Biotech valuations are languishing at a two-decade low, which Biotech Growth (BIOG ) says points to an overdue recovery in the beleaguered sector.

After delivering an underlying 55% total return in 2020/21, investors in the £331m investment trust have seen fortunes reverse in the 12 months to 31 March as the value of the portfolio tumbled by a third amid a violent sell-off in the biotech sector.

Despite the disappointing year, fund manager Geoff Hsu said the slump in high-growth biotech stocks, whose valuations came under intense scrutiny as inflation and interest rates started to rise, only added to his bullishness.

‘We believe the unprecedented sell-off in emerging biotech has driven valuations to 20-year lows, giving a compelling valuation argument to our bullish stance on the sector,’ he said.

Huge XBI drawdown 

He pointed to the performance of the XBI – an equal-weighted index of biotech companies of all market capitalisation – which suggests a sharp rebound is due.

The XBI has outperformed the main US stock market index, the S&P 500, since its inception in 2006, but over the 15-year lifespan there had been periods of sharp underperformance of the broader market.

‘Typically, these drawdown periods result in underperformance versus the S&P 500 of 30-45%,’ said Hsu.

‘The current performance drawdown of the XBI is 65%, making it the longest and most severe period of underperformance in the XBI’s history.’

However, Hsu said each of the previous drawdowns was followed by ‘a period of significant outperformance of the XBI versus the S&P 500’.

‘Given the severity of the drawdown, history would suggest we are overdue for a period of biotech outperformance,’ the fund manager (below) said.

Stocks valued less than cash

Hsu’s preference for smaller biotech firms means many are yet to become profitable, so he benchmarks their valuation by comparing their market capitalisation with the net cash on their balance sheets.

‘We view this as an objective measure of valuation as it does not depend on assumptions regarding probability of success of assets, launch timing or future revenue estimates,’ he said.

‘By this simple cap-to-cash metric, data indicates that almost 20% of biotech companies were trading at market caps below the net cash on their balance sheets as of the end of the fiscal year. That is a level we have not seen in over 20 years.’

Hsu said currently 100 companies were trading at ‘negative enterprise values’, and while some deserved that depressed valuation, ‘many have interesting technologies and programs that just haven’t reached fruition yet’.

‘The high proportion of companies trading below cash reflects an overall biotech sector valuation that is extremely depressed,’ he emphasised.

Like his Orbimed colleagues at Worldwide Healthcare (WWH ), which has also published its annual report, Hsu is also on the look out for a ‘relief rally’ when the sector receives certainty over drug pricing after the mid-term elections in November. The issue has plagued the sector for years but has sharpened again since Joe Biden became president.

‘Over much of the fiscal year, there was congressional debate about drug pricing proposals to be included in the Biden administration’s social spending bill,’ he said.

‘This is likely contributing to depressed valuations for healthcare broadly. A relief rally generally ensues once there is certainty about such reform proposals, so passage of a drug pricing bill could act as a clearing event for the sector.’

Losers and winners

A number of stocks in the portfolio have suffered heavy losses this year, including emerging life science tool company Singular Genomics Systems, which is down 73% year-to-date. Hsu said the stock ‘pulled back significantly’ after its flotation on Nasdaq in May 2021 as ‘early-stage tools companies fell out of favour’, compounded by ‘competitive concerns’ from bigger players.

Guardant Health, an oncology diagnostics company, has lost almost 60% in the broad pullback in its sub-sector ‘despite reporting generally strong financial results’.

‘The stock was particularly weak after rumours came out that it was considering a purchase of NeoGenomics, another public oncology diagnostics company, though the deal was never consummated,’ he said.

It hasn’t all been bad news for Hsu, whose fund benefited from the Pfizer takeover of holding Trillium Therapeutics for $2.3bn and the $450m takeover of Flexion Therapeutics by Pacira Pharmaceuticals, and again like the managers at Worldwide Healthcare, he expects an acceleration in M&A to boost returns further.

A weakening finance environment has made small, innovative companies ‘more receptive to M&A overtures’ from big pharma, while the depressed valuations of the former have encouraged larger players to make an offer.

‘M&A premiums from current depressed valuation levels could be significant,’ said Hsu.

‘Given the unprecedented correction we have seen in emerging biotech and historically low valuations, we think the sector is poised for a substantial recovery.’

Numis Securities analyst Gavin Trodd said Hsu’s bias to smaller companies had hurt performance. The trust had suffered a bigger fall than Worldwide Healthcare, sliding 40% in the past year, and now underperformed the Nasdaq Biotechnology index over five and 10 years, with shareholder returns of 15% and 227% trailing the benchmark’s 73% and 327%. 

Nevertheless, the shares have not de-rated and still trade close to net asset value, which Trodd said showed investor confidence in the well-resourced Orbimed team, which, despite the recent slump, had a ‘strong long-term track record’.