The Biotech Growth Trust — Valuations starting to improve with more to come

BIOG has a structural bias towards emerging (smaller-cap) biotech stocks, as the managers consider these stocks offer a better risk/reward profile than large-cap biotech stocks.

Following shareholder approval in July 2024, BIOG will change its benchmark from the NASDAQ Biotechnology Index (sterling adjusted) to the NASDAQ Biotechnology Index Total Return (net of withholding tax and sterling adjusted). This change becomes effective from 30 September 2024 and reflects the maturation of the biotech index, as some of the larger companies in the industry now pay a dividend. Although BIOG’s income is currently insufficient to require a dividend to be paid under investment trust taxation rules, the board believes the dividend income will become an increasingly larger percentage of the benchmark’s total return. Hence, a total return index is deemed a more appropriate comparator to assess BIOG’s performance.

Exhibit 2 shows BIOG’s overweight exposure to emerging biotech stocks. Following an extended drawdown during a period of higher interest rates, smaller-cap biotech stocks are starting to perform relatively better.

Hsu expects the performance gap to completely close but there is still a way to go. Between the end of March 2021 and the end of June 2024, the performance of biotech stocks by market cap was large cap -0.9%, mid-cap -29.3% and small cap -30.3%. It should be remembered that it is not just in the biotech sector that small-cap companies have underperformed. Between the end of March 2021 and the end of June 2024, the US 1000 large-cap index rallied by c 30% compared with a c 10% decline in the US 2000 SMID-cap index.

History supports Hsu’s view that smaller-cap biotech stocks will make up lost ground versus the broader US market as after each period of significant underperformance, smaller-cap biotech stocks have subsequently hit a relative high point. In addition, absolute valuations were at an unprecedented low based on median market cap versus net cash on the balance sheet. More than 25% (> 150 of biotech companies) were trading below net cash. While valuations have started to recover, the manager suggests a reduction in interest rates could be a catalyst for biotech stocks to move substantially higher.

Hsu explains that biotech valuations have become disconnected to favourable industry fundamentals. There has been a stream of breakthroughs across a wide range of products and indications. The regulatory environment remains favourable, as shown in Exhibit 3; there were a record number of new molecular entity approvals in 2023 and the momentum has continued into 2024 (the 2022 dip is likely due to a COVID-related backlog). Within the US FDA there are different departments for drug and biologics approvals – the Center for Drug Evaluation and Research and the Center for Biologics Evaluation and Research.

Oncology is the largest biotech drug development area, given the unmet need. There are multiple innovative approaches across tumour types, giving physicians more options to extend the lives of cancer patients including cellular therapies, antibody-drug conjugates, bispecific antibodies, targeted therapies, radiopharmaceuticals and cancer vaccines.

Obesity treatment is a high-profile and potentially very large market. The current market leaders are US-listed Eli Lilly and Denmark-listed Novo Nordisk, whose products lead to 12–15% weight loss in 12 months (next-generation products could see 25% annual weight loss). Current drugs are weekly injectable products offering ancillary health benefits including lower heart attacks and strokes, but with weight loss comes undesirable muscle loss. Other companies are developing oral obesity products with novel mechanisms of action or combination therapies that have better side-effect profiles, but the market is considered to be large enough to support a range of players.

M&A activity within the biotech industry remains robust and Hsu expects this to continue. Major pharma companies have been highlighting their acquisition strategies as they seek to bolster their pipelines ahead of a major 2025–30 patent cliff. As an example, Merck’s $25bn sales of Keytruda are at risk of generic competition.

Biotech financing volume has picked up in 2024, although the number of IPOs has remained muted. There is robust demand for follow-on financings in strong companies, but weaker companies face financing challenges.

Hsu reiterated his and Golomb’s playbook. They 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 are lower than during the bursting of the dot.com bubble or the global financial crisis. Hsu and Golomb believe that biotech valuations are disconnected from favourable industry fundamentals, which offers significant share price upside from current levels. In addition, ongoing robust levels of M&A should continue as pharma companies seek new products ahead of a major patent cliff. The managers consider the political risk is low as healthcare is not a subject high on the presidential election agendas. Hence, they consider now is a very good time to invest in biotech innovation at low valuations.

