Biotech Growth Trust (The) — Favourable industry fundamentals

The biotech sector has delivered above-average returns over the last decade (Exhibit 1, left-hand side), and the strong momentum seen in the 2020 recovery following the coronavirus-led market sell-off, had continued in 2021 until the recent period of profit taking in the technology and biotech sectors. Investors may be focusing on the sector’s positive fundamentals, which include robust volume growth, helped by demographic trends; high levels of innovation within the industry; a supportive regulatory and benign political environment; ongoing demand for IPOs; and continued M&A activity.

However, when taking a view on the biotech sector, investors should also take valuations into account. US stocks are 12 years into a protracted bull market and, in aggregate, the valuation of biotech shares looks somewhat rich. The DS World Biotech index is trading at a forward P/E multiple of 26.4x, which is higher than the five- and 10-year averages of 24.5x and 23.0x respectively. While a biotech fund may be a valuable addition to a global equity portfolio, investors may benefit by waiting for a general market pullback, maybe in response to higher inflation expectations/interest rates, or a period of meaningful relative sector underperformance.

Hsu remains bullish on the fundamental outlook for the global biotech industry in 2021 but is mindful that biotech stocks performed strongly in 2020 (the NASDAQ Biotech Index rallied by c 25% in $ terms), while there has been a 12-year US equity bull market. The manager is very encouraged by ‘the golden era’ of innovation within the drug industry. The pipeline is as full as it has ever been; between 2014 and 2019 the number of late-stage pipeline products increased by 50% across a broad range of therapeutic areas including oncology, central nervous system disorders and infectious diseases. Hsu suggests that ‘there is no evidence that this momentum is abating’.

On the political front, while the Democrats regained control of the Senate, it was achieved by the narrowest of margins and their control of the House of Representatives narrowed from a 35- to a 10-seat majority. The manager suggests that President Biden has higher priorities than the healthcare industry, including dealing with COVID-19 and supporting the US economy, meaning there is unlikely to be dramatic drug price legislation.

Hsu believes that the favourable regulatory environment is unlikely to change and the high level of new product approvals will continue. In the US there have been record numbers of Food and Drug Administration (FDA) approvals of new molecular entities in recent years: 46 in 2017, 59 in 2018, 48 in 2019 and 53 in 2020.

The manager says that the biotech IPO market has been robust over the last few years. BIOG has been an active participant in several of these deals. Hsu comments that ‘most cutting-edge new technologies are typically being developed by newer companies and investor appetite for these firms is strong’. He reports that the shares of companies that have come to the market have subsequently performed strongly and, while there is often high demand for IPOs, OrbiMed’s stature within the industry allows it to receive above-average allocations.

Hsu says that there was significant M&A activity in 2020 despite COVID-19 and people working from home. The largest contributor to BIOG’s performance in 2020 was Immunomedics, which was taken over for $21bn by Gilead Sciences at a greater than 100% premium. Other deals included Sanofi’s acquisition of Principia Biopharma and Johnson & Johnson’s acquisition of Momenta Pharmaceuticals. In December 2020, AstraZeneca bid $39bn for Alexion Pharmaceuticals at a 45% premium, showing that there is demand for large as well as small-cap biotech companies.

The manager remains very bullish on the biotech opportunities in China, which make up more than 10% of BIOG’s portfolio and are not represented in the benchmark. There are no investment guidelines restricting the trust’s exposure to the country. Historically, the Chinese domestic drug market was focused on speciality generics and traditional Chinese medicines, but a number of developments in recent years are encouraging innovation. The government has committed to building a biotech ecosystem in the country as part of its ‘Made in China 2025’ plan, while the Chinese FDA has introduced initiatives to expedite approval of innovative drugs. Biotech companies at the pre-revenue stage are now able to list their shares on the Hong Kong Stock Exchange and the new A-share STAR board. Also, large multinational pharma companies are bringing their expertise to China and investing in drug development infrastructure; several have in-licensed innovative assets from Chinese companies. OrbiMed has a local research team in China, meaning it is well positioned to take advantage of investment opportunities in the country.

