BB Biotech — A cutting-edge sector and a high dividend

Biotechnology is the exploration of biological processes, systems or living organisms, especially the genetic manipulation of microorganisms, for the development of products, including antibiotics and therapeutic drugs. Biotech is one of the most important technologies of the 21st century and makes a significant contribution to society – the new, innovative drugs and technologies it is developing are helping to meet the growing demand for healthcare products and services as life expectancy rises and chronic diseases become more prevalent. These products help improve quality of life for many people and in some cases, may save lives.

The biotech industry ranks among the most attractive of all fast-growing sectors, with an estimated annual growth rate of more than 10%. According to BION’s managers, sector revenues are forecast to reach around $290bn in 2024 and they expect demographic trends and lifestyle changes to sustain this growth momentum over the long term, to the extent that by 2026, more than half the 100 bestselling drugs, and almost 40% of total global drug sales, will come from biotech labs.

BION offers investors a rare opportunity to gain exposure to this cutting-edge, expanding industry. The company invests in high-quality biotech assets that target substantial market opportunities by developing drugs for unmet medical needs, and many of these businesses are otherwise difficult for individual investors to access. BION is the largest biotech investor among its peers (see Exhibit 6), with 30 years of experience since the company was founded in Switzerland in 1993. The fund invests for the long term and adopts a fundamental, active, benchmark-independent investment strategy based on the scientific, medical and financial expertise of the management team and research analysts based in New York and Zurich. BION’s board members are all renowned and highly experienced practitioners within the biotech sector.

While many investment managers pursuing a variety of growth and tech-focused strategies are now trying to identify companies set to benefit from the expansion of AI tools, BION’s managers are a step ahead. As is perhaps fitting for investors in a cutting-edge industry, they are making increasing use of AI technology to improve the efficacy of their investment process. AI tools provide valuable insights during the due diligence process, by synthesising a broad range of data and helping to answer complex questions about patient journeys and the benefits of medication and therapies. The technology also has a key role in computer-assisted drug-hunting. To further support its research in these areas, BION has expanded the portfolio management team with the addition of three data scientists.

Biotechnology is a growth sector, and as such has been hurt over the past 18 months or so by the aggressive interest rate policies implemented by the US Federal Reserve and other central banks, as they try to quash persistent inflation. The rapid rise in rates has raised concerns about the cost of capital and the financial stability of both the biotech sector overall and individual companies. This has fostered a general tendency to broadly overestimate risk within the sector, and underestimate opportunities, so that positive developments, such as encouraging trial results and regulatory approvals, have been dismissed by investors, while any whiff of bad news, such as missed milestones, has triggered selling. This mindset has been particularly detrimental to small- and mid-cap companies, which together comprise more than 80% of BION’s portfolio. In addition, investor attention has been drawn away from the growth potential of biotech by recent developments in the field of AI, most notably the launch of ChatGPT. This AI-powered language tool is capable of human-like conversation and simple research tasks and has sparked excitement about AI’s capacity to disrupt many established industries and drive productivity growth. As a result, there has been some sector rotation away from biotech, in favour of so-called ‘tech titans’ offering exposure to AI.

BION’s managers believe that the financial strength and resilience of companies in the portfolio are ‘exceptional’ and ‘clearly better’ than before the COVID-19 pandemic. At the end of Q323, more than 80% of portfolio holdings, mostly mid-cap companies, were either profitable or financed to reach profitability, and offer a ‘highly attractive risk/return profile’, according to the managers. The remaining holdings are earlier and mid-stage pipeline companies requiring additional financing in coming years. Several of BION’s holdings have seen positive developments this year (see details in the Portfolio section below).

Yet, the generally bearish sentiment overhanging the biotech sector, especially the small- and mid-caps that are BION’s focus, and the sustained selling pressure in equity markets more broadly, meant that the portfolio’s NAV declined 11.8% (in CHF) in the first nine months of 2023, while the share price dropped 20.8%. This compares with the 6.3% decline in the benchmark, the Nasdaq Biotech Index (NBI).

However, BION invests for the long term, so it is more meaningful to look through short-term fluctuations in market sentiment and instead assess the company’s performance over a longer time frame. BION’s performance has been good on this basis. It has delivered outright returns and outperformed the NBI: over the 10 years to end September 2023, it delivered an average annualised return of +7.0% on an NAV basis and +10.3% in share price terms, compared to a benchmark return of 6.8%. In addition, BION has been one of the top long-term performers among the selection of peers illustrated in Exhibit 6.