At the end of June 2024, BIOG’s top 10 holdings made up 41.9% of the portfolio. This was a lower concentration compared with 46.9% a year earlier and six names were common to both periods. The portfolio had 65 positions, which was six higher year-on-year, while the active share declined to 66.6% from 73.0% (this is a measure of how the fund compares with its benchmark, with 0% representing full index replication and 100% no commonality).

Looking at BIOG’s portfolio breakdown in Exhibit 5, the notable change is a marked reduction in the trust’s exposure to unquoted companies (-4.4pp) as some of the former private Chinese companies listed. The proportion of the portfolio invested in the dominant US increased by 6.1pp to more than 85% of the fund.

Over the long term, from BIOG’s inception in May 2005 to the end of June 2024, the trust’s NAV total return of +968.3% compared with the NASDAQ Biotech Index’s +866.0% and the UK market’s +257.1% total return. The trust’s performance has turned a corner after a prolonged period of underperformance between Q121 and Q323, when emerging biotech stocks significantly lagged their larger-cap peers (Exhibit 6).

There are seven funds in the AIC biotechnology and healthcare sector. Comparing BIOG with its biotech peers International Biotechnology Trust (IBT) and RTW Biotech Opportunities (RTW), BIOG’s NAV total returns rank first over the last 12 months and third over the last three years. BIOG ranks second out of two funds over the last five and 10 years.

Three of BIOG’s other peers invest more broadly in the healthcare sector, Bellevue Healthcare Trust (BBH), Polar Capita Global Healthcare Trust (PCGH) and stablemate Worldwide Healthcare Trust (WWH), while Syncona is an early-stage healthcare investor. Looking at BIOG’s NAV total returns compared with all of its peers, it ranks first over one year, seventh over three years, fifth out of six funds over the last five years and fourth out of five funds over the last decade.

BIOG currently has the third-widest discount in the sector (no funds are trading at a premium), the fourth-highest ongoing charge and the largest level of gearing. The trust does not receive sufficient income to require a dividend payment; biotech peer IBT makes a distribution out of capital.

Since the publication of our March 2024 update, BIOG has released its FY24 results. Its NAV and share price total returns of +26.5% and +27.1% respectively were considerably ahead of the benchmark’s +5.0% total return. The three largest contributors to the trust’s performance were Vera Therapeutics, which had positive trial data for a key immunotherapy product; Scholar Rock Holding, which announced it would advance programmes in obesity, whereby its products would help patients on GLP-1 weight-loss therapies retain their muscle mass; and Janux Therapeutics, which had positive Phase I data for its medicine used for prostate cancer and may prove successful for the treatment of other tumours. On the other side of the ledger, the three largest detractors were Travere Therapeutics, which had a disappointing launch for Filspari, a treatment for a kidney disease; uniQure, whose Phase I/II trial for a gene therapy used in the treatment for Huntington’s disease did not meet expectations; and Biogen, which had a slower-than-expected launch of Leqembi, its first-in-class treatment for Alzheimer’s disease.

BIOG has started to recover some relative underperformance as it is now ahead of the benchmark over the last six and 12 months.

In Exhibit 11, we highlight BIOG’s performance versus its NASDAQ Biotechnology Index benchmark over the last 10 years. The trust’s upside capture rate is 104%, suggesting that in months when biotech shares are rising, BIOG will outperform by a very modest amount. It has a larger downside capture rate of 112%, which implies that in months when biotech shares are falling, the trust will likely underperform by more than 10%. This analysis is not surprising given BIOG’s bias to emerging biotech stocks, which are inherently more risky than large-cap biotech stocks.

