The following article was contributed by Helen Dospod. Helen assists Servant Financial with portfolio analysis and construction and investment research.
For several years the Biotechnology subsector of the Healthcare industry experienced an amazing bull market, gaining over 400% in the five years preceding its peak in July, 2015. The bullish interest in Biotechnology stocks was based on the industry’s rapid growth. The completion of the Human Genome Project in 2000, combined with other rapid technological advances, have helped to revolutionize medical research in the last decade. Low interest rates further helped to fuel research and development, as well as acquisitions of smaller Biotechnology firms with promising drug pipelines.
This wave of innovation prompted significant industry research and development and in 2012 the FDA announced a new “Breakthrough Therapy” designation to help bring promising drug advances to the public as quickly as possible. It was developed in order to expedite the development and review of drugs which are: 1) intended to treat serious or life-threatening conditions, and 2) show substantial improvement over other existing therapies.
Biotechnology is a subset of the healthcare industry and includes medical research, pharmaceuticals and therapies which have their basis in biological sources or processes. The term commonly refers to research or therapies which may use vaccines, blood components, tissues, gene therapies, allergenics, or other living cells. They are often produced through processes involving recombinant DNA technology (DNA molecules formed by gene splicing to bring together genetic material from multiple sources to create unique sequences). These kinds of therapies comprise a large number of the Breakthrough Therapy applications which have grown at a rapid pace in just a few years (figure 1 from FDA.gov).
One example of a drug that has been given Breakthrough Status by the FDA this year is Venclexta. It is used to treat people with chronic lymphocytic leukemia (CCL) by inhibiting a protein in the cancer cells (abnormal lymphocytes) that helps keep those cancer cells alive and makes them resistant to chemotherapy. Venclexta binds to this protein, which helps kill the cancerous lymphocytes in blood and bone marrow. In clinical trials, nearly 80% of patients with a specific genetic marker and relapsed CLL showed a strong positive response to the drug with deep remissions. It is also being tested as a potential treatment for other diseases like non-Hodgkin’s lymphoma and metastatic breast cancer.
The number of such Breakthrough Therapies that have been approved by the FDA’s Center for Drug Evaluation and Research (CDER) has increased from 3 in 2013 to 21 in 2015. Around 28% of the Breakthrough designations granted through 2015 were for oncology (cancer) therapies. This has inspired a lot of enthusiasm around Biotech companies and their ability to create innovative new molecular and biologic entities (or so-called “novel drugs”), that can be both distinctive in the market and life-changing for patients.
However, since Hillary Clinton famously tweeted last September her intention to create a plan to address “price gouging” (in reaction to the drastic overnight price increase of the specialty drug Daraprim), stock prices in the Healthcare sector plunged and have not yet recovered. While there has been a lot of market volatility since Clinton’s tweet, the S&P 500 has managed to gain 10% in that time while the iShares NASDAQ Biotechnology ETF (IBB) is down by 25% over the same period. In the looming shadow of the presidential election, the Healthcare sector has continued to lag the broader US market, plagued by the uncertainty of how possible political policies will affect future pricing power and profits in the industry. We think this regulatory uncertainty has produced a favorable long-term investment opportunity for the Biotech sector.
According to Morningstar’s Market Fair Value analysis, the Healthcare sector as a whole is currently one of the cheapest sectors (aside from Financials), and Biotechnology is the most underpriced sub-sector. When Morningstar calculates a fair value, they do it based on company earnings, cash flow and other fundamentals and their long-term outlook in order to determine the business's intrinsic value. According to Morningstar, the combined market prices of Biotech stocks are selling for only 81% of their intrinsic value (as of 10/26/16), which implies a potential 23% gain in the market price.
While many might consider Biotech as too volatile or even speculative, there are several large-cap Biotech companies with healthy balance sheets, broad drug portfolios, and consistent cash flows. One indication of the profitability and capital efficiency of a company is its Return on Invested Capital (ROIC). Investment research firm New Constructs composed a list of the currently traded S&P 500 stocks that gained 10% or more in 2008. There were not many stocks during the height (or lows) of the market downturn that posted double-digit annual returns:
All of the stocks listed in the chart above had double-digit ROIC figures in 2007, which most of them have maintained for the past decade. Amgen, Celgene, and Gilead highlighted in blue are Biotech companies. Their ROIC for the trailing 12 months (ttm) are currently still above 10%, showing that these companies have remained profitable even while their stock market prices have decline over the past year. If we can use ROIC as an indicator of a high-quality company, then these largest companies of the Biotech sector fit the bill.
Technical analysts would say that the momentum for Healthcare has shifted upward lately. The chart below for IBB points out how “biotech has been making higher highs all year.” Pullbacks, like the one surrounding the pricing of Mylan’s Epi-Pen, “have been short-lived.” Goldman Sachs indicated in August that the Healthcare sector overall is gaining momentum and looks as if it will become a leading sector in the near future.
According to Fidelity’s most recent Quarterly Market Update, the U.S. is shifting into a more mature, late phase of the business cycle (characterized by credit tightening and slow growth) with low odds of a near-term recession. Historically the Healthcare sector has done very well in late cycle phases, as well as during recessionary phases.
In 2008, while the S&P 500 lost over 38% of its value in 2008, the IBB (the iShares Biotechnology ETF which has the broadest exposure to U.S. Biotechnology stocks) was down only 12%. Biotechnology holdings might once again serve a more defensive role in a portfolio during the next downturn.
Although the Biotechnology sector looks attractive on many levels, there is still the uncertainty surrounding the 2016 election cycle. There are two main factors to consider. Firstly, there is uncertainty about who will win the Presidency and what, if any, healthcare policy changes the winner would try to enact. A Clinton victory would likely see a push for change in drug pricing. While she is currently favored to win by most recent polls, those same polls show that the legislative branch is also likely to remain divided, making extreme policy changes unlikely. In the off chance that the Democrats sweep both houses of Congress, many think that pharmaceutical companies with older and generic drugs are the most at risk from policy changes. It is believed that few politicians would be willing to curtail life-changing and life-saving drug developments from coming to market. It should also be noted that any changes that are eventually pushed through probably would not take effect for years.
Secondly, it is difficult to ascertain how much of an impact policy changes would actually have on Healthcare companies. Morningstar recently examined the Biotech sector and determined that its pricing power should “remain strong, especially for innovative new drugs” and for drugs which meet currently unmet needs in the market. Larger Biotech companies, with larger product portfolios and pipelines, are less likely than their smaller counterparts to be reliant on above-inflation drug pricing policies to secure profits.
Furthermore, we might be able to look to the enactment of the Affordable Care Act and its impact on the Healthcare sector. While there was a lot of fear about whether Healthcare companies would be able to remain profitable with these changes, the Health Care Sector SPDR ETF (XLV) rose by 120% since Obamacare went into effect in March of 2010. Given the uncertain and charged political environment, Servant Financial has added only a small toehold position in the VanEck Vectors Biotech ETF (BBH) in our aggressive and moderate portfolios. BBH focuses on the 25 Biotech companies with the largest market capitalization and highest liquidity. VanEck's selection process leaves out the smallest and most volatile Biotech companies.
We believe that a focus on larger cap stocks helps BBH maintain an overall higher quality portfolio of companies. The Biotech companies listed above (which did best in 2008) account for 3 of the top 4 holdings of VanEck Vectors Biotech ETF (BBH) and one-third of its portfolio. The ROIC, which we used as one indicator of high quality stocks, is 21% for the overall BBH portfolio. We plan to opportunistically add to these positions, as we eagerly await the outcome of the election.
Comments