The investment opportunities and valuations in the biotechnology sector are here to set the stage for the next decade, according to OrbiMed’s Geoffrey Hsu (pictured). 
The co-manager of The Biotech Growth Trust says that the staggering performance of the sector should be seen as a ‘buy sign’ for investors and should not be ringing alarm bells, despite fears that a correction or even a sell-off is inevitable.
Over one, three, five and 10 years, the NASDAQ OMX Biotechnology index and the IT Biotechnology & Healthcare sector have significantly outperformed many other benchmarks, including the FTSE 100 and the S&P 500.
Performance of sector and indices over 10yrs
Source: FE Analytics
However, the majority of this outperformance comes from the last three years, when the sector and benchmark started rallying harder than ever.
This sharp incline, as shown in the graph above, has made many investors nervous about investing in the sector due to concerns that this performance will not be able to continue for much longer.
Laith Khalaf, senior analyst at Hargreaves Lansdown, says that while investors should approach the sector with caution, they shouldn’t necessarily write it off based on market performance.
“I think the valuations are quite high, but there are some companies with interesting products coming through. The important thing to do is try and avoid the companies that don’t have anything that’s making money and that’s the problem,” he explained.
“There are tailwinds though, in the form of the development of new drugs coming out and the fact that we do have an ageing population in most of the world who are going to increasingly need more medical assistance.”
“The worry though is valuation and, at an individual stock level, sometimes the result can be quite binary – either a company delivers the profits that it’s expected to or it doesn’t, in which case the share price can collapse.”
Despite the potential risks, Hsu believes investors who have turned pale on the sector are missing out on phenomenal gains for their portfolio and, as such, expels three of the biggest myths about the biotech sector in the article below.
Myth one: Biotech is in a bubble
It is easy to see why so many investors believe biotech to be in a bubble, following the aforementioned huge boost in performance over the past three years.
There have been similar incidents of hard-rallying regions or sectors that have delivered remarkable performances that are then followed by huge sell-offs, the most recent being the Shanghai Stock Exchange, which has lost nearly a quarter of its value since June.
Performance of index in 2015
Source: FE Analytics
“The question about whether biotech is in a bubble is probably the most common question that I get. I would say that if one looks at the valuations of profitable biotech companies, you can see that actually their P/E multiples aren’t that stretched relative to historical norms,” Hsu pointed out.
“Biotech tends to trade at a higher P/E in general compared to markets because the growth rates are generally higher. I would agree that this could be called a bubble if those P/E multiples were super inflated but, if you look at the multiples they’re actually not.”
As a result, the manager doesn’t believe that the sector is in a valuation bubble, particularly in terms of well-established large-cap companies.
He says that the share price appreciation over the last few years can be attributed to earnings growth as opposed to capital expansion, which is a factor he believes that many investors overlook.
“Among the smaller cap biotech companies, I would agree there are some companies that are over-valued but there are still plenty of companies that we think do offer compelling value and have very interesting assets,” he said.
“It’s our job as managers of this trust to differentiate between these two types of companies obviously, so maybe on the smaller end of the spectrum there are pockets of overvaluation but I would not say that overall biotech is particularly overvalued, and that’s why we don’t really feel like this is a bubble.”
Hsu admits that, like other sectors, biotech will of course experience natural corrections in the future, which he says is healthy.
“We’ll see some dips every now and again but I think that’s natural and our view is that the science being done in biotech right now is strong, and that supports a constructive and positive outlook for the sector,” he added.
Myth two: Biotech is high risk
Another reason that investors are often deterred from the sector is the view it is high risk.
Despite biotech’s three-year rally, the sector average’s annualised volatility over the same time period is approximately double that of the IT UK Smaller Companies, IT Global and IT UK All Companies sectors.
The sector’s downside risk is also twice as high and it has a significantly higher max loss, which measures the longest running consecutive loss without making a gain.
However, Hsu argues that biotech funds and trusts cannot all be tarred with the same brush.
“Investing in an individual biotech company can be high risk and the shares can be volatile, but I would say that investing in a well-diversified portfolio of biotech [stocks] is actually not as risky as some investors may believe,” he said.
“In fact, if you look at the performance of The Biotech Growth Trust, even in periods of significant volatility such as the financial crisis of 2008 and so forth, you’ll see that the fund actually did quite well relative to many other sectors during that turbulent time.”
Performance of fund vs sectors in 2008
Source: FE Analytics
Hsu adds that the industry as a whole has matured dramatically over the last 10 years, leading to more companies in the sector boasting low volatility and steady earnings growth.
Currently, The Biotech Growth Trust holds a 50 per cent weighting in these larger profitable names and a 50 per cent weighting in younger companies further down the market cap spectrum, which the manager says offset each other as part of a diversified portfolio.
“Yes, one of them might go down one day but another one might go up quite a bit, so I think diversification is the key to making this asset class risky,” he explained.
“Frankly, in terms of sensitivity to broader macroeconomic factors, it’s in many ways less sensitive because all the value is being generated from the particular drugs that are being developed within the sector.”
Myth three: Biotech is a cyclical sector
Some investors have categorised biotech as a cyclical sector in the past due to its volatility and as such will choose to steer clear if they want to have a more defensive portfolio.
“I guess biotech is cyclical in the sense that there are periods where the FDA [Food and Drug Administration] might go through a risk averse view towards drug approvals or there might be a high profile drug withdrawal from the market and so forth, and of course the financial window for these companies can wax and wane,” Hsu admitted.
“I would say that the signs we’re seeing right now in the sector is that it can sustain a lot of new drugs in some very large therapeutic categories for many years – I guess that’s consistent with our generally constructive view on the sector.”
“There are a lot of sectors out there that can go through cycles, whether you’re talking about airlines for instance, there are a lot of consumer sectors that can be cyclical as well, but I would actually say is that, if you’re a long-term investor and if you’re investing in innovative companies that are generating value, you will succeed.”
Hsu says that every investor is going to have differing preferences and time horizons, so the biotech sector won’t be suitable for everyone.
“Sure, biotech is going to have crunches now and again as well, but over the long term there should be net valuation in the industry and that’s exactly what we’ve seen so far,” he added.
The Biotech and Growth Trust, also managed by Richard Klemm, is £497m in size and has delivered a top-decile performance over five and 10 years.
Performance of fund vs sector and benchmark over 10yrs
Source: FE Analytics
It is currently 9 per cent geared and is trading at a 6.9 per cent discount. The Biotech and Growth Trust an ongoing charges figure of 1.22 per cent and charges a performance fee.