BIOG, in keeping with many other investment trusts is trading at a wider-than-average discount during a period of elevated investor risk aversion. The current 7.4% share price discount to cum-income NAV is wider than its average discounts of 6.6%, 5.5% and 5.7% over the last three, five and 10 years, respectively. Looking at Exhibit 12, over the last three years, BIOG traded in a range of a 2.9% premium to a 12.7% discount. One may argue that the trust deserves to trade on a higher valuation now that its performance is getting back on track.

Renewed annually, the board has the authority to purchase up to 14.99% and allot up to 10% of BIOG’s issued share capital. It remains committed to limiting the discount to 6% over the long term, in normal market conditions. During FY24, c 5.3m shares were repurchased (c 13.6% of the share base) at a cost of c £43.6m and an average 7.3% discount to cum-income NAV, which added 0.9% to BIOG’s NAV. Share buybacks are continuing in FY25.

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 and Josh Golomb at OrbiMed Capital, which is a global healthcare specialist investor with more than $17bn of assets under management. OrbiMed operates from three continents with offices in New York, San Francisco, London, Herzliya (Israel), Hong Kong, Shanghai and Mumbai. It has a team of around 140 people, of whom more than 35 hold PhD or MD qualifications and around 15 are former CEOs or company founders.

Hsu and Golomb aim to generate long-term capital growth from a diversified portfolio of global biotech equities and related securities. The trust’s performance is measured against the NASDAQ Biotechnology Index (sterling adjusted) and its currency exposure is unhedged. BIOG’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 (including any private equity funds managed by OrbiMed and its affiliates); and swaps exposure is permitted up to 5% of gross assets at the time of entering into the contract. The managers may employ gearing up to 20% of net assets.

Hsu and Golomb aim to generate long-term capital growth from a globally diversified portfolio of biotech companies across the market cap spectrum. They can draw on the broad resources of OrbiMed’s experienced investment team; their scientific expertise is deemed critical in terms of evaluating potential investments. 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 managers seek the best potential opportunities across the globe, most of the portfolio is held in US companies, reflecting its dominance in the biotech industry; however, BIOG has a notable exposure to China. The trust’s holdings are regularly reviewed to ensure the original investment theses are still valid and positions are sized correctly. The managers note that BIOG’s portfolio turnover is relatively high because of its large emerging biotech exposure, where stocks can be volatile around news about clinical results.

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 applicable environmental, social and corporate governance factors into account when evaluating a prospective or existing investment via a five-step process:

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 seeking representation on their boards of directors. The managers seek to invest in reputable management teams and are especially aware of corporate governance in emerging markets, as company credentials in these regions may not be as high as those of firms in developed regions.

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 July 2024, the trust’s net gearing was 6.8%, which compares with its typical range of 5–10%.

OrbiMed is paid an annual management fee of 0.65% of BIOG’s NAV. It is also entitled to a performance fee of 15.0% of outperformance versus the benchmark if the cumulative outperformance since the start of the arrangement on 30 June 2005 gives rise to a total fee greater than the total of all performance fees paid to date.

Frostrow Capital is the trust’s alternative investment fund manager, providing company management, secretarial, administrative and marketing services. It receives a tiered annual fee of 0.3% of BIOG’s market cap up to £500m, 0.2% between £500m and £1bn and 0.1% above £1bn.

In FY24, the trust’s ongoing charges were 1.2%, which were 10bp higher than 1.1% in FY23; no performance fees were payable.

BIOG is a conventional investment trust with one class of share. There are currently 32.4m ordinary shares in issue and the average daily trading volume over the last 12 months was c 87k shares.

The trust has a five-year continuation vote; the last was held at the July 2020 AGM where the resolution was passed by a significant majority (99.9% of votes were in favour).

As Geoff Hsu is a partner at OrbiMed, he is considered to be a non-independent director, and his fees are waived.

On 9 October 2023, BIOG’s board announced the appointment of Hamish Baillie as an independent, non-executive director, with effect from 1 November 2023. He is a non-executive director of Mid Wynd International Investment Trust, and his 20-year executive career was spent at Ruffer, until his retirement in October 2022.