Biotech: Poised to Perform

Health care stocks

Biotech: Poised to Perform

Biotech companies represent a potential driver of above-average long-term earnings growth, yet current valuations appear to assign little value to the rich research and development pipelines in many firms in this industry.

“We continue to favor biotech stocks from firms developing innovative treatments for rare diseases and conditions with a high unmet need.”   -- Margaret Vitrano

 

Health care has been one of the most unpopular areas in the market for more than two years — particularly biotechnology stocks. Yet we still regard the sector as a compelling source of sustainable performance.

We view biotech companies as a potential driver of above-average long-term earnings growth that can fit into what we call our "select" bucket of growth stocks. These typically carry higher multiples to reflect their higher growth rates, but for biotechs, multiples have generally been compressed by increased scrutiny of drug pricing.

To better understand the current malaise in the biotechnology industry and what the near-term future holds, it’s helpful to review the bull and bear markets the group has experienced over the last six years.

From 2011 through the summer 2015, biotechnology and pharmaceutical stocks significantly outperformed the broader market. This bull market was driven by four trends: the end of the patent cliff of branded drug expirations, increasing optimism about innovative drug therapies and technologies, a more favorable regulatory environment for new drug approvals, and robust prescription-drug pricing power. Hillary Clinton’s initial tweets on the campaign trail about the high prices of certain branded drugs coincided with the end of the rally.

Since then, biopharmaceutical stocks have endured above-average volatility, with negative sentiment overshadowing resilient fundamentals. From July 1, 2015 through May 31, 2017, the NASDAQ Biotechnology Index of large cap biotech stocks lost more than 22% while the S&P 500 Index was up 15.5%.

Despite recent weakness, three of the four trends that powered the biopharmaceutical bull market remain in place today. The patent cliff is still not an issue, with no major patent expirations expected until the middle of the next decade. Regulators remain supportive of new drug treatments, and we are optimistic that the regulatory environment will continue to be favorable for innovative new drugs under the Trump administration.

Rate of drug approvals (%)

Source: U.S. Food and Drug Administration (FDA). While new approvals dipped in 2016, we view this as an aberration and a function of timing (with multiple approvals coming at the end of 2015 and the start of 2017).  Note: forecasts are inherently limited and should not be relied upon as an indicators of actual or future performance. 

Perhaps most importantly, innovation is alive and well. Based on our fundamental research and active management approach, we continue to invest in biotechnology companies that are developing innovative treatments for rare diseases and inflammatory conditions with high unmet need. Treatments in these areas face less competition and should be less vulnerable to pricing pressure.

Few of these positive catalysts are being recognized by investors as share prices have yet to catch up with business fundamentals. Profitable biotech stocks are trading at their biggest discount to the overall stock market in more than 20 years. We believe current valuations assign little to no value to companies with rich research & development pipelines.

Although drug pricing remains a headwind for the industry, innovation should continue to be rewarded. Over the long term, we believe the value of quality biotech assets will be realized through a re-rating of share prices or a significant wave of industry consolidation. In the meantime, we will use short-term periods of volatility to continue to add to our biotech exposure.

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