Just as it is more meaningful to look through short-term market fluctuations when judging performance, equally, BION’s managers are not allowing these machinations, negative or positive, to cloud their assessment of the portfolio’s prospects. And in their view, there are good reasons to be optimistic. Firstly, as mentioned above, they are very upbeat about the sector’s ability to maintain its current growth momentum over the medium term. This ‘rising tide’ should support ‘all ships’, especially BION’s carefully curated portfolio holdings. Meanwhile, the sell-off over the past year or more means valuations, especially among small and mid-cap companies, are now depressed relative to historical levels. For example, in the period since 2001, assessing company valuations relative to the net cash on their balance sheets, valuations are at an all-time low – below the levels seen in the dot-com bust and the global financial crisis. Within the biotech universe, the percentage of companies trading at less than the net cash on their balance sheets is at an unprecedented high of 20–25% (100 to 120 companies). Such historically low valuations mean that the market offers many interesting investment opportunities, which will allow the managers to gain exposure to this rapid growth, at attractive levels.

Furthermore, the managers expect to see several key regulatory, clinical and commercial milestones before the year-end, which should support the performance of several portfolio holdings. Aside from important pipeline updates, forthcoming news on clinical outcomes includes an update on Vertex Pharmaceuticals’ VX-548 treatment for acute pain. In addition, Ionis Pharmaceuticals, in partnership with AstraZeneca, is awaiting approval from the US Food and Drug Administration (FDA) on its application for approval of Eplontersen, aimed at treating patients with nerve disorders, while CRISPR Therapeutics (partnered with Vertex) expects an FDA decision on its CTX001 treatment of sickle cell disease. Neurocrine, Incyte and Celldex, three other portfolio holdings, should also release news on milestone developments during Q4.

On the broader regulatory front, the news is likely to be more mixed. There are signs that US agencies such as the Federal Trade Commission are becoming more accommodating in their stance on large takeovers. However, the US government recently published a list of the first 10 drugs that will be subject to price negotiations under the provisions of the Biden administration’s Inflation Reduction Act. Nine of these drugs are produced by major pharmaceutical entities and one is from the biotech company, Amgen (not held in BION’s portfolio). These negotiations are aimed at reducing the cost of drugs used regularly by people in the government’s Medicare scheme. This program is scheduled to begin in 2026 and is estimated to save the US government $237bn over the following 10 years, so drug manufacturers and investors in the sector will be watching the progress of talks carefully.

Also on a more cautionary note, BION’s managers are monitoring developments in numerous lawsuits initiated by pharmaceutical and industry bodies against the US Department of Health and Human Services and they say they are ‘poised to integrate potential consequences into [their] assumptions and future estimates.

As well as providing exposure to a rapidly growing, innovative sector, investors may also be attracted to BION for its highly competitive dividend policy. Since 2013, it has paid a dividend equivalent to 5% of the average share price during December each year. A dividend of CHF2.85 per share was paid with respect to the year ended 31 December 2022 (2021: CHF3.85 per share) and the company is expected to announce the dividend for the year ended December 2023 in January 2024, for approval at the AGM in March 2024.

This compares very favourably with BION’s peers in the biotech and healthcare sectors, as all other investment companies in this group pay no, or very low, dividends. This is the case because many biotech companies are at a relatively early stage of development and thus prefer to reinvest cash to fund future growth. However, BION’s directors recognise shareholders’ appetite for income and BION has accordingly adopted a different approach to that of its peers. This high distribution policy appears to be appreciated by shareholders – it is arguably one of the factors underlying the share price move from discount to premium over the past seven years. However, it is important for shareholders to be aware that the company’s dividend payments may in part represent a return of their capital.

Until early 2016, BION’s shares traded at a double-digit discount to NAV. However, for the last seven years BION’s shares have generally traded at a premium. The move to a premium was arguably underpinned by strong investor interest in the biotech sector, buying by passive investors following index inclusion and BION’s high distribution policy (discussed above). BION reached a record-high premium to NAV of c 40% in January 2022, but the premium subsequently fell to single digits in Q422. It has since trended lower, and recently dipped briefly into discount territory (Exhibit 1).

The narrowing trend in BION’s premium over the past year should not be perceived as a reflection of BION individually. On the contrary, most investment companies have seen their premiums narrow or discounts widen recently. There are several possible explanations for this, including the higher interest rate environment, which means that for the first time in many years cash and bonds are offering relatively attractive, low-risk returns. This provides a viable alternative to investments in equities and investment companies. In addition, the cost-of-living crisis may well have had a detrimental effect on the appetite for investment companies and other investment vehicles, as individuals and households have less cash available to allocate to savings products.

