The case for investing in biotech

Carl Harald Janson discusses the outlook for biotechnology and healthcare

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The biotechnology sector has been at the forefront of the current flurry of healthcare merger and acquisition activity, with larger companies snapping up their smaller and more innovative competitors. 2014 was a record breaking year for healthcare deals and this year is also off to a strong start. In the first half of 2015, the total value of healthcare deals is currently USD 279bn – an increase of 20% for the same period last year, according to Dealogic.

As the number of deals has increased so too has the premium that firms are prepared to pay. AbbVie bought biotech company Pharmacyclics, which makes just one cancer drug, for USD 21bn - a premium of nearly 50% over its pre-deal value.

These punchy premiums have caused some to voice concerns about the continued strength of deal activity and question the price tags attached to some of these healthcare deals. But there are sound economic reasons for this uptick in activity.

The long-term prospects for this sector remain intact. While the population in the developed world is ageing, in the emerging markets there is a growing middle class. Both of these demographic trends will increase demand for drugs. In addition, there are still a large number of diseases - from Alzheimer’s to cancer - which lack effective therapies.

But there has been an important shift within the healthcare companies which could ramp up the earnings potential for the sector.

In recent years, there has been a much greater understanding of the mechanism underlying different diseases which has resulted in the development of revolutionary new therapies such immuno-oncology. This greater understanding of the causes of individual diseases means the healthcare sector is now developing drugs which are disease modifying rather providing symptom relief.

In addition, the healthcare sector has become more efficient at research and development, with the overall spending in the sector falling while the number of potential cures is increasing.

The healthcare sector is also getting better support from the US drug regulator which is speeding up the approval of breakthrough therapies that change the way a disease is treated. In 2014 more than 40 new products were approved – the highest number of approvals for at least 14 years.

These efficiency improvements will translate in to strong sales for prescription drugs over the medium term. The consensus of equity analysts is a compound annualised growth rate of 5% with total worldwide prescription sales expected to reach USD 1.1trn by 2020.

It is one thing to be able to develop an effective new compound and quite another to ensure it is a commercial success. That requires a deep understanding about the technical aspects of drug development and trial design, knowledge of how to approach regulatory authorities as well as the most effective way to access capital.

We will only invest in those companies where we think the management team has the necessary skills to navigate the pitfalls of drug development successfully. Once we have invested, we stay close to the management team so we can understand both the opportunities and risks at each company.

Even by taking all these steps, investing in biotech companies is risky business – there is a strong probability that products will fail to make it to market. One way to mitigate that risk is try to avoid binary events for a particular company such as when a particular drug is due to receive approval from the FDA. We think it is better to travel than arrive – so we will invest a long time ahead of such an event and then either trim our exposure to a company or exit it altogether.

One company which fits our investment criteria is Incyte. The company already has one drug approved - Jakafi - which is used to treat a genetic disorder that causes the body to produce too many red blood cells. The company has successfully managed to get Jakafi approved for an additional indication which will double the sales of this compound.

In addition to this drug, Incyte has an interesting pipeline of oncology compounds as well as a strong management team who proved they can successful commercialise a product.

Another company which matches our investment criteria is the Danish biotech firm Genmab. This firm specialises in making monoclonal antibodies which are used to treat cancer and other conditions. One of its monoclonal antibodies – daratumumab – looks especially interesting.This compound targets the CD 38 molecule which is found in high quantities on the surface of multiple myeloma cells. This is a particularly devastating form of cancer with a very poor prognosis.

Genmab should have the only product on the market, which could materially change the way a particularly pernicious cancer is treated, for several years. That could translate into billions of dollars of sales.

While the long-term outlook for the biotech sector is positive, it is much more difficult to predict the short-term direction of stocks. The sector has had a strong bull run for several years so it’s not unreasonable to expect some corrections over the short-term. But such re-ratings should be viewed as an opportunity to pick up those biotech stocks with excellent long-term prospects at a good price.