Attractive industry fundamentals and valuations

Healthcare stocks have outpaced the performance of the world market over the last decade (Exhibit 1, LHS). There is potential for this long-term outperformance to continue given favourable industry fundamentals due to high levels of industry innovation, which has historically been the greatest driver of value creation within the sector, and robust demand growth helped by an aging global population. In recent years, the US Food and Drug Administration (FDA) has approved record numbers of new molecular entities and this trend is continuing in 2021; also, ongoing M&A should also support the performance of healthcare stocks. Although investors are concerned about the potential for a material change to US drug prices, this seems unlikely given the very narrow Democrat leadership margins in the US Senate and House of Representatives, and President Biden has higher priorities than healthcare reform. The pricing issue has put pressure on the valuation of healthcare stocks – the Datastream World Pharma index is trading on a 15.4x forward P/E multiple, which is a 14.2% discount to the world market and considerably wider than the 3.0% average discount over the last five years. If investors pay more attention to the healthcare industry’s positive attributes or if there is greater clarity regarding US drug pricing, there is potential for the sector to be afforded a higher valuation.

Polischuk remains optimistic about the prospects for the global healthcare sector helped by strong secular demand growth:

In terms of valuation, Polischuk believes ‘it is okay to pay for quality assets and cheap stocks are often cheap for a reason’. However, the healthcare sector is trading near historic low valuations; its forward P/E multiple discount to the benchmark S&P 500 index is now c 20% compared to an average c 10% premium since 1990. Investors are concerned about the risk of lower drug prices under the new Biden administration, which the manager believes is creating a near-term opportunity, and he expects the valuation gap to narrow. There has also been a material drawdown in small-cap biotech stocks as investors have focused on value and economic recovery stocks following news about successful COVID-19 vaccine trials in early November 2020. Polischuk does not expect this underperformance to persist, as these stocks could become targets for large-cap pharma companies, which have plenty of cash.

The manager cites the above-average annual total returns generated by the healthcare sector as ‘proof that investing in healthcare is a must’, and he believes that ‘an active manager can really outperform its benchmark given the idiosyncratic nature of the healthcare industry’. Polischuk highlights some important 2021 investment themes. There have been several COVID-19 therapies and vaccines approved by the FDA; he suggests the healthcare industry’s response to the virus has been an undisputed success and ‘it is amazing to have achieved so much in less than 12 months’. So far in the US, three novel vaccines have been approved (Pfizer/BionTech and Moderna in December 2020 and Johnson & Johnson in February 2021) and their efficacy has exceeded consensus expectations. The manager reiterates that innovation continues to be the number one value driver for almost all of healthcare and the industry is enjoying ‘a golden era’ across a broad range of categories including oncology, immunotherapy, novel biologics, robotic surgery and liquid biopsy. He explains that immunoncology stimulates the body’s own immune system to fight cancer cells and these therapies are expected to generate $33bn in sales in 2021 (companies operating in this area make up c 20% of WWH’s portfolio). Targeted therapies are next-generation cancer treatments, they are precision medicines with increased efficacy and tolerability (c 10% of the portfolio). Liquid biopsies can detect diseases from a drop of blood rather than via a tissue sample. This approach offers benefits including early detection, especially for cancer, and can be used to monitor relapse post treatment (c 10% of the portfolio). Polischuk says that within emerging markets, there are a host of macro tailwinds such as aging populations and a relaxation in listing rules in China allowing pre-revenue biotech companies to come to the market. Two strategies are employed when investing in emerging markets: seek and identify the blue-chip leaders, and focus on initial public offerings (IPOs) and crossover opportunities (the last round of financing before an IPO). WWH’s emerging market exposure makes up around 20% of the fund.

Turning to the political environment, the manager believes President Biden’s priority is not reforming the healthcare sector. Instead, his higher priorities are the economy, dealing with the pandemic, government stimulus and tax reform. Polischuk expects Biden to expand rather than overhaul Obamacare and suggests that while some changes to US drug prices are likely, he does not expect any egregious legislation; instead, there may be a reduction in out-of-pocket expenses and expansion of the Medicare and Medicaid programmes. The manager believes Biden wants to be known as a ‘can-do’ president; hence, he does not expect a radical change in drug pricing. He believes healthcare stocks can trade on higher valuations once there is greater clarity on this issue.

