The Biotech Growth Trust — Firing on all cylinders

Biotech shares have bounced back particularly strongly following the coronavirus-led stock market sell-off in February and March this year, adding to their long-term outperformance versus global stocks (Exhibit 2, left-hand side). There are reasons for investors to remain optimistic about the biotech sector:

Given these favourable attributes, investors may benefit from an allocation to biotech stocks as part of a diversified portfolio. One caveat is that aggregate sector valuations look unappealing versus history (Exhibit 2, right-hand side). The DS World Biotech index is trading at a forward P/E multiple of 31.7x, which is higher than the five- and 10-year averages of 24.0x and 22.2x respectively. In relative terms, biotech stocks are trading at a 35.0% premium to the US market, compared with the 35.1% five-year and 39.6% 10-year averages.

BIOG was launched in June 1997 and is listed on the Main Market of the London Stock Exchange. Following the departure of Richard Klemm from OrbiMed Capital in February 2020, the trust is now managed solely by Geoff Hsu. OrbiMed has more than $13bn of assets under management (c $5bn in public equities), 11 regional offices and a team of more than 100 investment professionals, of whom 30 hold PhD or MD qualifications and 15 are former CEOs or healthcare company founders. Hsu aims to generate long-term capital growth from a diversified portfolio of global biotech equities and related securities. BIOG’s performance is measured against the NASDAQ Biotechnology index (sterling-adjusted), and its currency exposure is unhedged.

The trust’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 (excluding a maximum $15m in private equity funds managed by OrbiMed and its affiliates); and swaps exposure is permitted up to 5% of gross assets. Hsu may employ gearing up to 20% of net assets; net gearing was 8.5% at end-June 2020, towards the high end of the typical range of 5% to 10%.

OrbiMed has managed BIOG since 18 May 2005, so is celebrating its 15th anniversary. From this date to end-June 2020, the trust’s NAV delivered a +1,205.2% total return, which is significantly ahead of the benchmark’s and the broad UK market’s total returns of +832.8% and +137.3%, respectively (source: OrbiMed).

Hsu explains that biotech has proved to be a defensive sector during the COVID-19 outbreak, as its industry fundamentals are relatively less affected by economic shutdowns; treatments have continued to be administered and clinical delays have been modest. The manager says that demand for biotech products is robust and should accelerate once the economy is on a more even keel, while the financing environment remains very favourable. He is highly confident that one or more vaccines will prove to be effective in combating the disease. There are around 150 vaccines and more than 250 treatments for COVID-19 currently in development, while Gilead Sciences’ remdesivir and generic dexamethasone have already shown efficacy. Hsu has not chased the names directly associated with tackling the pandemic, as he is unsure about their products’ ultimate revenue potential, but some current/former holdings with COVID-19 exposure have contributed positively to the trust’s performance, such as CanSino Biologics, Gilead Sciences and Regeneron Pharmaceuticals.

The manager comments that ‘whether you are an optimist or a pessimist about the outcome of a COVID-19 vaccine, biotech is a great place to invest’. He says that the political environment has improved and with Joe Biden being selected as the Democrat presidential candidate in the US, the worst-case scenario (for the industry) of ‘Medicare for All’ was taken off the table. Regardless of who wins the November election, Hsu expects a continued split Congress with a Republican-led Senate and a Democrat-led House of Representatives, which will make new laws difficult to pass. Despite recent actions by President Trump aiming to decrease US drug pricing, the manager believes that other policies will be higher priority, given the need to stimulate the economy and support employment. He says that public opinion towards the healthcare industry has improved noticeably, given its response to the coronavirus pandemic; it is now viewed as ‘providing significant value to society in a responsible way’. Hsu believes that even if the Democrats gain control of Congress, they will not achieve a high-enough majority to put through sweeping drug price changes.

