BB Biotech — Update 27 February 2017

Last year was a volatile one for biotech stocks, with markets struggling to recover losses from a sharp sell-off in January 2016. As well as a rise in risk aversion, which saw generalist investors pull out of the biotech market, stocks suffered from volatility as a result of the US presidential election race, with repeated attacks from both main candidates on perceived overpricing by pharmaceutical companies. However, as shown in Exhibit 2 (left-hand chart), performance of the NASDAQ Biotech Index (shown in Swiss franc terms) has stabilised more recently, and longer-term outperformance of both the broader healthcare market and the UK equity market has been substantial.

The factors underpinning innovation and growth in biotechnology remain: advances in scientific understanding, an ageing population in the developed world needing more medical treatment, and a growing middle class in the developing world leading both to more Western-style diseases and greater demand for healthcare services. In spite of this, as shown in the right-hand chart, forward P/E ratios for biotech companies have declined substantially compared with global equities as a whole in the past three years, suggesting value still exists in the market for investors with the skill to select the stocks with high likelihood of clinical success.

BB Biotech (BION) was launched in 1993 to invest in companies in the innovative area of biotechnology. Based in Switzerland, with a primary listing on the SIX exchange and secondary, euro-denominated listings in Germany and Italy, BION holds a concentrated portfolio of 20-35 stocks, with a bias towards fast-growing smaller and mid-cap names. Five to eight (currently six) core holdings account for as much as half the portfolio. While the fund does invest in some promising earlier-stage biotech companies, holdings are primarily in companies that already have products on the market. Up to 10% of assets may be invested in unquoted companies, although the fund currently has no exposure to these. BION uses the NASDAQ Biotechnology Index as a performance measure, although owing to the fund’s short stock list and non-US listed exposure (currently c 15%), the portfolio will tend to differ markedly from the benchmark. The fund is a constituent of the Stoxx Europe 600 Index, which may be a factor in its high level of trading liquidity.

BION is managed by a team at healthcare investment specialist Bellevue Asset Management, led by Dr Daniel Koller, and is overseen by an executive board of healthcare industry experts. Based mainly in Zurich and New York, the management team includes physicians and scientists with a variety of specialisms. Bellevue has managed the fund since its inception.

BION’s managers are positive on the outlook for biotechnology stocks for four principal reasons: the continued pace of innovation, a favourable regulatory environment, overstatement of political risk, and the historically attractive level of valuations compared with the broader stock market.

The team sees multi-billion dollar sales potential for new treatments in areas such as immuno-oncology, liver disease, central nervous system disorders, and orphan diseases such as spinal muscular atrophy (SMA), where BION has exposure both through Ionis Pharmaceuticals, whose Spinraza treatment (partnered with Biogen) has just been approved in the US, and early-stage rival AveXis. Koller points out that gene therapy advances in this area mean that newborns diagnosed with the most serious form of the disorder now have a greater chance to grow up.

The manager argues that breakthrough treatments will continue to enjoy pricing power, as will alternatives to existing therapies where they offer superior efficacy and safety. While US president Donald Trump echoed rival candidates’ rhetoric on the need to rein in some high drug prices, he has also signalled the possibility of tax cuts for US drug companies and an even more accommodative regulatory regime.

Koller points to Spinraza as an example of how quickly the FDA can act. The treatment was still in Phase III in the second half of 2016 when the trial was halted early on ethical grounds because of strong evidence of efficacy. Stopping the trial allowed participants who had been receiving a placebo to benefit from the new treatment. Ionis and Biogen filed for approval with the FDA in September 2016 and Spinraza was given the go-ahead in December, with EU approval expected during 2017.

After several years of very strong performance, the sell-off in biotech stocks during 2016 has seen P/E valuations fall back to levels last seen at the market trough in 2011, which Koller describes as “a complete misjudgment of the market opportunities”. Large-cap biotech stocks are trading at a valuation discount to both large-cap pharmaceutical stocks and the broader S&P 500 Index, with valuations of small- and mid-cap biotech stocks at even more depressed levels.