Polischuk explains pharma and biotech companies have deep therapeutic pipelines, highlighting high levels of innovation, and he is encouraged the elevated level of FDA new drug approvals is continuing in 2021. He remains optimistic about the prospects for healthcare M&A, the pace of which reaccelerated after a slowdown in early 2020. While the macroeconomic environment has dominated the investment backdrop this year, the manager expects a pick-up in healthcare M&A activity in H221.

WWH’s managers will continue with their strategy of focusing on catalysts within the healthcare industry either clinical, regulatory or financial outcomes. They reiterate their 2021 playbook to monitor COVID-19 developments; focus on innovation, primarily in biopharma and small-cap therapeutic stocks; capitalise on inexpensive valuations and the recent drawdown in emerging biotech stocks; selectively monetise the macro trends in emerging markets; continue to invest in private companies and participate in crossover financings; and employ a tactical use of gearing. The managers remain very bullish on the outlook for the healthcare sector given important tailwinds, distressed valuations and receding headwinds following the US presidential election.

At the end of May 2021, WWH’s top 10 positions made up 39.0% of the fund, which was broadly in line with 38.5% a year earlier; just four names were common to both periods.

Compared to when we last published on WWH in February 2021, there are two new top 10 names in the portfolio, AstraZeneca and AbbVie, both of which are large-cap pharma companies. UK-listed AstraZeneca generated 11% year-on-year revenue growth in Q121, of which just 4% was due to its COVID-19 vaccine, and the company reiterated its 2021 guidance for low-teens percentage revenue growth along with faster than top-line EPS growth. Its acquisition of Alexion Pharmaceuticals should close later this year and adds blockbuster products Soliris/Ultomiris to the firm’s portfolio. These drugs are used for the treatment of paroxysmal nocturnal haemoglobinuria, a rare disorder that causes some patients' immune systems to attack healthy blood cells. AstraZeneca has a significant oncology franchise, the FDA has expanded its addressable patient population for one of its important growth drivers, Tagrisso for the treatment of lung cancer, while a number of its other oncology products are receiving approvals for additional indications.

US-listed AbbVie delivered Q121 revenue of $13.01bn and EPS of $1.99, both of which were above consensus expectations, enabling the company to raise its full-year guidance. Important growth drivers include its immunology and aesthetics franchises, which are helping to diversify the company’s revenue stream away from immunosuppressant Humira (c 37% of sales in Q121), which went off-patent in Europe in 2018 and is due to do so in the US in 2023. AbbVie acquired Allergan in 2019, its portfolio included Botox – sales for this product increased by 45% year-on-year in Q121 to c $0.5bn. M&A is ongoing, including the March 2021 announcement of the purchase of an exclusive right to acquire Mitokinin, which includes its PINK1 clinical programme for the potential treatment of Parkinson’s disease. AbbVie offers an attractive c 4.5% dividend yield.

As shown in Exhibit 3, over the 12 months to end-May 2021, WWH has lower exposures to biotech (-7.8pp) and pharma companies (-3.5pp) and higher weightings in healthcare providers/services (+4.4pp), healthcare equipment/supplies (+3.6pp) and life science tools & services (+3.0pp). In terms of geographic exposure, the trust has a notable higher weighting in emerging markets (+6.0pp) broadly offset by lower weightings in developed Asia (-4.4pp) and Europe (-2.5pp).

Compared with the benchmark, WWH retains underweight exposures to large-cap pharma (although the below-index weighting has declined over the last year) and large-cap biotech stocks (none currently held) with meaningful overweight exposures to emerging markets and emerging biotech companies.

In FY21 (ending 31 March), WWH’s NAV and share price total returns of +30.0% and +27.4% were significantly ahead of the benchmark’s +16.0% total return. This was the fourth-largest annual outperformance in the trust’s 26-year history and was due to both good stock selection and sector allocation, and despite sterling appreciating by 11.3% versus the US dollar over the period. In terms of absolute NAV performance the best contributors were: Natera (diagnostics, +£1.01), the company’s core non-invasive prenatal testing business generated strong volume growth and received expanded clinical guidance; Horizon Therapeutics (speciality pharma, +£0.95p), experienced a very strong uptake for Tepezza, the first and only FDA approved medicine for the treatment of thyroid eye disease; and Alexion Pharmaceuticals (large-cap biotech, +£0.81), which received a take-over bid from AstraZeneca at a 45% premium. The largest detractors were eHealth (healthcare services, -£0.39), higher than expected levels of customer churn; Vertex Pharmaceuticals (large-cap biotech, -£0.20), discontinuation of a key pipeline product in development for the treatment of a rare pulmonary disease; and Biogen (large cap biotech, -£0.18), the company lost two important patent cases for Tecfidera, their lead product for the treatment of multiple sclerosis.