The manager says that the US Food and Drug Administration (FDA) regulatory environment is very favourable. Former FDA commissioner Scott Gottlieb instituted policies to expedite drug approvals, lowering the time taken and costs involved in developing new drugs. These changes have continued under his successor Stephen Hahn and, despite COVID-19, the pace of new drug approvals in 2020 is similar to last year. The past three years have seen record numbers of novel drug approvals by the FDA (46 in 2017, 59 in 2018 and 48 in 2019). Hsu cites an ‘unprecedented, golden era of innovation’ in the biotech industry, with a 50% increase in late-stage product development across a wide range of therapeutic categories over the past five years. A series of novel technologies are beginning to come to the market, such as bispecific antibodies, cellular therapy, gene therapy, protein modulators and RNA therapies. While so far there is only a handful of marketed products, the manager expects ‘dozens more to come to fruition over the next five to 10 years’. He highlights some recent new product approvals with blockbuster (greater than $1bn pa) sales potential, including Vertex Pharmaceuticals’ Trikafta for the treatment of cystic fibrosis, which has consensus peak sales estimates of c $9bn. The bulk of innovation is being undertaken by emerging biotech companies, which represent around two-thirds of BIOG’s portfolio.

Hsu says that M&A has been a historical driver of positive returns in the biotech industry and, while there was a slowing in activity in H120 due to COVID-19, the manager says that interest in undertaking M&A is high. Meanwhile, he notes that the number of licensing and partnering deals has continued unabated, despite people working from home. Hsu expects M&A deal flow to pick up by the end of the year, while the IPO market remains robust. The manager also highlights opportunities in China, which is now the number two global pharma market; the level of innovation is rising and the establishment of a biotech ecosystem is part of the government’s ‘Made in China 2025’ programme. He says that BIOG is well placed to take advantage of investment opportunities in the region, given its ‘on-the-ground’ Chinese expertise.

Hsu aims to generate long-term capital growth from a globally diversified portfolio of biotech stocks across the market cap spectrum. He is able to draw on the broad resources of OrbiMed’s experienced investment team, working closely with four core biotech analysts and two specialist analysts in adjacent sectors covering speciality pharma and life science tools & diagnostics, along with two analysts covering emerging markets, who are based in Hong Kong. Given the attractive opportunity set in the industry, OrbiMed is in the process of hiring an additional two biotech associates.

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 if 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 manager seeks out the best potential opportunities across the globe, the majority of the portfolio is held in US companies, reflecting its current dominance in the biotech industry, although BIOG has a notable c 10% exposure to China. The trust’s holdings are regularly reviewed to ensure the original investment theses are still valid and positions are sized correctly.

Hsu notes that BIOG’s portfolio turnover is relatively high as a result of its emerging biotech exposure, where stocks can be volatile around news about clinical results. A review undertaken with the trust’s board showed the investment team’s research efforts can generate excess returns, which could be enhanced by monetising successful positions more quickly, rather than holding on to stocks for too long, as well as exiting underperforming stocks deemed to have further downside risk. The increased portfolio turnover has borne fruit, as has the change in the structure of the portfolio (highlighted below in the current portfolio positioning section).

At end-June 2020, BIOG’s top 10 positions made up 36.1% of the portfolio, a significantly lower concentration compared with 54.0% a year earlier; five positions were common to both periods. Exhibit 3 shows the trust’s subsector breakdown. Notable changes over the 12 months to the end of June are higher emerging biotech exposures in the US (+11.3pp) and the Far East (+5.5pp), with a lower weighting to US major biotech (-15.4pp).

Hsu explains that during FY20, there were a number of structural shifts in the portfolio aiming to enhance BIOG’s long-term performance.

In FY20 (ending 31 March), BIOG’s NAV and share price total returns of +18.5% and +10.9%, respectively, were considerably ahead of the benchmark’s +1.2% total return. It was a year of two halves: in H120, the trust’s NAV fell by 5.6%, before rising by 24.1% in H220. Performance was helped by a strong US dollar, which rose by 4.8% versus sterling over the financial year, while gearing also contributed 1.0pp. The very strong relative performance was helped by BIOG’s bias towards emerging rather than large-cap biotech stocks, positive clinical catalysts, the takeover of ArQule and Ra Pharmaceuticals at significant premiums, and strong performance from the trust’s Chinese holdings. Positive contributors to performance included Deciphera Pharmaceuticals (developing kinase inhibitor treatments for cancer – successful Phase III results for ripretinib in gastrointestinal stromal tumours, which exceeded expectations); CanSino Biologics (a Chinese vaccine company – investor enthusiasm about its meningococcal vaccine was followed by the development of one of the leading vaccine candidates for COVID-19); and Aurinia Pharmaceuticals (successful Phase III trial results for its novel calcineurin inhibitor, voclosporin, in treating lupus nephritis). Detractors included Milestone Pharmaceuticals (disappointing results for its Phase III trial of etripamil for the treatment of paroxysmal supraventricular tachycardia); Alexion Pharmaceuticals (continued concerns about future competition to the company’s lead products Soliris and Ultomiris); and Mirati Therapeutics (its shares rallied on hopes of a possible takeout, but then significantly underperformed when this did not occur).

