index chalking up a gain of 12% to outperform the S&P 500 index over the past three months as of the time of writing.

Deciding the right time to profit-take can be notoriously difficult, but is this a good opportunity to step off the gravy train and recycle gains into another high-growth sector?

Current valuations may suggest so, with the S&P 500 currently trading at a price-earnings ratio of 21, fast approaching its 20-year-high, and some of the Magnificent Seven trading on far higher valuations.

With this in mind, which sectors offer similar high-growth potential but at more attractive valuations? Well, the biotech sector may just fit the bill, with strong projected earnings growth and valuations well below long-term averages (and almost 25% below the S&P 500 average).

The Darwinian shake-out of the biotech sector since its glory days in the pandemic has left a universe of higher-quality companies trading at attractive valuations (and some trading below the value of their cash balances).

It’s also a cyclical sector which is highly sensitive to investor sentiment, creating a headwind in the face of higher interest rates and the general flight to ‘safer’ assets in the past two years.

But cyclical sectors can prove lucrative for buy-and-hold investors, and even more so for investors achieving the holy grail of buying in just as the recovery starts to build momentum.

Looking ahead, the biotech sector certainly ticks the box in terms of long-term secular growth drivers. Ageing populations, increased life expectancy, the prevalence of chronic diseases and the growing middle class in emerging economies will fuel global healthcare spending to record highs in the next decade.

On the supply side, the rapid increase in the number of biologic treatments is constantly expanding the universe of products for chronic diseases. And the biotech sector is at the heart of this, accounting for more than 80% of drugs in the development pipeline, according to US firm IVQIA, as well as being at the forefront of developing cutting-edge treatments for previously untreatable diseases.

An upturn in mergers and acquisitions (M&A) often marks the start of a new biotech cycle as companies are the first to exploit attractive valuations, and the recent rise is expected to continue as large-cap pharma companies outsource high-risk, early-stage R&D to their nimbler peers.

These pharma giants have built significant acquisition war chests to plug an estimated $200bn loss in annual revenue by 2030 due to ‘patent cliffs’.

One such beneficiary of takeover activity is International Biotechnology Trust, which has received seven offers for portfolio companies in the past calendar year alone. The significant premiums paid for Horizon, Seagen and Chinook Therapeutics have contributed to its 10-year share price return of more than 170%, compared to 130% for the IT Biotech & Healthcare sector.

As biotech is a more speculative sector, the trust’s managers take an active approach to risk management with the aim of preserving capital and reducing downside risk. They invest in a basket of companies targeting the same disease, rather than trying to ‘back the winners’, and reduce exposure ahead of binary outcomes such as clinical trial data.

International Biotechnology Trust also tailors its portfolio weighting according to the cycle, investing in a higher proportion of companies with ‘oven ready’ products during a downturn, and building exposure to earlier-stage companies ahead of a potential upturn.

Moving to the broader healthcare sector, Bellevue Healthcare offers a differentiated approach with a highly concentrated portfolio of up to 35 stocks across the market-cap spectrum. This means it can underperform the benchmark on occasions, particularly when smaller-cap stocks are out of favour with investors, but should be well-positioned for a recovery in valuations.

The trust invests in companies providing innovative solutions that lower costs through improved efficiency and/or achieving superior patient outcomes. The managers take a holistic view of the healthcare universe, which can include software suppliers and health insurance providers, as well as traditional pharmaceutical and biotech companies.

One of Bellevue Healthcare’s top-performers last year was radiopharmaceutical therapy provider Point Therapeutics, which was acquired by Eli Lilly at a premium of close to 90% (of the closing share price prior to announcement). Due to the trust’s concentrated portfolio, M&A activity can significantly boost overall returns. 

It goes without saying that timing the upturn of a cyclical sector can be challenging, but the recent bounce could signal the green shoots of a sustained resurgence. Given the long-term tailwinds for the biotech sector, investors may be attracted by the valuations on offer and the opportunity to diversify their portfolios beyond the Magnificent Seven.

Jo Groves is an investment writer at Kepler Partners. The views expressed above should not be taken as investment advice.

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