WWH has had a tough period of relative performance in recent months, which has been detrimental to its long-term record; in our last report (published on 5 February 2021), the trust was ahead of its benchmark over one, three, five and 10 years. However, WWH’s NAV and share price total returns remain comfortably ahead of its benchmarks over the last five and 10 years and even more so versus the broad UK market over the last three, five and 10 years.

During 2021, the macro backdrop has dominated the market; there has been a rotation from growth to value stocks as investors have become more confident in an economic rebound as the global coronavirus vaccine programme gains momentum. Large caps have also outperformed smaller-cap stocks, which has not been helpful for the trust’s relative returns given its high weighting to emerging biotech stocks (c 20% of the portfolio).

In Exhibit 8, we show a number of healthcare funds; the seven members of the AIC Biotechnology & Healthcare sector and two Swiss companies. There are three pureplay biotech funds, Switzerland-listed BB Biotech, Biotech Growth Trust and International Biotechnology Trust; five healthcare funds, BB Healthcare Trust, Switzerland-listed HBM Healthcare Investments, Polar Capital Global Healthcare, RTW Ventures and WWH; and Syncona, which is an early-stage healthcare investor. WWH’s NAV total returns are above average over five years ranking third out of seven funds and below average over the other periods shown, although the performance ranges within the selected peer group are very wide. On 19 July 2021, WWH was one of the four funds trading at a premium. The trust has a noticeably lower annual fee than its peers, although a performance fee may be payable. It has an above-average level of gearing and a below-average dividend yield; although it should be noted that the four funds with the highest yields pay dividends out of capital.

In FY21, WWH’s revenue return per share was 10.4% lower year-on-year (24.1p vs 26.9p) primarily due to sterling strength and a reduction in the portfolio yield. Its dividend per share declined by 12% from 25.0p to 22.0p (1.1x covered). At the end of FY21, WWH had £18.1m in revenue reserves, which is c 1.3x the last annual dividend payment. The trust pays semi-annual dividends in January and July and based on its current share price, WWH offers a 0.6% dividend yield.

WWH’s board implemented a discount-control mechanism in 2004, aiming to ensure a maximum 6% share price discount to ex-income NAV in normal market conditions. It has the authority, renewed annually, to repurchase up to 14.99% and allot up to 10% of issued share capital. In February 2021, a general meeting was held to ask for shareholder approval to issue an additional 6.3m of new shares; the proposal was duly passed. Spreading fixed costs over a larger base could reduce the ongoing charges ratio and an increased share count may lead to increased liquidity in the secondary market. In FY21, c 10.7m (c 20% of the share base) were issued at an average premium of 0.8% to cum-income NAV raising £380.6m. On 13 July 2021, WWH announced the publication of a prospectus relating to the issuance of up to 20m new shares.

WWH’s shares are currently trading at a 0.1% discount to its cum-income NAV. Over the last 12 months the trust has traded in a range of a 3.5% premium to a 2.3% discount. This compares with average premiums of 0.7% and 0.4% over the last one and three years respectively, and average discounts of 0.3% over the last five years and 2.9% over the last decade.

WWH was launched in 1995 and is traded on the Main Market of the London Stock Exchange. The trust is managed by global healthcare specialist investor OrbiMed, which has more than $20bn of assets under management (c $6.5bn in public equities). The firm operates from 11 regional offices and has a team of c 100 investment professionals, of whom more than 20 hold PhD or MD qualifications and around 15 are former CEOs or company founders. WWH’s managers Sven Borho and Trevor Polischuk aim to generate a high level of capital growth from a diversified portfolio of global healthcare stocks, and the trust’s performance is measured against the MSCI World Health Care Index (sterling adjusted). Data from OrbiMed show that from the trust’s inception in 1995 to 31 March 2021, its NAV total return compounded at a rate of +15.9% pa, which is meaningfully ahead of the blended benchmark’s total return of +11.9% pa. (The blended benchmark is the Datastream World Pharma/Biotech TR Index from inception to 30 September 2010, the MSCI World Health Care Gross Index from 30 September 2010 to 31 December 2011, and the MSCI World Health Care Index from 31 December 2011.)

There are a series of investment guidelines and limits in place:

Derivatives are permitted to enhance returns and mitigate risk (maximum 5% of the fund’s net exposure), up to 12% of WWH’s gross assets may be held in equity swaps, currency exposure is unhedged and the managers may gear up to 20% of net assets.

