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Investment Ideas: Biotech opportunity
I was planning to update my model portfolios, but I think there’s a more immediate opportunity in biotech. Featuring a long interview with Andrew Craig on biotech tiddlers
Apologies for readers expecting an update on my model portfolios. I promise they’ll arrive next week instead. Instead this week I want to shine a spotlight on the biotech sector. For the record I have very heavy exposure to biotech names, probably running at around 25% of my total wealth. That hasn’t been a smart strategy in names I currently own such as Syncona, Arix, RTW Ventures, Biotech Growth Trust and Polar Capital Biotechnology fund.
The table below shows the full gory detail. It doesn’t make pleasant reading. Look in particular at the 5 year price return for the long-established funds. Not one fund has delivered a return over the last five years that is in excess of the S&P 500 or the NASDAQ composite.
This fairly chilly market environment is even worse for smaller cap stocks, and especially those based overseas in the UK, Europe and Australia. These stocks may have outperformed their local indices but that doesn’t say much – most other developed world markets have consistently under performed US equities generally.
In the last few months though I’ve noticed that more and more smart investors are beginning to pick up on this underperformance. It’s the subject of my latest Citywire column which you can find HERE. I remain heavily committed to the biotech space and think that as the markets slowly wake up to the deep structural changes at work we’ll see that gap closed – but that’s merely a hope or ambition. Where I do think there is an immediate opportunity is around unloved small and micro cap biotech stocks. They suffer from a double bind. The first major bind is that many investors tend to steer clear of biotech names because they require expert knowledge. I’m a great believer that investors buy what they understand and as most investors are NOT life sciences graduates, they tend to not to buy life sciences stocks unless they are boring well known names such as GsK that pay a dividend.
The second bind is with the small, highly trained and expensive group of experts – analysts and researchers. This is a relatively small group of people who as I just said are very expensive to keep in house. Thus one probably expects them to focus on the large cap names in a portfolio where the coverage is greatest. There is little incentive to spend too much time digging around in micro cap land – so they don’t bother. Thus many micro caps fly below the radar. Add in the bias towards the US – there are UK listed biotechs remember – and you have the makings of a classic information blackout.
So, I think the opportunity is now specific to smaller cap biotechs. Which is where Andrew Craig comes in. You’ll probably have heard of him through his popular website Plain English Finance. He is also the author of the book How to Own the world: A Plain English guide. Crucially, for todays purpose , he is also a long time corporate adviser to life sciences companies who is quietly building the book for a listed small to mid cap biotech listed fund as we speak. Before moving over full time to set up this fund and build Plain English Finance he was a partner at the hugely respected WG Partners – which is a “Global, specialist life sciences investment boutique offering strategic advice, capital raising and M&A services”. Trust me when I say that WG is a market leader in the biotech space.
Anyway, Andrew is currently, as I said, building a book to fund a new specialist London listed investment fund which specifically invests in smaller capitalised listed biotechs (plus a small handful of privates) mostly though not exclusively based in the UK and Australia. I have featured some of his comments in my Citywire column but here’s the full print out of our email conversation.
Are biotech stocks generally underperforming the market?
Biotech stocks are underperforming YTD in the US (NBI) and UK. In the UK, specifically: 2020 and 2021 were both very / pretty strong for UK listed biotech. That said there was real COVID “froth” in 2020 - NOVACYT, AVACTA, YOURGENE, GENEDRIVE, SYNAIRGEN, OPEN ORPHAN etc...
Then in 2021 - From the BIA: "Over the course of 2021, the broad biotech index returned +16% vs +14% for the FTSE All Share. Cell & Gene Therapy, Research Tools, Medical Devices and Small Molecule all returned over 20%. 2021 has also seen a further increase in the number of new investors active in the sector, although not at the pace seen in 2020."
But it is obviously a different story YTD in 2022.
Syncona - 24% YTD
Biotech Growth Trust - 24%
FTSE AllShare c. -1.8%
FTSE 100 +2%.
So, investors more recently have been a bit spooked. Is that because valuations were stretched?
Another key point about (earlier stage) biotech is that you can’t use conventional valuation metrics (profit multiples at least, even sales multiples). You have to work back from a Total Addressable Market, layer on probability of success of reaching that market and then do DCF / NPV. Also you need to do all this with a weather-eye on take out value to a large-cap for whom the IP might be valuable, plugged into their programmes or research infrastructure. That makes it incredibly subjective. There is also a big difference between on-market mid- and large-caps who have an “E” to put a “P” on and earlier stage small-caps here. So, midcap valuations in the US probably are stretched but smallcap valuations in the UK are not (IMO) for a raft of structural reasons.
