Worldwide Healthcare Trust — Healthcare industry prospects are shining brightly

Concern about US drug pricing controls has been a periodic healthcare industry overhang since the Hillary Clinton era in the early 1990s. The overhang has been lifted following the passing of the Inflation Reduction Act 2022; overall WWH’s managers consider the industry impact is neutral. A drug price inflation cap is deemed neutral, while the redesign of Medicare Part D should be positive as it lowers patients’ out-of-pocket expenses, so should lead to higher drug volumes. Medicare price negotiations will be introduced in 2026 and the managers consider this element is negative but manageable. The drugs affected are the top 10 used by the elderly population that have no biosimilar or generic competition by 13 years post approval for biologics and by nine years post approval for small molecules, with a further 10 drugs added each year. This equates to an estimated $40bn revenue hit out of a $660bn US prescription base through to 2032. WWH’s managers suggest that, as the Medicare price negotiations are scaled in over multiple years and the rules are now known, the drug price overhang is removed. In addition, there are court proceedings under way, so the situation on drug price controls could change.

An uptick in healthcare industry M&A is being helped by another looming patent cliff, where c $250bn of branded drug sales are at risk between 2025 and 2030. This means that large-cap pharma companies have a big pipeline and revenue gap to fill. They are looking for biotech and specialty pharma products that will be launched by 2025 and have at least $1bn revenue potential. The M&A upcycle started in Q222 and WWH has so far benefited from three takeouts of portfolio companies: Global Blood Therapeutics by Pfizer (at a 102% premium); Turning Point Therapeutics by Bristol-Myers Squibb (122% premium); and Seagen by Pfizer, although Merck was previously seen as a potential acquiror (42% premium). According to the managers, M&A should be the most important driver of the healthcare sector’s performance over the next 12 to 18 months. Some major pharma companies are very active in M&A, while others have yet to make a move. There is combined $1.5tn cash on the balance sheets of major pharma companies versus a total biotech industry valued at just $250bn; all of WWH’s small and mid-cap holdings are considered to be potential takeover candidates.

The managers report that up to 2032, there are a potential 15 novel biotech company-sourced product launches with more than $60bn in cumulative revenues. Adding in a further 25 products equates to more than $20bn in additional revenues. Since 2016, the number of molecules under development has increased by 70% and has been led by treatments in oncology. This category is now plateauing, with immunology and central nervous system products increasing in popularity. There has been a series of positive data readouts in oncology, obesity and Alzheimer’s drug trials. Obesity is a very important category and is currently dominated by Eli Lilly and Novo Nordisk. There have been products approved for the treatment of Alzheimer’s, which is positive for Eli Lilly and Eisai/Biogen, whose drug recently received full approval. WWH’s managers highlight a new era of ‘mega blockbuster’ drugs that are benefiting a narrow list of pharma companies, meaning those that are not clear winners will have to make acquisitions.

Biotech stocks have had a torrid time due to a variety of reasons including investor risk aversion and trial failures. Looking at the relative performance of the SPDR S&P Biotech ETF (XBI) Index versus the US bellwether S&P 500 Index, between early 2021 and mid-2022, the XBI declined by 77% peak to trough; the absolute decline was 65%. Since mid-2022, the XBI has failed to sustain short-term periods of outperformance meaning recent years have been the longest and the largest biotech downturn both in absolute and relative terms. Borho explains that until 2021 and 2022 there had not been two consecutive years when biotech stocks underperformed the broader US market; he does not expect 2023 to be the third consecutive year of underperformance. Given the high level of industry innovation and the attractive valuations of many biotech stocks, the manager describes the current situation as the ‘biggest dislocation in my career, worse than during the bursting of the technology bubble or the global financial crisis’.

In sterling terms, over the last decade global healthcare stocks have modestly outpaced the world market; however, they have performed significantly better than the broad UK market (Exhibit 1).

Exhibit 2 shows the performance of the US healthcare sector in recent years. Its defensive qualities are shown by its modestly negative total return in 2022, when the US market delivered a double-digit decline. In strong equity markets healthcare stocks tend to be around the middle of the pack, but they have underperformed so far this year in a narrow market that has been led by companies deemed to be beneficiaries of the growth in artificial intelligence. WWH’s managers expect healthcare stocks, particularly those with high-growth potential, to perform relatively better for the balance of the year.

The Datastream World Pharma Index is trading on a 16.2x forward P/E multiple. This is a 3.1% premium to the valuation of the Datastream World Index, which is broadly in line with its 10-year average. However, versus US stocks, global pharma companies look more reasonably valued; the Datastream World Pharma Index is currently trading at an 18.5% discount to the Datastream US Index, which is meaningfully wider than the 11.7% average discount over the last decade.