WWH is subject to a five-year continuation vote, the next is due at the 2024 AGM.

WWH’s broad mandate means managers Borho and Polischuk are able to participate in all subsectors of the healthcare industry anywhere in the world, aiming to generate long-term capital growth. They are able to draw on the broad resources of OrbiMed’s investment team, including employees based in China. The firm has employed a Public Equity Portfolio Review process since 2009; the team meets regularly to discuss WWH’s portfolio structure and individual holdings. Topics include clinical events, which have historically been the largest source of biotech and pharma share price volatility; regulatory events; new drug launches; doctor surveys; key opinion leader consultations and other field research. Company meetings are a very important element of the investment process. Stocks are selected from an actively covered universe of around 1,000 companies, ranging from early-stage preclinical businesses through to multinational biopharmaceutical firms and WWH’s portfolio is diversified by geography, subsector and market cap. The managers seek companies with underappreciated product pipelines, robust balance sheets, strong management teams and that are trading on reasonable valuations. At end-May 2021, WWH had 84 positions versus 73 at end-May 2020. Its unlisted exposure was 6.4% at end-May 2021, which was higher than 0.8% a year earlier.

OrbiMed believes there is a high congruence between companies seeking to act responsibly and those that succeed in building long-term shareholder value. To the extent that it is practicable and reasonable, OrbiMed takes into account applicable environmental, social and corporate governance (ESG) factors when evaluating a prospective or existing investment. On a quarterly basis, the company’s valuation and risk committee conducts a proactive screening of these across its holdings. Firms with potentially concerning ESG factors, as provided by third-party data services, are highlighted for discussion and potential referral to investment team members for further action if appropriate. OrbiMed may seek to engage with portfolio companies to promote changes in their conduct or policies and could ultimately decide to sell the investment in these firms. In some cases, it may adopt an ‘activist’ approach to encourage change at investee companies, which may include a proxy campaign or through seeking representation on their boards of directors. The managers seek to invest in reputable management teams and are especially cognizant about corporate governance in emerging markets, as company credentials in these regions may not be as high as those of firms in developed regions.

WWH has an overdraft facility with JP Morgan Securities and gearing of up to 20% of NAV is permitted and at end-May 2021, it was 8.3%. Historically, the trust had a higher level of gearing, but the managers now employ a more pragmatic and tactical approach given the high levels of market volatility experienced during FY21.

After the dramatic V-shaped stock market recovery in April 2020, leverage was reduced by c 1,000bp to c 3% and then to c 1%. A low level was maintained until November 2020 ahead of the US presidential election and was then increased to c 8%. Leverage was reduced in January 2021, but was increased in March and April this year following a sell-off in small-cap biotech stocks; exposure was added to biotech, medical devices and large-cap pharma companies.

OrbiMed is paid a base management fee of 0.65% of WWH’s NAV and is eligible for a 15% performance fee for outperformance versus the benchmark (on incremental outperformance since launch, if it has been maintained for a 12-month period). In its FY21 annual report there was a £31.7m performance fee provision, which is payable if WWH’s outperformance continues in FY22.

Frostrow Capital is the trust’s alternative investment fund manager and is paid a tiered fee: 0.3% of WWH’s market cap up to £150m, 0.2% on £150m to £500m, 0.15% on £500m to £1bn, 0.125% on £1bn to £1.5bn, and 0.075% over £1.5bn, along with a £57,500 pa fixed fee. In FY21, the trust’s ongoing charge was 0.9%, which was in line with FY20 (no performance fees were payable in either period).

WWH is a conventional investment trust with one class of share; there are 65.2m ordinary shares in issue. At end-FY21 the shareholder base was made up as follows: private wealth managers (55.2%); shares held on investment platforms (26.0%); mutual funds (8.8%); and other (10.0%). The trust’s average daily trading volume over the last 12 months is c 120k shares.

Borho is a founder and managing partner of OrbiMed and one of WWH’s lead managers, so is considered a non-independent director; he waives his director’s fee. Holbrook retired at the July 2021 AGM (Bates succeeded him as senior independent director and chairman of the nominations committee), and Smith is standing down at the July 2022 AGM, at which stage McCutcheon will extend his term and assume the role of chairman. With effect from 1 April 2021 (the start of FY22), the directors’ fees increased by 4%, which the board deems to be appropriate given the level of work associated with the increasing size and complexity of the company.