Whatever the reasons for the decline in BION’s premium, the situation arguably provides an opportunity for investors to gain or add exposure to the company at a relatively attractive level, especially given that the valuations of biotech companies are at all-time lows, as discussed above.

As discussed above, BION lagged its benchmark over the financial half-year ended June 2023, although performance improved in Q323. The relative underperformance in H123 was due in large part to the company’s bias in favour of small- and mid-cap companies, which have fared worst in the current environment. The depreciation of the dollar versus the Swiss franc also detracted from returns in H123, although the subsequent appreciation of the dollar against the Swiss currency has been one contributing factor to BION’s improved performance during Q323.

Positive news on several portfolio holdings has also supported recent returns. For example, Ionis, BION’s largest position, representing c 13% of the portfolio, was one contributor. Ionis is a leading player in antisense technology (genetic-based drug design for administration in vitro to regulate gene expression by binding target RNA molecules in sequence-specific manners). Ionis has a diversified pipeline with candidates in many different disease areas, including rare diseases, cardiac and metabolic conditions, and neurology. The company has delivered a relative return of c 18% pa for BION over its 13-year holding period. Ionis’s latest positive milestones were the approval in May 2023 of its drug Qalsody, a treatment for amyotrophic lateral sclerosis, while Eplontersen (mentioned above) is expected to be approved later this year. The company also reported a positive outcome for Olezarsen in people with familial chylomicronaemia syndrome and has agreed a licensing deal with Roche for two pre-clinical candidates for the treatment of Alzheimer’s disease and Huntington’s disease. Ionis’s share price has risen significantly in recent months and BION’s managers believe the company is well-financed and well-positioned to become a multi-product company with growing profitability.

Argenx, BION’s second largest holding, was one contributor. Argenx develops treatments for autoimmune diseases. It has made an annualised relative return of c 40% since acquisition in 2018. In Q2 it received FDA approval to inject Vyvgart Hytrulo, for use in patients suffering from generalised myasthenia gravis. This decision provides an alternative delivery option and additional choice for patients, facilitating the expanded use of this drug. Argenx’s share price jumped c 29% (in US dollars) in July after the company announced positive top-line results from a further study on Vyvgart Hytrulo. The company’s mid- and long-term revenue and profit outlook improved further with the success of its registrational trial for subcutaneous efgartigimod to treat chronic inflammatory demyelinating polyneuropathy patients.

In September, the share price of Neurocrine Biosciences, another top 10 holding rose following several positive announcements, including encouraging top-line results from a Phase III study on Crinecerfont for treating patients with congenital adrenal hyperplasia. This takes the company a step closer to adding a second large commercial product, alongside Ingrezza, its treatment for chorea associated with Huntington’s disease. Neurocrine also received FDA approval of a new drug application for Ingrezza – a sprinkle granule formulation for patients who have difficulty swallowing capsules.

The shares of Revolution Medicines, which focuses on precision oncology drugs, saw gains following the announcement of an agreement to acquire EQRx in an all-stock transaction intended to add $1.0bn to Revolution’s balance sheet. One of BION’s smaller holdings, Exelixis, announced positive results for its pivotal trail evaluating Cabozantinib in advanced pancreatic and extra-pancreatic neuroendocrine (NET) tumours.

The favourable performance impact of these developments has been partially offset by adverse news on other holdings. One notable detractor from recent returns was Sage Therapeutics, a top 10 holding. This company, which focuses on developing treatments for neurological disorders, saw its share price drop by more than 42% (in US dollars) in August after the FDA disappointed expectations by only partially approving the use of Sage’s drug, Zuranolone. Approval was granted for its use for postpartum depression, but not for use by the broader cohort of patients with major depressive disorder. The FDA requested additional studies to support the case for Zuranolone’s wider use. Sage and its partner Biogen have since laid off staff and are reassessing the direction of their research efforts. BION’s minor exposure to Mersana Therapeutics also detracted. Its share price declined 61% (in US dollars) in Q3 following news that a clinical trial of upifitamab rilsodotin, designed for the treatment of ovarian cancer, did not meet its primary target.