At end-January 2021, BIOG’s top 10 positions made up 30.8% of the portfolio, which was a lower concentration compared with 45.3% a year earlier; just three positions were common to both periods. The holding in Vertex Pharmaceuticals has declined, partly due to negative newsflow. In October 2020, its stock price fell by c 20% following the discontinuation of the Phase I/II trial for a product that investors considered the company’s most promising pipeline asset. Hsu believes very little pipeline value is reflected in the company’s share price and views its commercial execution in cystic fibrosis as very strong. The manager considers it prudent generally to have smaller position sizes in emerging biotech companies compared with when the fund had a much larger weighting in major biotech stocks given their higher risk profiles and lower trading volumes. BIOG’s portfolio is currently split c 85% and c 15% between emerging and major biotech stocks as the bulk of industry innovation comes from the smaller-cap companies. As a result, Hsu says that the number of holdings in the fund has increased to c 80 compared with a historical range of 35–45. He explains that BIOG’s portfolio is actively managed; from the end of September 2020 to the end of January 2021, there were 16 new positions initiated and 12 complete disposals. The manager regularly adds to and trims positions, commenting that ‘it is a very fluid process’ and holdings are actively managed ahead of a binary event to ensure that he is comfortable with the level of risk.

Exhibit 3 shows the trust’s geographic breakdown. Notable changes over the 12 months to the end of January are a lower North America weighting (-8.6pp) and, on the assumption that the ‘other’ category in January 2020 was China, a higher (+4.6pp) weighting to the country.

Hsu comments that in 2020, all segments of BIOG’s portfolio did very well including emerging market stocks, which were meaningful contributors to the trust’s performance. Its strategy of crossover investments whereby BIOG participates in the last round of financing prior to a company listing on the stock market and then increases its position size at the IPO has proved successful. The manager adds that on average crossover followed by IPO investments tend to generate 3–4x the returns compared with traditional investments.

BIOG’s relative returns are shown in Exhibit 6. It has meaningfully outperformed the benchmark over one, three, five and 10 years in both NAV and share price terms. Recent underperformance in January 2021 was due to erratic share price moves in both the biotech sector and the broader market as a result of short squeezes orchestrated by retail investors in select stocks such as GameStop and AMC Entertainment. BIOG’s total returns are ahead of the MSCI World index over all periods shown (with the exception of one month), while the outperformance compared with the broad UK market is even more notable over one, three, five and 10 years.

In Exhibit 8 we show the six well-established funds in the AIC Biotechnology & Healthcare sector, along with two Switzerland-listed funds (BB Biotech and HBM Healthcare Investments). BIOG has performed relatively well, ranking first over one and 10 years by a considerable margin, and second over three and five years. On 8 March 2021, the trust was one of two funds trading at a discount. BIOG has one of the lowest ongoing charges in the selected peer group, the second highest level of gearing and is one of two funds not paying a dividend.

BIOG’s investment objective is to generate long-term capital growth rather than income and a large proportion of the fund is invested in early-stage companies that invest for further growth rather than returning cash to shareholders. In FY20, the trust’s revenue return was a modest 1.0p per share, which was in line with FY19. No dividend has been paid since 2001 (0.2p per share).

Having historically traded at a discount, BIOG had been regularly trading close to NAV until the recent period of profit taking in the technology and biotech sectors. Its current 8.7% share price discount to cum-income NAV compares with average discounts of 2.5%, 5.7%, 5.8% and 5.1% over the last one, three, five and 10 years respectively.

Renewed annually, BIOG has authority to purchase up to 14.99% and allot up to 10% of issued share capital. The board remains committed to limiting the discount to 6% in normal market conditions. However, buybacks were suspended in March 2020 due to extreme stock market volatility. Given the trust’s generally higher valuation in recent months, so far in FY21, c 2.3m shares have been issued (5.7% of the share base) raising c £31.0m.

BIOG was launched in June 1997 and is listed on the Main Market of the London Stock Exchange. The trust is managed by Geoff Hsu at OrbiMed Capital, which is a global healthcare specialist investor with more than $16bn of assets under management (c $5.5bn in public equities). OrbiMed operates from 11 regional offices and has a team of around 100 investment professionals, of whom 30 hold PhD or MD qualifications and 15 are former CEOs or company founders. Hsu aims to generate long-term capital growth from a diversified portfolio of global biotech equities and related securities. BIOG’s performance is measured against the NASDAQ Biotechnology Index (sterling-adjusted), and its currency exposure is unhedged. The trust’s investment guidelines state that at the time of investment, a maximum of 15% of gross assets may be held in a single stock; up to 10% may be in unquoted securities (excluding a maximum $15m in private equity funds managed by OrbiMed and its affiliates); and swaps exposure is permitted up to 5% of gross assets. Hsu may employ gearing up to 20% of net assets; net gearing was 4.0% at end-January 2021.