The managers’ strategy is to favour emerging biotech stocks, which are offset by a significant below-index weighting in large-cap pharma companies. WWH also has modest exposures to emerging markets and unlisted firms, both of which are not represented in its benchmark.

Over the 12 months to end-June 2023, the largest changes in WWH’s subsector exposure were a higher allocation to medtech/devices (+6.6pp) and a lower emerging markets weighting (-4.6pp). This was partly a result of poor performance and also due to active selling.

Unsurprisingly, given the US’s dominance in the global healthcare industry, US-listed companies make up the greater part of WWH’s portfolio. In the year to end-June 2023, the largest changes to the trust’s geographic exposure were a higher weighting to Japan (+3.1pp) and a lower allocation to China/Hong Kong stocks (-4.6pp).

As shown in Exhibit 6, at end-June 2023 WWH’s top 10 positions made up 42.1% of the fund, which was broadly in line with 42.4% a year before; seven positions were common to both periods. It is interesting to note that although the MSCI World Health Care Index is dominated by the US (more than 70%) and pharma companies (around 40%), the trust’s top 10 list includes a meaningful exposure to European pharma companies (16.6%) along with US healthcare & supplies and providers & services businesses (21.0%).

Within WWH’s top 10 holdings is the trust’s largest biotech holding. It is a swap derivative that is constructed and managed by OrbiMed and is made up of 20 biotech companies that the firm considers to be the most likely M&A targets. It has identified some companies that were bid for, including Turning Point Therapeutics, and provides WWH with extra exposure to potential M&A targets without the managers having to add a significant number of new names to the portfolio.

Drilling down further, at end-June 2023, WWH’s top 20 and 30 holdings made up 76% and 93% of the fund, respectively. Its active share was 70% (a measure of how a fund differs from an index, where 100% is zero commonality and 0% is full index replication). The percentage of the portfolio invested in profitable companies was 78%.

WWH is by far the largest member of the seven-strong AIC Biotechnology & Healthcare sector. Its NAV total returns rank fifth out of seven funds over the last 12 months and three years, fourth out of six over the last five years and first out of five over the last decade. The trust’s closest peers are Bellevue Healthcare Trust and Polar Capital Global Healthcare Trust; compared with these two funds, WWH ranks third over the last one, three and five years but first out of two funds over the last 10 years. The trust’s shorter-term NAV total returns have been negatively affected by its strategy of favouring emerging biotech stocks and investing in emerging markets, with a below-market weighting to large-cap pharma companies.

WWH has a narrower-than-average discount in a sector where no funds are trading at a premium. It has the lowest ongoing charge, although a performance fee may be payable. It currently has the second-highest level of gearing and a below-average dividend yield, although the two funds with the highest yields can pay dividends out of capital.

Looking at WWH’s relative performance in recent financial years (ending 31 March), FY21 was one of the best, while FY22 was one of the worst. In FY23, WWH’s -0.1% NAV and -4.1% share price total returns lagged the benchmark’s +2.5% total return (the trust’s results were helped by sterling falling by 6.5% versus the dollar during the period). FY23 was a bit of a ‘mixed bag’ with distinct periods. As shown in Exhibit 9, April and May 2022 was a tough performance period due to investors’ macroeconomic concerns, mainly the war in Ukraine, high inflation and rising interest rates; growth stocks were out of favour. Over the summer in 2022, healthcare fundamentals were positive, there were some positive trial readouts and M&A picked up; WWH meaningfully outperformed its benchmark. In Q322, investors became more defensive and focused on macroeconomic issues and large-cap pharma outperformed, so unsurprisingly the trust underperformed. Then in March 2023, markets sold off due to concerns about problems in the financial sector following the failure of Silicon Valley Bank; WWH outperformed during this period.

During FY23, emerging biotech stocks were by far the largest positive contributor to WWH’s performance, helped by acquisition bids for three portfolio companies, which we highlighted earlier in this report. There were smaller positive contributions from the trust’s large-cap pharma and Japanese holdings. The largest detractor to the trust’s performance was its exposure to Chinese healthcare companies.

Looking at individual stocks, the top three absolute positive contributors were Global Blood Therapeutics and Seagen, which were both acquisition targets, and Daiichi Sankyo. This company is a leader in the development of third-generation antibody drug conjugates for the treatment of cancers. The largest negative contributors to the fund’s performance were Shanghai Bio-heart Biological Technology, Mirati Therapeutics and Horizon Therapeutics. Shanghai Bio-heart Biological Technology had a successful IPO in late-2021, but its share price declined in November 2022, for no obvious reason. The managers speculated that there was profit taking ahead of important data releases and the expiration of the lock-up for private investors in December 2022. Mirati Therapeutics had disappointing trial data. Horizon Therapeutics had poor sales and guidance for its lead product Tepazza, for the treatment of thyroid eye disease, and there was a delay in one of its important trials. This position was sold but the company subsequently received a take-over bid from Amgen at a 48% premium.

