The Biotech Growth Trust — Historic low sector valuations

BIOG is a specialist fund with a bias towards emerging rather than large-cap biotech stocks. As such, the trust’s relative performance is broadly dependent on how smaller-cap biotech stocks perform versus the wider sector.

In Exhibit 1, we show how BIOG tends to perform compared with its benchmark. Its upside capture is 105%, while its downside capture is 119%. This suggests that during months when the NASDAQ Biotechnology Index rises, the trust will modestly outperform, but in months when the index falls, the trust will underperform to a larger degree. The analysis appears sensible given BIOG’s tilt towards less mature biotech stocks, which are inherently higher risk than large-cap biotech stocks.

OrbiMed continues to invest in its research team, seeking to improve investment performance. BIOG’s FY23 annual report contained details about the appointment of Josh Golomb as co-manager for the trust. He joined OrbiMed as a partner in 2021 and has around 20 years of biotech investment experience. Including BIOG’s two co-managers, OrbiMed now has seven analysts on its biotech research team, who work alongside a speciality pharma analyst, two tools/diagnostics analysts and four analysts who are based in China.

At end-August 2023, BIOG’s top 10 holdings made up 47.9% of the fund, which was a higher concentration compared with 40.4% a year before; five names were common to both periods. The portfolio had 62 positions, which was three less than 65 at end-August 2022. Over the 12 months to the end of August 2023, the trust’s active share fell from 76.8% to 70.7%; this is a measure of how the fund compares with its benchmark, with 0% representing full index replication and 100% no commonality. This is evidenced by the fact that BIOG’s top two holdings are US large-cap biotech holdings, which did not feature in its top 10 list on 31 August 2022; although the trust maintains its bias towards emerging biotech stocks.

There has been a notable increase in the trust’s annualised portfolio turnover, to c 123% at 31 August 2023 compared with c 80% a year before. Hsu has explained previously that BIOG’s portfolio turnover is relatively high, as this keeps the portfolio fresh with new ideas, which he considers important in terms of the trust’s performance. The manager notes that once biotech companies have had a significant value-creating catalyst, their share prices can languish while waiting for the next value inflection point. Therefore, it may be better to sell these companies, using the proceeds to invest in other businesses with potential near-term catalysts. Hsu also admits that some investments are unsuccessful, in which case the positions should be sold.

Exhibit 3 shows BIOG’s geographic split; North America remains the largest region as it is the most innovative and developed biotech market. In the 12 months to the end of August 2023, the largest changes were a higher weighting in Chinese quoted biotech companies (+3.2pp) and a 2.8pp lower allocation to unquoted companies.

At 31 August 2023, the total Chinese exposure was 11.0pp (5.6pp listed and 5.4pp unquoted), which was broadly in line with 10.7% a year before, although then the mix was skewed towards unquoted businesses (8.3pp) versus listed companies (2.4pp). According to Hsu, China has around 15% of the biotech industry’s early drug-development pipeline.

The manager highlights BIOG’s portfolio structure with its bias towards emerging (smaller-cap) biotech names and its large underweight position in large-cap biotech companies. Over the course of FY23, there was a significant divergence between the performance of large and small/mid-cap biotech stocks.

The manager also provides longer-term data, from 31 March 2021 (end-FY21) to 30 June 2023, for the different market cap bands in the NASDAQ Biotechnology Index. Large caps fell by 4.3%, which was considerably less than the 33.3% and 37.1% declines in the value of mid-cap and small-cap biotech stocks, respectively.

These differences in performance between large and small-cap stocks broadly mirror the US market, where between 31 March 2021 and 30 June 2023 a widely used index of 1,000 large-cap stocks rose by 8.9%, while the stablemate index of 2,000 small/mid-cap stocks fell by 14.9%.

The XBI is a US exchange-traded fund of equal weighted small and mid-cap biotech stocks and since its inception in 2006 has a long-term record of outperformance versus the bellwether US S&P 500 Index. There have been periods when the XBI underperformed, but after each relative drawdown it resumed its outperformance. However, it is important to note that the most recent pullback is unprecedented in terms of being the longest and the largest absolute and relative move; between 8 February 2021 and 2 June 2022 the peak drawdown was 73.3%. Hsu is hopeful that small and mid-cap biotech stocks will outperform over the next 12 to 18 months.