Hsu aims to generate long-term capital growth from a globally diversified portfolio of biotech stocks across the market cap spectrum; he is able to draw on the broad resources of OrbiMed’s experienced investment team. Stocks are selected on a bottom-up basis following thorough in-depth fundamental research, which includes financial modelling, an assessment of research pipelines and identification of potential catalysts; company meetings are a very important element of the research process.

Reasons to initiate a new position include whether an early-stage company is approaching profitability, ahead of anticipated positive clinical data, or if a business is considered a potential takeover target. While the manager seeks out the best potential opportunities across the globe, the majority of the portfolio is held in US companies, reflecting its current dominance in the biotech industry, although BIOG has a notable double-digit exposure to China. The trust’s holdings are regularly reviewed to ensure the original investment theses are still valid and positions are sized correctly.

Hsu notes that BIOG’s portfolio turnover is relatively high as a result of its emerging biotech exposure, where stocks can be volatile around news about clinical results. A review undertaken with the trust’s board showed the investment team’s research efforts can generate excess returns, which could be enhanced by monetising successful positions more quickly, rather than holding on to stocks for too long, as well as exiting underperforming stocks deemed to have further downside risk. The increased portfolio turnover has borne fruit, as has the 2020 change in the structure of the portfolio whereby the majority of the fund is held in emerging rather than major biotech stocks. Hsu will continue to invest in unquoted companies (c 3% of the fund at end-January 2021).

OrbiMed believes that 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 manager seeks to invest in reputable management teams and is 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. He suggests that the biotech sector does not have the same concerns as within other industries given biotech companies are providing a social good.

Gearing of up to 20% of NAV is permitted and is employed via a loan facility with JP Morgan Securities, priced at 45bp above the US Federal Funds rate. At the end of January 2021, the trust’s net gearing was 4.0%, which is below the low end of the typical range of 5–10%. The manager explains that the level of gearing is a result of bottom-up stock selection, while it has naturally declined as BIOG’s NAV has risen considerably.

OrbiMed is paid an annual management fee of 0.65% of BIOG’s NAV and Frostrow Capital (the trust’s alternative investment fund manager, which provides company management, secretarial, administrative and marketing services) receives an annual fee of 0.3% of the trust’s market cap, plus a fixed fee of £60k pa. A performance fee is payable – 16.5% of outperformance versus the benchmark (15.0pp and 1.5pp to OrbiMed and Frostrow, respectively). It is only payable to the extent that the cumulative outperformance since the commencement of the arrangement on 30 June 2005 gives rise to a total fee greater than the total of all performance fees paid to date. No performance fee was paid in FY20, but assuming BIOG’s outperformance is maintained, the maximum amount that could become payable by 30 September 2021 is £18.5m. In H121, the trust’s ongoing charges were 1.1%, which was in line with FY20.

BIOG is a conventional investment trust with one class of share. There are currently 41.5m ordinary shares in issue and the average daily trading volume is 104.5k shares. The trust has a five-year continuation vote – the last was held at the July 2020 AGM when the resolution was passed by a significant majority (99.9% of votes were in favour).

As Hsu is a partner at OrbiMed, he is considered to be a non-independent director.

On 18 January 2021, the board announced the appointment of Dr Nicola Shepherd as an independent non-executive director with immediate effect. She is the founder and a director of Bellows Consulting, which operates in the biomedical translational sector, providing strategic advice and assisting clients in moving their projects closer to the market. Previously, Dr Shepherd held positions as a senior member of the innovations division at the Wellcome Trust; in late-stage development and manufacturing at AstraZeneca; at Global Prior Art (a US patent specialist in intellectual property); and Brown University. She is a member of the CARB-X Advisory Board and a reviewer for Innovate UK.