The Biotech Growth Trust — Positive outlook for the biotech sector

While investment in biotech stocks can be volatile, as shown in Exhibit 2 (left-hand side), over the long term, investment returns from biotech equities have been significantly above those generated from global equities. Following the appointment of Donald Trump as US president, there has been less of a focus on US drug pricing, and biotech shares have performed strongly. Exhibit 2 (right-hand side) shows the relative forward P/E valuations of global biotech stocks versus both global pharma and US equities. Biotech shares are trading on a forward P/E multiple of 20.6x; this is a c 40% premium to global pharma stocks, which is broadly in line with the average premium over the last 10 years. However, compared to the broader US equity market, biotech stocks’ current premium of less than 10% compares with a c 25% premium over the last 10 years.

Exhibit 3 shows the valuation of the largest US biotech and pharma stocks. The average growth of biotech stocks is negatively skewed by Gilead, which is exiting a period of very high earnings growth in recent years, due to its successful hepatitis franchise. However, on average, for reasonably comparable future earnings growth expectations, large-cap biotech stocks are trading at more attractive forward earnings multiples than large-cap pharma stocks for both 2018 and 2019.

Fundamentals within the biotech industry remain positive; the regulatory backdrop is favourable and companies developing life-saving, innovative therapies are able to charge premium prices, which in turn funds future drug development. For investors seeking exposure to the sector, a specialist fund with a positive long-term performance record may be of interest.

BIOG was launched in June 1997 and is listed on the Main Market of the London Stock Exchange. Since May 2005, the trust has been managed by OrbiMed, the world’s largest specialist healthcare investment manager, with c $15bn assets under management. OrbiMed has a more than 20-year track record of investment in both public and private equity, and employs more than 100 investment professionals, many of whom have PhD or MD degrees and/or are former founders or CEOs of healthcare companies. BIOG is managed by New York-based Richard Klemm and Geoff Hsu, who aim to generate long-term capital growth from a concentrated global portfolio of biotech shares. At end-September 2017 there were 36 positions in the portfolio. The managers select stocks on a bottom-up basis, without reference to the NASDAQ Biotechnology index (sterling-adjusted) benchmark. At the time of purchase, a maximum 15% of NAV may be invested in a single stock, 10% may be in unquoted investments and a maximum $15m may be invested in private equity funds managed by OrbiMed. Gearing of up to 20% is permitted; at end-January 2018, net gearing was 6.2%. Based in the UK, Frostrow Capital is the Alternative Investment Fund Manager (AIFM), and provides company secretarial, administrative and distribution services. Since OrbiMed took over the management of BIOG in May 2005 to end-September 2017, its NAV total return of 785.0% is 183.5pp ahead of the benchmark’s 601.5% total return.

Hsu says that heading into 2017, there were fears that US President Trump would make an official announcement about controlling drug prices. This did not occur, so sentiment improved, and the biotech sector was able to generate positive investment returns. However, in the recent State of the Union address, Trump mentioned that lowering drug prices was a top priority for his administration, which has led to some uncertainty as to whether there will be some official policy announcement in 2018. Another policy issue to monitor would be potential changes to the Patient Protection and Affordable Care Act (Obamacare), following the failure of Republicans to repeal this healthcare bill in 2017.

The US has recently passed a tax reform bill, reducing the corporate tax rate from 35% to 21%, which Hsu says is positive for corporate America, including the biotech sector. An element of the bill was a lower tax penalty for repatriation of overseas assets, which should provide US biotech companies with the opportunity to undertake more M&A or return cash to shareholders. This is already evident: for example in early February 2018, major US biotech company, Amgen, announced a $10bn share repurchase programme. Regarding M&A, recently announced deals include French pharma company Sanofi’s acquisition of US haemophilia treatment specialist Bioverativ and Belgian novel biological therapeutic company Ablynx. Celgene has announced its intentions to acquire CAR-T therapy company Juno Therapeutics, and Impact Biomedicines, which is a private company with a product targeting the bone marrow cancer myelofibrosis.

The manager highlights positive fundamentals within the US biotech industry, including a very favourable regulatory environment. In 2017, there was the highest number of US Food and Drug Administration (FDA) approvals of branded and generic drugs in history; the number of branded approvals was the most since 1995. Hsu says that the quality of drug filings is better than in the past, and the FDA is supportive of drugs that have a transformational effect on patients. The FDA now has a more flexible approach, approving products based on trial datasets that in the past would have been seen as insufficient to grant approval. Trump is keen for drugs to be approved more readily, especially generic drugs, as it ensures that prices can be kept under control via free market mechanisms. An environment in which approval times are reduced also cuts the cost of getting a drug to market.

Innovation within the biotech industry is very strong. In 2017, there were two CAR-T therapies launched. These are first-in-class cellular immunotherapies for leukaemia and lymphoma. T-cells are harvested, modified to attack cancer cells and reinserted back into the patient’s body. There was also the first approval of a gene therapy to treat a rare eye disease and other indications. Hsu says that the outlook is for further scientific developments and innovation.

Biotech company valuations are reasonable versus history, and Hsu expects multiples to recover as a result of increased M&A as large-cap companies deploy their cash. Some have large revenue drivers that are beginning to slow, such as Amgen’s white blood cell booster neulasta, which may require them to acquire smaller companies to supplement their product pipelines.