Biotech company valuations are depressed, looking at those with a market cap greater than $10m, and their median market caps versus the net cash on their balance sheets. In the period since 2001, the valuation on this basis is at an all-time low, below the levels seen in the dot-com bust and the global financial crisis. The percentage of companies trading at less than the net cash on their balance sheets within the biotech universe is 20–25% (100 to 120 companies), which the manager says is unprecedented. Hsu believes that we are in the late stage of the interest rate hiking cycle and as rates come down this should be a tailwind to the performance of biotech stocks. He notes that there is recession risk due to higher interest rates. However, looking at the performance of healthcare stocks during the last four recessions, biotech stocks were the best-performing subsector; large caps followed by smaller biotech stocks. The manager suggests that this is a comfort as, if the US does go into recession, the biotech sector should be a good place to be.

Hsu believes that valuations within the biotech sector do not take into account robust company fundamentals. He explains that innovation has been an important driver of the performance of biotech stocks. Since 2012, there have been record levels of drug candidates in development, with the number of pipeline products increasing by 70% between 2016 and 2022, and growth in all therapeutic areas. The manager comments that novel drug development technology has accelerated in the last five to six years and that we are in the early stages of these technologies reaching their full potential, with only a few products having reached the market so far.

There has been a series of notable new drug approvals that address large markets and therefore have significant revenue potential. Hsu highlights 10 recent launches with consensus peak sales potential greater than $1bn (blockbusters), with some having more than $10bn potential sales (mega blockbusters). The manager notes that the majority of pipeline and approved novel drugs come from emerging biotech companies (53% of new drugs launched in 2021). They have been increasing their share of the biotech industry research and development pipeline, which currently stands at two-thirds and is still growing.

BIOG’s portfolio has exposure to a wide range of novel technologies, including antibody-drug conjugates (11.3% of NAV at 30 June 2023); cell therapy (13.5%); gene therapy/gene editing (17.9%); multispecific antibodies/T-cell engagers (17.6%); and oligonucleotide therapeutics (27.0%). There is some overlap between the NAV percentages stated.

Within the highly innovative biotech industry there have been ongoing important positive clinical trial results and first-in-class product approvals. Relatively recent developments include the first gene therapies for haemophilia A and B (BioMarin Pharmaceutical and uniQure), the first gene therapy for Duchenne muscular dystrophy (Sarepta Therapeutics) and positive Phase III results for an anti-amyloid antibody for the treatment of Alzheimer’s (Eisai and Biogen).

Hsu reports that the US regulatory environment remains constructive. While there was a dip in the number of US Food and Drug Administration new molecular entity approvals in 2022, 37 versus a range of 46 to 59 in the prior five years, this was likely due to COVID-related delays. So far in 2023, there have been 40 approvals, suggesting that last year was an anomaly.

M&A activity has historically been an important driver for the performance of the biotech sector. However, this year the benefits of an acceleration in biotech M&A have been outweighed by the uncertain macroeconomic background. With target companies trading on very low valuations, acquirers can sometimes afford to pay triple-digit premiums and the deals are still accretive. In H123, five of BIOG’s holdings were bid for: CinCor Pharma by AstraZeneca (a greater than 200% premium including contingent value rights); Seagen by Pfizer (a 42% premium); Bellus Health by GSK (a greater than 100% premium); Chinook Therapeutics by Novartis (an 83% premium including contingent value rights); and DICE Therapeutics (a 42% premium). There is a significant patent cliff looming in the second half of the decade, so with an estimated $250bn branded sales at risk, there is an urgent need for large-cap pharma companies to acquire businesses to bolster their pipelines.