WWH has a positive long-term performance record. In the c 28 years since the fund was launched in April 1995 to end-FY23, the trust has generated NAV total returns of 14.5% per year, which is considerably ahead of its benchmark’s 11.9% annual total returns. However, as shown in Exhibit 10, the trust’s NAV has underperformed the MSCI World Health Care Index over all periods shown. Borho acknowledges that WWH’s performance needs to improve. He explains that FY22 was ‘a killer’ due to the trust’s heavy exposure to innovative small and mid-cap companies. This strategy has worked over the long term, but was the wrong approach in FY22. He adds that ‘we have to do better – there is a lot of wood to chop’.

WWH’s semi-annual dividends are paid in January and July. The managers do not have a particular yield requirement as the trust’s board believes WWH’s capital should be deployed in the portfolio, rather than paid out as dividends.

The following text refers to the trust’s latest annual report and does not reflect the July 2023 10:1 share split. In FY23, WWH’s revenue return was 14.2% higher year-on-year at 30.6p per share, helped by a greater exposure to higher-yielding stocks and sterling weakness. The annual dividend of 31.0p (c 1.0x covered) was made up of an unchanged 7.0p per share interim payment and a 23.1% higher 24.0p per share final distribution. At the end of FY23, WWH had c £23.5m in revenue reserves, which is around 1.2x the last annual dividend payment.

WWH’s shares are trading at an 8.8% discount to cum-income NAV, which compares with a 2.2% to 8.5% range of average discounts over the last one, three, five and 10 years, respectively. During the last 12 months, the trust’s valuation range is a 0.8% to 11.0% discount.

In 2004, WWH’s board implemented a discount-control mechanism, 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 (a prospectus is required to enable further share issuance). During FY23, c 2.8m shares were repurchased at an 8.8% average discount to cum-income NAV, at a cost of c £91.6m.

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 c $18bn of assets under management (c $4.4bn in public equities) and operates from three continents with offices in New York, San Francisco, Herzliya (Israel), Hong Kong, Shanghai, Mumbai and London. OrbiMed has a team of around 140 people, of whom more than 30 hold PhD or MD qualifications and 15 are former biotech CEOs. 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 (Datastream World Pharma/Biotech TR (sterling adjusted) Index from inception to 30 September 2010).

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 not hedged 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 can participate in all subsectors of the healthcare industry anywhere in the world, aiming to generate long-term capital growth. They can draw on the broad resources of OrbiMed’s investment team, including employees based in China. The firm has used 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 and strong management teams, which are trading on reasonable valuations. There is a disciplined portfolio construction process to ensure the fund remains focused on high-conviction positions, and there is also a rigorous risk-management process.

At the end of June 2023, the trust had 62 positions, noticeably lower than 77 a year earlier. Its unlisted exposure was 5.7% at the end of June 2023, compared with 7.6% at the end of June 2022. WWH has good access to ideas and unquoted companies given OrbiMed’s large private equity team. The managers are mindful of liquidity issues when investing in private companies and understand that there is increased competition for crossover deals (the last round of financing before a company’s IPO).

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 ESG factors when evaluating a prospective or existing investment. The company utilises ESG scores from third-party providers and supplements these with its own proprietary analysis. As well as regular monitoring of these combined data, OrbiMed regularly engages with WWH’s portfolio companies. It also tracks ESG information on relevant factors including safety of clinical trials, drug/product safety and ethical marketing. OrbiMed considers that it is leading the charge in terms of meaningful ESG engagement in the healthcare sector. WWH’s managers seek to invest in reputable management teams and are especially cognisant 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 a US dollar overdraft facility with JP Morgan Securities at the US overnight bank funding rate plus 45bp. Gearing of up to 20% of NAV is permitted. Historically, the trust maintained a relatively high level of gearing, but over the last few years the managers have employed a more pragmatic and tactical approach, hoping to take advantage of periods of stock market volatility. At end-June 2023, net gearing was 16.1%.

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). At end-FY23, no performance fees were accrued or payable. 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 FY23, the trust’s ongoing charge was 0.8%, which was 10bp lower than 0.9% in FY22.

WWH is a conventional investment trust with one class of share; there are 600.2m ordinary shares in issue. Over the last 12 months, WWH’s average daily trading volume was c 1,170k shares.

Sven 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.