Where next for biotech?

For all the complexity of its science, the biotechnology sector’s business model is remarkably simple. A biotech firm must raise enough cash to fund its research for long enough to get to the point where it has a drug or technology that can be sold for a profitable return. Then the cycle begins all over again.

For investors in the sector then, the question to ponder is whether biotechs can make good on this model. Really, that’s two questions: do they have a drug or technology that will make it big one day, and can they raise enough cash to reach that point?

Ironically, given the uncertainties of drug development, it is the second of these questions that should worry investors most. Funding for biotechs is remarkably capricious. When markets are in confident mood, cash is plentiful. When anxiety starts to bubble up, as it has done over the past year, it becomes very difficult very quickly for biotechs to raise money.

All of which is to say that the biotech sector finds itself in a curiously tricky position right now. We have just had a global reminder of what scientific research can achieve for healthcare, with vaccines for Covid-19 developed at breakneck pace. Yet volatile global markets have prompted capital providers to run for cover; biotechs are once again finding it really challenging to raise money.

Still, that might just mean opportunity knocks for investors in the sector. The value of many biotech companies – both privately-owned firms and stock market listed businesses – has fallen sharply. Many now trade on valuations below the cash they hold. In other words, investors are betting they’re going to burn through their money before developing saleable assets.

Calling the bottom of any market is tricky. Back in February, the investment company analysis team at Stifel described the biotech industry as a “fertile environment for active funds to pick through the wreckage”. Since then, we’ve not seen much sign of improvement. Killik & Co’s Mick Gilligan describes the sector as “very out-of-favour after a torrid few years”.

What we do know, however, is that the demand for new drugs and treatments is not going to diminish. In that sense, this is a defensive market – as the world’s population continues to grow, its healthcare needs will expand. As we saw during the pandemic, the biotechnology sector is responsible for meeting those needs, both in emergency situations and on an ongoing basis.

What the vast majority of investors are certainly going to need in order to take the plunge is professional help. This is an industry where most people are not qualified to make a judgement about the prospects for individual companies – while they may be able to weigh the financials, they lack the scientific and medical expertise to assess a biotech’s prospects of success.

This is where collective funds come in. The collective approach to biotechnology provides crucial diversification. If the entire sector is out of favour, there is no hiding from depressed valuations, but in a fund, you are at least protected from the impact of individual failures and blow-ups. You also get the benefit of managers with genuine expertise in evaluating biotech’s prospects.

Where to find such funds? There are no fewer than seven investment companies focused on biotech and healthcare stocks. All of them are currently in the red, performance-wise, over the past year, and in five out of seven cases, their shares trade at a discount to the value of their underlying assets. For investors interested in exploiting the potential of biotech companies to bounce back, these funds are the place to start.