With US drug price reform having passed in August 2022 as part of the Inflation Reduction Act 2022, the manager considers that the legislation is manageable for the biotech sector and removes the overhang of drug price controls. Also, pharma companies have launched legal action, so Hsu suggests that the current legislation could be watered down. The manager believes that the healthcare sector can re-rate now the overhang of price controls has lifted.

As shown in Exhibit 5, BIOG’s relative performance has been very difficult since Q121, as emerging biotech stocks, which have served the trust well over the long term, have significantly underperformed large-cap biotech stocks. BIOG has a structural underweight position in the larger biotech names as the managers believe there are more attractive growth profiles available in emerging biotech stocks.

Exhibit 6 shows the seven members of the AIC Biotechnology & Healthcare sector. BIOG’s NAV total returns are below average over the periods shown. Despite this, the trust currently has the narrowest discount in the sector. BIOG has a below-average ongoing charge, although it is one of five funds eligible for a performance fee. Its level of net gearing is higher than the sector average and it is one of the three companies that do not pay a dividend.

Looking at BIOG’s relative performance over the last few months, the trust has been negatively affected by both the macroeconomic backdrop and company-specific events. An uncertain economic environment and a realisation that interest rates are likely to stay higher for longer has contributed to an investor ‘risk-off’ attitude, which has disproportionately affected emerging rather than large-cap biotech stocks. There have also been large fund flows into other areas such as large US technology stocks.

March 2023 was a particularly difficult month for BIOG as its NAV fell by 14.5%, while the benchmark declined by a far more modest 0.8%. The failure of US regional bank Silicon Valley Bank (SVB) had a particularly negative effect on the share prices of small-cap biotech stocks, many of whom were SVB customers, despite these companies having minimal cash exposure to the bank. BIOG’s holding in Chinese vaccine company YS Biopharma hurt the fund’s performance by c 4pp. The company listed via a special purpose acquisition company (SPAC) merger, but its share price subsequently declined significantly. BIOG’s managers believe that this weakness was due to SPAC-related trading dynamics rather than YS Biopharma’s fundamentals.

M&A activity has been prevalent in recent months and BIOG has benefited from this. For example, in June 2023, Novartis made a bid for investee company Chinook Therapeutics at a c 67% premium to its pre-bid share price (an 83% premium including contingent value rights), while another portfolio investment, DICE Therapeutics, received a 42% premium bid from Eli Lilly. Unfortunately, these positive developments were more than offset by clinical setbacks from investee companies Mersana Therapeutics (five fatal events in more than 500 ovarian cancer patients dosed with its antibody-drug conjugate) and uniQure (mixed data from its Phase I/II trial of its gene therapy for the treatment of Huntington’s disease).

In an environment of elevated investor risk aversion, in general, investment trust discounts have widened. BIOG is no exception, as its 7.3% share price discount to cum-income NAV is larger than its average discounts of 4.6%, 5.4% and 5.5% over the last three, five and 10 years, respectively. There is scope for the trust to be afforded a higher valuation if there is an improvement in its relative performance, while a positive change in investors’ risk tolerance should also be helpful. Looking at Exhibit 10, BIOG traded at a premium for parts of the last three years.

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. In FY23, c 2.4m (c 5.9% of the share base) were repurchased at a cost of c £22.6m. Buybacks have continued in FY24; so far, c 2.9m shares (c 7.4% of the share base) have been repurchased at a cost of c £23.0m.

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 c $18bn 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 more than 130 people, of whom more than 30 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 out the best potential opportunities across the globe, most of the portfolio is held in US companies, reflecting its dominance in the biotech industry, although 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 cognisant 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 August 2023, the trust’s net gearing was 8.8%, 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 commencement 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 FY23, the trust’s ongoing charges were 1.1%, which were in line with FY22; no performance fees were payable.

BIOG is a conventional investment trust with one class of share. There are currently 35.9m ordinary shares in issue and the average daily trading volume over the last 12 months was c 80k shares.

At the end of FY23, BIOG’s shareholder base was split as follows: 72.4% retail investors (72.0% at end-FY22); 9.5% mutual funds (9.5%); 8.5% pension funds (9.9%); and 9.6% other (8.6%).

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.