Exhibit 5 shows how BION has performed in months when the benchmark has risen and fallen. Over the last decade, the trust’s cumulative upside and downside capture were 118% and 107%, respectively. As these readings are both above 100%, they suggest that BION outperforms on the upside, but loses more than the benchmark on the downside. While the upside capture has been stable for several years, the downside capture has been on a gently increasing trend over the past few years, until recently, consistent with BION’s underperformance over this period, as discussed above. The more recent dip in the downside capture reflects the company’s outperformance in Q323. The trust’s use of gearing has served to amplify both gains in times of market strength, and losses when the market is weak. 

BION is not included in the AIC’s Biotechnology & Healthcare sector as its primary listing is in Switzerland, but in Exhibit 6 we present it and another Swiss company, HBM Healthcare Investments (HBMN), alongside members of the AIC peer group, to provide a relevant comparison. This group includes four funds (BION, Biotech Growth Trust, International Biotechnology Trust and the relatively recently launched RTW Biotech Opportunities) that focus primarily on biotech stocks, and four funds (BB Healthcare, HBMN, Polar Capital Global Healthcare and Worldwide Healthcare Trust) that are focused on healthcare more broadly and generally include some biotech stocks alongside stocks from other sectors. The last fund, Syncona, is a venture capital/growth capital investor focusing on backing and building early-stage companies, mainly in the biotech space.

BION is the largest fund in this grouping. The performance of most members of the group has struggled over the past year as biotech and healthcare more generally have been out of favour with investors. Over the longer term, the funds with a broader healthcare remit have done best in NAV total return terms over the past few years, as the biotech sector devalued faster than healthcare. BION’s recent performance has lagged due to its mid- and small-cap bias, as these sectors have underperformed the market, but long-term performance remains strong – BION ranks third among its peers and has outperformed the average over 10 years on an NAV total return basis. One key differentiator for BION is that it is the only company among its peers to pay a substantial dividend, which is set at 5% of the average share price over December each year. The company’s ongoing charge is close to the average of its peers, and it is the only fund currently trading at a premium. BION has the highest level of gearing among its cohort.

BION is differentiated from its NBI benchmark by its concentrated portfolio of c 30 stocks. At end-September 2023, the company’s top 10 holdings comprised 78% of its NAV (Exhibit 7). The company also differs from the NBI by being able to hold up to 10% of its assets in private equity. Investments are chosen according to a multi-level due diligence process with a focus on standard financial parameters, as well as the competitive environment, development pipelines, patents and end-user perception.

BION’s managers have adopted a more defensive investment stance over the past year, given the high interest rate environment and the generally poor investor sentiment towards the sector. Specifically, they have focused on well-financed, profitable companies, and eschewed more risky ventures, which are more vulnerable in the ‘risk-off’ climate. However, a defensive stance does not mean an inactive one. On the contrary, the low valuations of the biotech sector in general, and in small- and mid-cap names particularly, have presented the team with opportunities to add to existing holdings at attractive prices and consider potential new portfolio holdings, although no new names were added to the portfolio in Q2 or Q3 and BION has not participated in any takeover activities year-to-date.

Notable recent transactions include an addition to the company’s holding in Black Diamond Therapeutics, a targeted oncology player. Promising clinical data on BDTX-1535, a treatment for lung cancer, allowed Black Diamond to undertake a capital raising. BION made an additional investment to maintain its 15% ownership stake in the company. Exposure to Black Diamond was raised further via open market transactions. The managers like this company in part due to its deployment of massive computational power and machine learning to deepen its understanding of disease processes and speed up the identification and development of new treatments. BION also participated in the US$40m private placement of Molecular Templates, allowing the company to fund its pipeline into 2024.

The BION team took advantage of the sharp sell-off in Mersana mentioned above to increase its position, as it maintains its high conviction in the company’s longer-term prospects. They also added to positions in Relay Therapeutics, Celldex, Macrogenics and Sage. These transactions were funded by some modest profit-taking on Vertex, Ionis and Incyte.

These portfolio changes have not had a dramatic impact on portfolio structure. BION’s top 10 holdings are largely unchanged over the past year (Exhibit 7) – a strong indicator of the managers’ high conviction in the portfolio’s key positions. Most of these top 10 holdings are revenue-generating companies and the team expects the remainder to become cash flow-positive in the near future. As shown in Exhibit 8, BION’s portfolio exposure by technology is still led by the small molecule category, followed by RNA, antibody and gene and cell therapy. Mid-cap stocks ($5–30bn still dominate the portfolio, comprising 54.0%, followed by small caps (up to $5bn), totalling 29%. Large-cap stocks (>$30bn) make up the remaining 17.0% (Exhibit 9).