The BION team views biotech fundamentals as attractive, and Koller says the main driver of the slump in valuations is ‘risk-off’ sentiment, leading to outflows of funds from more generalist investors and short-selling by institutions. He adds that the market for biotech stocks needs an inflection point, which could come in the shape of increasing policy visibility from the new US administration; in the meantime, uncertainty could provide an attractive entry point for investors.

BION’s management team is made up of sector experts with a variety of specialisms, allowing them to assess developing biotech themes and innovations. The managers follow a continuous process of industry analysis, interviewing physicians and specialists, attending industry conferences, monitoring medical journals and meeting company managements. Beginning with a global universe of c 800 companies, the team focuses on indications or diseases where scientific or technological advances coincide with strong market potential. This filters the opportunity set to 300-400 companies, to which qualitative and quantitative tests are applied in order to arrive at a ‘long list’ of c 150 potential investments.

The team builds in-depth financial models for each candidate stock, as well as assessing factors such as innovation, ownership of intellectual property, quality of management, and pharmacoeconomics. While screening criteria are weighted towards clinical considerations such as efficacy of new treatments, economic factors are also important, with the fund having a bias towards companies that are already generating above-average sales and profits growth.

Bellevue’s analysts draw up investment proposals based on the outputs of this process, which include clinical data, financial models, recommendations on position size and purchase price, and an estimate of potential upside and downside. The proposals are discussed by the team and presented to the executive board at monthly meetings. The board has final sign-off on new investments, complete exits and major changes in weightings, although the Bellevue team has autonomy in day-to-day portfolio management.

The end portfolio has 20-35 stocks (usually c 30-35), with five to eight core holdings accounting for around half of total assets. The stock list includes companies from across the size spectrum and around the world, although the portfolio reflects the dominance of the US as a home for biotech companies. Once in the portfolio, stocks are monitored from both a scientific and a financial perspective, and debated at regular board and strategy meetings.

At 31 December 2016, BION had 33 holdings, towards the top of its 20-35 stock range but still significantly more concentrated than most peers. The length of the stock list is indicative of an increase in exposure to smaller and mid-cap stocks that the managers expect to move up the size curve and become the major biotech players of the future. The six core holdings (Celgene, Incyte, Ionis Pharmaceuticals, Actelion, Gilead and Radius Health) made up 55.3% of the portfolio, compared with 50.9% at 31 December 2015. The biggest changes in exposure by clinical focus during the year were a 3.4pp increase in oncology and a 4.2pp reduction in infectious diseases.

Purchases in the second half of 2016 include antibody technology company Macrogenics, central nervous system specialist Intra-Cellular Therapeutics, AveXis, a gene therapy player developing a treatment for spinal muscular atrophy, and oncology stock Myovant Sciences, bought at IPO in November. Three of these four have market capitalisations below $1bn, while the largest, AveXis, is c $1.6bn, illustrating the move into promising smaller companies.

Sales include Clovis Oncology and Infinity Pharmaceuticals, on the back of sub-optimal clinical data, as well as a reduction in the large holding in Swiss cardiovascular specialist Actelion following bid rumours. Actelion has now agreed a takeover by Johnson & Johnson; the former’s drug discovery and early-stage pipeline operations will be spun out into a new Swiss-listed entity. M&A activity also saw long-standing holding Medivation (acquired by Pfizer) and new purchase Tobira Therapeutics (bought by Allergan) exit the portfolio in the second half of 2016.

BION’s NAV performance suffered in 2016 along with the wider biotech market, experiencing a sharp sell-off in January, although it rebounded strongly in early November following the US presidential election, opening up a large margin over the benchmark NASDAQ Biotechnology Index (Exhibit 4, left-hand chart). Longer-term total return performance also remains strong in absolute terms and versus the index (Exhibit 4, right-hand chart and Exhibit 6). BION has strongly outperformed the more generalist MSCI World Health Care Index and (of relevance for UK-based investors) the FTSE All-Share Index over the short, medium and longer term (Exhibit 5).

