Biotech investors have had a rough go of it in recent months. The S&P 500 Biotech Index has fallen around 20% since its high point in July of 2015, as investors have grown worried about the potential for regulatory policy changes that could affect drug pricing and valuations among stocks in the industry.
Rajiv Kaul, the manager of Fidelity® Select Biotechnology Portfolio (FBIOX), thinks that election-year rhetoric could be contributing to some of the recent volatility, but that the market may be misreading the potential impact these risks could have on biotech stocks.
It is not the first time biotech stocks have experienced a major swing in prices (see chart below). But Kaul says he still believes that biotech’s five-to-10-year investment story remains compelling and may warrant a small place in a diversified portfolio, but only for investors who can live with the potential ups and downs.
The pullback: the risks and the rhetoric
A key factor in the recent selloff has been investor concerns that new regulations could impact the prices of drugs. Kaul says while these concerns may have been exacerbated by political rhetoric connected to the presidential election, the likelihood of significant reform remains low. What’s more, the risk of any regulation to specific companies varies greatly, in a way the market does not seem to be appreciating, in Kaul’s opinion.
“There have been some high-profile cases of companies taking old generic drugs, raising prices, and cutting research and development,” says Kaul. “That business model would be very adversely impacted by pricing reform, but it is not the kind of business that I think has a long-term runway to growth or makes an attractive investment.”
Instead, Kaul has focused on the companies creating new lifesaving drugs and those that can actually help to save the health care system money, relative to existing therapies.
“In my view, the market’s not differentiating between companies with great science and tremendous innovation, and these other companies that are basically trying to engineer higher profits through higher prices,” says Kaul. “That’s where I see a great opportunity. No matter what the political outcome is in the United States during the next election cycle, there’s always going to be a need for better medicine that can cut costs for the healthcare system.”
Kaul has been using this pullback as a buying opportunity for what he believes are attractively valued stocks in the industry—some larger cap biotech stocks have free cash flow yields approaching high single-digits to low double-digits.1
The long-term outlook: Progress after decades of R&D
This is a particularly fertile time for biotech drug discovery. After decades of investment in research, the biotech industry is beginning to produce novel therapeutics for many previously unmet medical needs. More biopharmaceutical drugs were approved during the 2000–2009 period than in the 1980s and 1990s combined,2 and in 2014 the FDA approved more new “molecular entities” (chemical particles) than in any of the past 15 years.
Through its Breakthrough Therapy program, the FDA is expediting the approval process for drugs treating diseases for which there currently are few or no treatment options. In 2014, 22% of the novel drugs approved by the FDA fell into this category. Today seven of the 10 leading drugs in the world are biotechnology drugs.
Despite recent progress, treatments have yet to catch up with research. Since 1987, scientists have identified molecular causes for some 7,000 diseases, and drugs have been developed for only a small minority of them. The upshot: Biotech companies still have only scratched the surface of the industry’s growth potential.
Key investment drivers
Several themes are fueling investment opportunities in the biotech industry, including:
Personalized medicine. The combination of the Human Genome Project and the commercial application of diagnostics has created opportunities to develop more personalized and effective treatments. Excitement about the Human Genome Project began more than 15 years ago, but it has taken until recently for these genome-sequencing advances to result in therapies.
More biotech companies. The biotechnology industry continues to add start-ups rapidly, giving investors an ever-larger investment universe.
Innovation and economic insensitivity. The biotechnology industry is unusual in that it contains high-growth companies at the forefront of innovation, but is relatively insulated from the economic cycle. “The drivers in the biotech space aren’t directly tied to the economy, so the industry tends to have low correlations to the broader market,” Kaul explains. “If a biotech firm comes up with a better cure for multiple sclerosis or cancer, the stock is very likely going to work regardless of what the economy overall is doing,” says Kaul.
Favorable demographics. Older populations tend to use more pharmaceuticals and other treatments than younger ones do. Approximately 10,000 people in the United States turn 65 every day, and many other countries are also aging rapidly.
Investors should bear in mind the risks inherent in biotech. In particular, not every molecule a biotechnology firm develops will gain approval from the FDA. The possibility of failing clinical trials will always be a serious risk for biotech and pharma firms. It can take up to 15 years to bring a product to market and cost as much as $1 billion,3 and according to one estimate, just 8% of drugs make it all the way through the process and gain FDA approval.4
Another risk is reimbursement pressure, and it may become even more severe in the coming years. Even if a drug is approved by the FDA, there is no guarantee that it will be added to health insurers’ formularies or prove to be profitable.
While the industry may have a bright outlook, obviously not all biotech stocks will perform equally well. To help manage risk, Kaul believes it makes sense to focus on the following elements:
Valuation. “I think of myself as a value investor,” says Kaul. “You have to make sure you’re not overpaying, based on each investment’s risk and potential reward.”
Likelihood of success. As an active manager, Kaul tends to pick and choose the companies he thinks have the best chance at success. “Our team quantifies what we think is the probability that each company in the biotech universe will deliver on its potential. We only want to invest in the companies with the highest probability of positive outcomes.”
Diversification. “I want to ensure that no one company will make or break the fund,” says Kaul, whose portfolio holds more than 200 names. He has typically invested in a combination of large and early-stage companies. “Historically we have held between 65 and 70 percent of assets in shares of larger, more established firms, with the balance of the fund's assets trying to capture greater upside from the newer, more innovative names.”
The bottom line
Stocks in the biotech industry have a history of volatility, and no one knows what will happen in the short term. But the industry is experiencing a wave of innovation, and companies that discover drugs that improve and extend patients’ lives could potentially deliver attractive returns to investors. Of course, the first priority is to ensure that your investing strategy appropriately reflects your time horizon, financial circumstances, and emotional capacity for volatility. Within this context, it may make sense for some long-term investors to consider how biotech stocks may fit into their portfolio, and it may pay to take a diversified approach to the industry.
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