BIOG has delivered very strong absolute total returns over the past decade (Exhibit 5, RHS) – NAV +22.5% pa and share price +23.3% pa, which are ahead of the benchmark’s +20.1% pa. Investors have enjoyed particularly high returns over the past 12 months (NAV +40.4% and share price +51.5% versus the benchmark +19.3%), which includes pullbacks over the past month.

The trust’s relative returns are shown in Exhibit 6; it has outperformed its benchmark over almost all periods shown, in both NAV and share price terms. Outperformance versus the broad UK market is particularly notable over the near-, medium- and long term.

Renewed annually, BIOG has authority to purchase up to 14.99% and allot up to 10% of issued share capital. Due to the high levels of stock market volatility in March 2020 as a result of the coronavirus pandemic, BIOG’s board decided that it would be in shareholders’ best interests to suspend buybacks, although it remains committed to limiting the discount to a maximum of c 6% in normal market conditions. During FY20, 12.8m shares (24.6% of the share base) were repurchased. So far in FY21, there have been no further buybacks, but a modest number of shares have been issued at a premium to NAV (Exhibit 1).

BIOG’s current 3.3% share price premium to cum-income NAV compares with a wide valuation range of a 5.2% premium to a 19.8% discount over the past 12 months. Over the past one, three, five and 10 years, the trust has traded at average discounts of 7.2%, 6.6%, 6.5% and 5.5%, respectively.

BIOG is a conventional investment trust with one class of share; there are currently 39.6m ordinary shares in issue. Gearing is employed up 20% of NAV via a loan facility with JP Morgan Securities, priced at 45bp above the US Federal Funds rate. At the end of June 2020, the trust’s net gearing was 8.5%.

OrbiMed is paid an annual management fee of 0.65% of BIOG’s NAV and Frostrow Capital (the trust’s alternative investment fund manager, which provides company management, secretarial, administrative and marketing services) receives an annual fee of 0.3% of the trust’s market cap, plus a fixed fee of £60k pa. A performance fee is payable – 16.5% of outperformance versus the benchmark (15.0pp and 1.5pp to OrbiMed and Frostrow, respectively); none was paid in FY20, despite the trust’s outperformance. A performance fee is only payable to the extent that 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. For FY20, BIOG’s ongoing charges were 1.1%, which was in line with the prior three financial years. The trust is subject to a continuation vote every five years; the next is due at the July 2025 AGM. Just 0.01% of shareholders voted against the proposal at the recent 2020 AGM.

BIOG’s investment objective is to generate long-term capital growth rather than income and a large proportion of the fund is invested in early-stage companies that invest for further growth rather than returning cash to shareholders. In FY20, the trust’s revenue return was a modest 1.0p per share, which was in line with FY19. No dividend has been paid since 2001 (0.2p per share).

Exhibit 9 shows the six well-established funds in the AIC Biotechnology & Healthcare sector, along with two Switzerland-listed funds, BB Biotech and HBM Healthcare Investments. BIOG’s NAV total return ranks first over the past 12 months by a considerable margin, and is also first out of six funds over the past decade, while its three- and five-year records are below the mean. At the date shown in the table, the trust was one of seven funds trading at a premium; it has one of the lowest ongoing charges (second only to its stablemate Worldwide Healthcare Trust), the highest level of gearing and does not pay a dividend.

There are six directors on BIOG’s board, five of whom are independent of the manager. Chairman Andrew Joy was appointed as a director in March 2012 and assumed his current role in July 2016. The other directors and their years of appointment are: Professor Dame Kay Davies (2012), Steven Bates and the Rt Hon Lord Willetts (both 2015), Julia Le Blan (2016), and Geoff Hsu (2018). As Hsu is a partner at OrbiMed, he is considered to be a non-independent director.