Innovation never sleeps :

The biotechnology sector has enjoyed an amazing run during the last 3 years and measured by the NASDAQ Biotechnology Index (NBI) has tripled in value over this period. Such performances obviously lead to questions around valuations and the sustainability of this rally and despite an excellent performance over 2014 the sector witnessed a severe correcting during the Spring time. Nevertheless, a wider historical view shows that the biotechnology sector has a long track record of beating the wider equity markets and since its inception by the end of 1993 the performance of the NBI has beaten the performance of the S&P500 (a widely used index of the generalist US equity markets) by a factor of around 3. On the flipside, this outperformance was not achieved in a perfectly linear way and especially during the first couple of years the NBI underperformed the general market. One has to take into account that the sector was then in its infancy and not very well understood by investors. Once the first antibody drugs were approved by the FDA by the end of the 1990’s things changed for the better and the sector never looked back, despite being caught up in the TMT volatility around the millennium change.

This strong performance comes at a price however, and this price is volatility. The underlying 90 day historic volatility of the NBI has remained fairly stable over twenty years at around 25 with some short upside bursts but this volatility is around twice the level of the S&P500 volatility. Investing in biotechnology needs a strong risk tolerance and also a somewhat longer time horizon.

Biotechnology is a peculiar sector with a relatively low correlation to the general market (a correlation meandering roughly between 0,60 and 0,80) and a low impact from and dependency on macro-economic data in terms of performance. This fact, coupled with the structural performance, makes biotechnology an interesting diversification for an equity investor. The risk-reward between performance and volatility is a positive one as the efficient frontier below shows. The low correlation goes a long way in explaining the actual decline in volatility when a moderate allocation of the biotechnology sector (represented by the NBI) is added to a generalist equity portfolio (represented by the MSCI World index), based on historic data.

Chart 1 : The efficient frontier

What is driving biotechnology performance?

The sector thrives on two engines: innovation, resulting in many new drugs being approved and secondly a strong pricing environment for those drugs. The innovation can clearly be illustrated by the 41 new drugs approved by the FDA during 2014, most of them biotechnology drugs. This is the highest number of approvals since 1995. But it is also visible in a burgeoning industry pipeline resulting in around 100 biotech IPO’s in the US alone over the year, many of them bringing interesting drugs in the clinic. This surge in innovation is the result of many years of research and spending, of better knowledge and better scientific tools. We can be clear and brief on this aspect, innovation is here to stay and if anything it will further accelerate. Immuno-oncology and gene therapy are but a couple of the recent breakthroughs that come to mind. Pricing, on the other hand, is a more complex debate. But let us make clear, when speaking about risk to current pricing we mean that only a meaningful reduction of general drug pricing levels orchestrated by politicians could bring the sector down. Debates around the price of a specific drug, like the ones we have witnessed this year around the Sovaldi hepatitis C drug from Gilead, are merely causes for short term profit taking. Will current high pricing for biotechnology drugs stick for the next years? We think yes, but we are also convinced that the debate will heat up and common sense dictates that the many new, pricey drugs will in the end make the bill for the health insurance systems around the world ever more difficult to foot. In that sense we, as investors, do welcome future bio-generic drug approvals as they will help the payers save money on old drugs and continue to pay up for new, innovative drugs. The pricing debate will also force more M&A, especially in oncology where combination use of different drugs looks the way forward. But for pricing of such a combination to remain affordable, the drugs must be in the hand of one company who then can bundle the pricing and go to the payers (private and government) with a sensible proposition. As oncology innovation often comes out of small companies with one key drug in development, merger activity is set to remain at a high level.

With innovation booming and pricing in reasonable shape, what can spoil the party?

Chart 2: Evolution of the Receptos share price over 2014 :

In summary, we continue to see the biotechnology sector as an interesting alpha generating satellite strategy. The key drivers innovation and pricing remain essentially intact as obviously do demographics, and rising health care standards in emerging markets. Stock picking will become ever more important and one has to remain focused on identifying the next potential breakthrough. A key risk going into 2015 is the high investor positioning in health care in general and, amongst US investors, in biotechnology stocks. This can lead to short term profit taking and volatility but this should not detract from the key attractions the sector offers in a wider timeframe.