Contributors to outperformance include strong returns from Actelion, Incyte (+20.9% in January 2017 in US dollar terms, after announcing new pivotal studies), Tesaro, Radius Health and Ionis Pharmaceuticals. Actelion is not widely held by biotech investors as it is Swiss-based and thus outside the NASDAQ benchmark; its shares have risen in value by over 90% since early November when rumours began to surface of a planned takeover by Johnson & Johnson, which was agreed in late January 2017. Takeovers of Medivation and Tobira also added to performance in 2016.

During 2016, BION’s discount to NAV – which had averaged c 20% over the previous three to five years – narrowed substantially. At 23 February 2017, the discount stood at 2.7%, narrower than the one-, three- and five-year averages of 4.2%, 14.1% and 17.4% respectively. In a volatile market, BION has ranged from an 11.2% discount to a 5.3% premium over the past 12 months. Factors supporting the narrowing of the discount may include the fund’s commitment to returning capital to shareholders via buybacks and capital distributions, its strong performance record, widening shareholder base (including an increasing number of UK investors), high levels of daily trading liquidity and inclusion in the Stoxx Europe 600 Index since December 2014. In March 2016, BION shareholders approved a new repurchase authority for up to 5.54m shares. As of 31 December 2016, no shares had yet been bought back under this facility.

BION is a closed-ended investment company listed on the Swiss SIX exchange, with secondary, euro-denominated listings in Germany and Italy. Following a five-for-one stock split in March 2016, there are 55.4m ordinary shares in issue. The fund may use gearing via a short-term bank loan with an interest rate of 0.4% pa. At 31 December 2016, CHF204m was drawn (31 December 2015: CHF160m), representing 6.8% net gearing based on net assets at that date. Bellevue Asset Management receives an all-in annual management fee of 1.1% of average market capitalisation, with no performance fee payable. The stated total expense ratio at 31 December 2016 was 1.28%, up from 1.13% at 31 December 2015.

Most biotech companies, because of their need to invest heavily in research and development, do not pay a dividend. However, in recognition of investors’ appetite for income, and as part of its discount management policy, BION seeks to return 5% of its market capitalisation (based on the volume-weighted average share price in December) to investors each year by way of a capital distribution. For FY16, a distribution of CHF2.75 per share has been declared. This compares with an equivalent figure of CHF2.90 for FY15 (the actual distribution was CHF14.50, but a five-for-one share split took place in March 2016). Because the distribution is set at a fixed percentage of the share price, it may fall as well as rise from one year to the next. Based on the 23 February share price of CHF57.55 and the FY16 dividend, BION has a prospective yield of 4.8% (5.0% based on the FY15 dividend).

For comparison purposes, Exhibit 8 below includes the four members of the AIC’s specialist Biotech & Healthcare sector, as well as Switzerland-listed public/private equity fund HBM Healthcare Investments. Three of the funds have a specific biotech focus while the other three invest more generally across healthcare. Within the group (all data in Swiss francs), BION is the largest fund. It ranks first for NAV total returns over one and five years and second over three years. In terms of risk-adjusted performance as measured by the Sharpe ratio, BION is in line with or above the average over one and three years. The discount to NAV is below average. Ongoing charges are average, although it is important to note that BION is the only fund not to levy a performance fee, so the actual fees paid by investors in other funds may be higher. Owing to its high distribution policy, BION has the second-highest yield in the group.

BION has three executive board members, all of whom are highly qualified industry experts. The directors sign off on all major investment decisions, although day-to-day portfolio management responsibility resides with Bellevue. The chairman (since 2013), Dr Erich Hunziker, has been on the board since 2011 and is a former CFO of Roche. The longest-serving director, Dr Clive Meanwell, was appointed in 2003 and is also founder and CEO of The Medicines Company. Professor Dr Klaus Strein joined the board in 2013, following senior R&D roles at Roche and Boehringer Mannheim.