Managers Klemm and Hsu are able to draw on the broad resources of healthcare specialist OrbiMed. Stocks are selected on a bottom-up basis, with a focus on financial modelling, an assessment of research pipelines and the identification of likely catalysts. Company meetings form a key part of the investment process to understand the development programmes and commercial prospects for individual drugs. Stocks may be purchased ahead of anticipated positive clinical data, if companies are viewed as a potential takeover candidate or if early-stage companies are approaching profitability. BIOG’s portfolio is invested across the market cap spectrum and holdings are continually assessed to ensure that the investment case remains intact. Understandably, portfolio turnover is high for smaller, rather than large-cap companies.

More than 90% of BIOG’s portfolio is invested in US biotech companies, split broadly two-thirds/one-third between major biotech and emerging biotech firms. US exposure has increased over the last 12 months, while exposure to Continental Europe has declined (Exhibit 4). This was partially due to the acquisition of Actelion by Johnson & Johnson.

The managers invest in three broad ‘buckets’: major biotech, emerging biotech and promising early-stage biotech companies. Positions in major biotech companies have robust earnings growth, strong pipelines and are trading on reasonable valuations. Emerging biotech companies in the portfolio have newly launched or late-stage products; they may be approaching profitability or viewed as potential takeover targets. Promising early-stage companies within the portfolio have novel therapeutic products, with potential to deliver positive clinical data.

During H118 (ending 30 September 2017), BIOG’s NAV and share price total returns of 10.9% and 10.3% respectively were ahead of the benchmark’s 6.6% total return. Relative performance was enhanced by a higher level of gearing in a rising market (9.2% at end-September versus 3.2% at end-March 2017). However, absolute returns were negatively affected by the strength of sterling, which appreciated by more than 7% versus the US dollar over the period.

BIOG’s absolute returns are shown in Exhibit 5. Over the last 12 months, the trust’s NAV and share price total returns of 7.0% and 15.0% compare to the benchmark’s 9.7% total return. Exhibit 6 illustrates BIOG’s relative returns. Its NAV total return has outperformed the benchmark over 10 years, while lagging over shorter periods. However, comparing the trust’s performance to the Datastream World Pharm & Bio, FTSE World and FTSE All-Share indices shows BIOG’s meaningful outperformance over both five and 10 years.

Hsu explains that recent relative performance was affected by a poor October 2017. Large portfolio holding Celgene had three negative announcements: cessation of Phase III trial of inflammatory bowel disease drug GED-0301 after an interim review showed a lack of benefit; weakness in Q317 sales of its key growth driver, psoriasis drug otezla; and a reduction in 2020 earnings guidance. Also in the month, DBV fell sharply. Its Phase III readout for a patch to treat to peanut allergy was positive. However, there was a secondary requirement that had not been disclosed by the company; the patch demonstrated efficacy, but not to the extent of the anticipated statistical plan.

In recent months, BIOG’s share price discount to cum-income NAV has been in a broadly narrowing trend, from c 10% to the current 3.6%. This is towards the lower end of the 12-month range (0.7% premium to 10.6% discount), although it follows a recent sharp widening in the discount caused by an increase in overall stock market volatility. The current discount is lower than the averages of the last one, three, five and 10 years (range of 4.9% to 5.8%). BIOG’s board employs a discount control mechanism, aiming to limit the discount to 6% in normal market conditions. As shown in Exhibit 1, there have been no share repurchases in the current financial year.

BIOG is a conventional investment trust, with one class of share; there are currently 55.8m ordinary shares in issue. Gearing of up to 20% of net assets is permitted via an overdraft facility with JPMorgan Chase. At end-January 2018, net gearing was 6.2%. OrbiMed is paid an annual management fee of 0.65% of net assets and Frostrow Capital, which is BIOG’s AIFM, providing company secretarial, administrative and distribution services, is paid 0.3% of market cap plus £60,000. While a performance fee is payable to reward cumulative outperformance versus the benchmark, no fee was paid in FY17. Ongoing charges in FY17 were 1.1%, which was 10bp higher than in FY16.

BIOG’s focus on capital growth and the early-stage nature of many of its investments means that the trust does not currently pay a dividend. The last time a dividend was paid was 0.2p per share in 2001. In H118, the net revenue return (after expenses) of £0.15m was 75% lower than £0.59m in H117. It has been transferred to reserves, reducing the revenue deficit from £1.93m to £1.78m.

In Exhibit 9 we highlight the members of the AIC Sector Specialist: Biotechnology & Healthcare sector. This includes two biotech funds: Biotech Growth Trust and International Biotechnology Trust; three healthcare funds: relatively new trust BB Healthcare, Polar Capital Global Healthcare Trust and Worldwide Healthcare Trust; and specialist fund investor Syncona. We also include two Switzerland-listed trusts, BB Biotech and HBM Healthcare Investments, both of which pay dividends out of capital. BIOG’s NAV total returns are ahead of the peer group average over 10 years, ranking second out of five trusts, but trail the averages over one, three and five years. While the trust’s discount has narrowed in recent months, it has one of the widest discounts in the peer group, its ongoing charge is lower than average and BIOG has a higher than average level of gearing. Reflecting the trust’s focus on capital growth rather than income, it does not pay a dividend.

BIOG’s board has six directors, five of whom are independent. Chairman Andrew Joy joined the board in March 2012 and assumed his current role in July 2016. The other four independent directors and their dates of appointment are Professor Dame Kay Davies (March 2012), Stephen Bates (July 2015), the Rt Hon Lord Willetts (November 2015) and Julia Le Blan (July 2016). The non-independent director is Sven Borho; he is a founding member of OrbiMed and was appointed to the board in March 2006.