The Biotech Growth Trust — Onwards and upwards for performance recovery

BIOG’s portfolio contains major biotech companies, which are large, profitable businesses that can be valued on traditional metrics such as P/E multiples and earnings growth, and emerging biotech companies, which do not generate sustainable profits and may have no revenues. The trust’s portfolio has a structural bias towards emerging biotech companies as, although they are inherently riskier, the managers consider that this is outweighed by their potential positive prospects. These companies represent two-thirds of the biotech industry’s research and development pipeline and 2021 data showed that 53% of new product launches were from emerging biotech companies.

Risk management is embedded into the investment process. There is comprehensive review and analysis of companies that have significant binary catalysts, with the managers aiming to limit negative outcomes to 100bp. For large-cap stocks the portfolio position size is 5–10%, while emerging biotech holdings are generally 1–3%. Annual portfolio turnover of 90% is relatively high as the managers add to or reduce the holdings to ensure they are appropriately sized, especially for companies with binary events.

Exhibit 1 clearly shows BIOG’s preference for emerging biotech stocks.

The NASDAQ Biotech Index bottomed in late-October 2023, and since then smaller-cap biotech shares have significantly outperformed large-cap biotech stocks. However, it is interesting to note that in the broader market, smaller-cap stocks are not yet playing catch-up. The managers believe that once this does occur it should fuel further momentum in the shares of smaller-cap biotech companies.

Using the XBI Index (the equal weighted SPDR S&P Biotech ETF) as a proxy for small- and mid-cap biotech stocks shows that versus the US bellwether S&P 500 Index, biotech sector drawdowns are followed by periods of outperformance. The latest drawdown was the longest, and the largest, in absolute and relative terms since the XBI Index was launched in 2006; between 8 February 2021 and 7 February 2024, the XBI Index underperformed the S&P 500 Index by 77pp.

Sector weakness led to depressed biotech company valuations. For those with a market cap greater than $10m, the median market cap versus net cash on the balance sheet was at a record low – so below levels seen during the period of Clinton drug price reform, the bursting of the dot.com bubble and the global financial crisis. There was a record number of biotech companies trading below the amount of net cash on their balance sheets, and while the sector has moved off its low point, using history as a guide, there appears to be significant further upside in biotech stocks.

The latest biotech sector drawdown seems disconnected from strong industry fundamentals, with a pipeline as full as it has ever been. Between 2016 and 2022 the number of Phase I candidates increased by 70% across all therapeutic areas. What the managers refer to as a ‘golden era’ of innovation is being driven by novel/next-generation technologies including gene editing/therapy, cell therapy and RNA therapeutics. There have also been notable new drug approvals to address large markets, some of which have mega-blockbuster consensus peak sales estimates of more than $10bn. These include Biogen and Eisai’s Leqembi for the treatment of Alzheimer’s disease and Vertex Pharmaceuticals’ Trikafta for the treatment of cystic fibrosis.

The regulatory environment remains supportive as in 2023 the US Food and Drug Administration approved a further 55 novel drugs (new molecular entities and therapeutic biological products). Within these approved drugs were several ‘firsts’, including Biogen and Sage Therapeutics’ Zurzuvae, which is the first and only treatment for postpartum depression.

M&A has historically been positive for the performance of biotech stocks. Activity was robust in 2023 and has continued so far in 2024. The managers expect this to continue, supported by attractive biotech company valuations and pharma companies having to bolster their product pipelines ahead of an unprecedented patent cliff. Between 2025 and 2030, an estimated $250bn of branded drugs are going off patent, the bulk of which occurs in 2027 to 2029. As an example, Merck had $25bn in Keytruda sales in 2023, which is used in the treatment of cancers, and is going off patent in 2028, so the company requires external as well as internal developments to plug its upcoming sales gap.

Hsu and Golomb will continue to favour emerging over large-cap biotech stocks, aiming to capture their full rebound from a significant period of underperformance. The managers believe that emerging biotech stocks are coming off unprecedented low valuations, which offers significant upside from current levels, especially considering the positive fundamental features of the biotech sector. In addition, ongoing robust levels of M&A should continue given the looming patent cliff. As a result of this constructive backdrop, the managers are very bullish on the prospects for BIOG.

At end-February 2024, BIOG’s top 10 holdings made up 43.1% of the fund, which was a higher concentration compared with 41.5% a year before; two names were common to both periods. The portfolio had 62 positions, which was very similar to 61 at end-February 2023. Over the 12 months to the end of February 2024, the trust’s active share fell from 82.4% to 70.5% (this is a measure of how the fund compares with its benchmark, with 0% representing full index replication and 100% no commonality). The lower active share is unsurprising given how well large-cap biotech stocks have performed versus smaller biotech companies.

Exhibit 3 shows that BIOG’s exposure to the dominant North American biotech market increased by 8.9pp to 88.0% in the 12 months to the end of February 2024. There was also a notable 5.5pp decline in the trust’s exposure to unquoted companies.

At 29 February 2024, BIOG’s total Chinese exposure was 6.9% (3.9% listed and 3.0% unquoted), which was considerably lower than 13.2% a year before (8.4% unquoted and 4.8% listed).

To provide a long-term perspective, from BIOG’s inception in May 2005 to the end February 2024, the trust’s NAV total return of +983.5% compared with the NASDAQ Biotech Index’s +843.0% and the UK market’s +228.7% total return.

Exhibit 4 shows that BIOG’s performance is solidly back on track following a prolonged period of underperformance starting in Q121, as emerging biotech stocks significantly underperformed the shares of large-cap biotech companies.

BIOG is one of the smaller funds of the seven members of the AIC Biotechnology & Healthcare sector. Reflecting the trust’s improved recent performance, its NAV total return is above average over the last 12 months, ranking third. It has below average returns over the other periods shown. BIOG’s has a lower-than-average discount in a sector where no funds are trading at a premium. It has a below-average ongoing charge and the highest level of gearing. The trust is one of three companies in the sector that does not pay a dividend.

BIOG’s relative performance is shown in Exhibit 7. The trust has certainly enjoyed a reversal in its fortunes in recent months with a near 20pp NAV outperformance versus its benchmark over the last six months. Biotech shares have started to perform better following a prolonged period of being out of favour with investors for both macroeconomic and company-specific reasons. During ‘risk-off’ episodes, emerging biotech stocks with their higher risk profiles tend to be disproportionately negatively affected compared with larger-cap more diversified biotech stocks.

Due to BIOG’s recent improved performance, it is now ahead of its benchmark over the last one and five years. However, there is more work to be done to restore the trust’s three-year record.

In Exhibit 9, we highlight BIOG’s performance versus its NASDAQ Biotechnology Index benchmark over the last 10 years. The trust’s upside capture rate is 111%, suggesting that in months when biotech shares are rising, BIOG will outperform by a modest amount. It has a larger downside capture rate of 121%, which implies that in months when biotech shares are falling, the trust will underperform to a greater extent. This analysis is not surprising given BIOG’s bias to emerging biotech stocks, which are inherently more risky than large-cap biotech stocks.