So, there are lots more opportunities in small caps in the UK - why are they underperforming?
American biotech sneezes, UK / Europe & Australia catch a cold! There was a great deal of froth in 2020 with COVID putting the spotlight on the sector. In the US there was also a great deal of fair-weather capital which was sucked in from faster money. Much of this has gone out YTD - particularly given jitters around tech & rotation out of growth back into value with inflation / interest rates etc…And thus there’s been a similar impact then felt in the UK.
That said, more fundamentally in the UK there are other factors. There’s limited interest from UK small cap generalist fund managers. There is also a long shadow cast by ‘biotech 1.0’ in the late nineties with that audience. There’s also Woodford plus the issues surrounding overseas investors and Brexit etc...One other factor worth considering is that a US midcap might fall from $1bn to $700m in this environment whereas a UK microcap might see its share price cut in half - less liquid stocks suffer more from sell-off of course, ceteris paribus.
Is there a gap opening up between small/mid caps and mid/large cap biotechs?
There has always been one. That’s because biotech companies can move up a long way on the back of clinical inflection points - mid and large caps which may have demonstrated clinical efficacy will always be much larger than small caps which haven’t (yet). That said in my honest opinion this is what is so exciting about the small caps. Small caps which may be several years away from commercialisation / FDA approval etc... trade completely differently to Midcaps which have an on-market product or products. Navigating that transition is particularly important for small caps the closer they get to it.
What do you make of the argument that there are some unloved biotechs trading below NAV
It’s very company-specific. A US midcap that over-raised on the wrong valuation in the froth of 2020 or 2021 might deserve to trade below NAV. If they don’t have a great asset and have a very gung-ho cash burn (as so many do) - then they could destroy plenty more value from here. By contrast UK small caps with quality IP which might be a year or three away from getting through Phase II perhaps , well, that’s much harder to say. It’s also hard to say what “NAV” is for such companies. Overall, its incredibly subjective.
Can’t you just buy individual biotech names rather than use a fund approach?
Given biotech outcomes (per asset and sometimes even per company, if a single asset company) can be “binary” - and value creation outcomes (from clinical trial transitions) are asymmetric, it is arguably the sector where it is most important to own a portfolio of names. Single stocks carry significant clinical risk. I would argue that 20-40 names should give you a chance of capturing a sufficient number of the big-winners - implying solid potential overall returns in a portfolio given how big those winners can be. You only need one 20-bagger to make up for a fair bit of failure (or mediocrity) elsewhere in the portfolio.
Here’s the key issue, isn’t it. Ok so there may be an opportunity and there may be a valuation gap, but what are the catalysts that will close this gap?
Commercial delivery first and foremost, specifically clinical progress. There is a crop of smaller companies poised to deliver clinical read-outs. There can then be a “virtuous circle” with positive read-outs enough to drive the stock up a fair bit. That in turn might then produce an absolute valuation which attracts a new audience of investors willing to consider a larger company (I’ve seen this first hand). Which then, in turn, may even lead to indexation, which can be another driver. Plus, such companies may then be making significant economic returns. That produces EBIT which equals value-creation. So, you could have a self-fulfilling upward spiral which is why these companies can and do go from tens of millions value to near or north of a billion and beyond. That’s particularly true of platform companies which can create (and licence) many assets once they’ve proven efficacy with their lead programme.
What are some of the names you are most keen about
On a long-enough time line (our time line - i.e. to have a chance for the market to go from "voting machine to weighing machine”) some of my names would include Angle Research plc, Avacta plc, Creo Medical plc, Open Orphan plc, Oxford Biomedica plc and RedX plc. But there are a fair few others. There’s also a number of Australian names which may / may not be relevant.
Are you planning a fund to address this gap?
Yes, were are. We are currently looking to launch a main London-listed fund with precisely this thesis. It will be called the PEF Conviction Life Sciences Company which will be the only collective investment vehicle of its kind giving investors pure exposure to a focused portfolio of smaller biotech and medtech companies from outside of the United States. We believe these companies to be structurally undervalued versus their US peers and see a number of short- and longer-term catalysts which could likely unlock that value differential.
For the record if Andrew is successful I for one would be investing in his fund. As for existing holdings in biotech more generally I own currently Syncona, RTW Ventures, Arix, Biotech Growth Trust, Polar Capital Biotechnology.