The Biotech Growth Trust — No style drift, sticking to long-term winning ways

Over the long term, biotech stocks have outperformed global equities but, as shown in Exhibit 1 (left-hand side), the recent significant drawdown (sell-off) in the biotech sector has meant that their performances over the last decade are now broadly in line. Growth stocks across the board have come under pressure as central banks in developed regions have started to hike interest rates to combat rising inflation. Inflation was already moving higher due to COVID-19 induced supply chain shortages, but the war in Ukraine has exacerbated product shortages.

The valuation compression in biotech stocks may have created a very interesting opportunity for long-term investors given that fundamentals in the biotech industry remain robust. Global demographic trends are supportive of demand growth, innovation levels are high, the regulatory environment is supportive, as evidenced by the continued above-average novel drug approvals at the US Food and Drug Administration (FDA), and there is a potential resolution to the US drug pricing issue ahead of the November 2022 mid-term elections. There is also the prospect of an uptick in biotech M&A as major pharma companies, which are flush with cash, seek to bolster their product pipelines by buying biotech stocks with innovative technologies at attractive valuations.

To provide additional valuation insights, in Exhibit 1 (right-hand side) we show the absolute and relative forward P/E multiples of the Datastream World Biotech Index. Its current 27.2x P/E multiple is an 11.4% discount to its five-year average and its 61.1% premium to the Datastream US index compares with the 60.9% and 70.5% average premiums over the last five and 10 years, respectively.

Explaining BIOG’s underperformance in FY22 (ending 31 March), Hsu describes the period as ‘a perfect storm’ due to macroeconomic factors. The manager’s investment strategy favours emerging over large-cap biotech stocks, and in FY22 not only did smaller-cap stocks underperform but there was a market shift from growth to value stocks. In the United States, a well-used index of 2,000 small and midcap stocks underperformed its brethren index of 1,000 large-cap stocks by 18.5pp during FY22. Unprofitable technology stocks in all industries sold off in the latter part of the period due to fears about higher interest rates, which exacerbated the underperformance of pre-revenue companies. Hsu also notes that during FY22, there was significant underperformance in the shares of biotech companies that listed in 2020 and 2021 and there was a lull in crossover activity, which is the last round of financing before an initial public offering (IPO); BIOG was very active in participating in crossover financing in 2021. In China, there was a market-wide sell-off starting in June 2021, due to tighter regulation across a variety of industries such as internet and education businesses; healthcare companies did not come under regulatory pressure, but their share prices still weakened. There was also an overhang from the delisting of Chinese companies’ American depository receipts due to accounting/regulatory policy differences between the US and Chinese regulators. In addition, lockdowns in response to China’s zero-COVID-19 policy have dampened the outlook for that country’s economic outlook. As an aside, the manager notes that during FY22, the Hang Seng Healthcare Index declined by 45.6%, but has since stabilised; he is anticipating a recovery in Chinese biotech stocks.

Focusing on the structure of BIOG’s portfolio, Hsu explains that the fund is significantly underweight large-cap and overweight smaller-cap biotech stocks; the c 30pp underperformance of the latter compared with larger-cap biotech stocks was a significant performance headwind for the trust in FY22. The manager notes that after the end of the period the performance divergence became even worse. He comments that the correction was not confined to biotech stocks as there was widespread underperformance of small-cap stocks and unprofitable technology companies. Hsu highlights that Goldman Sachs constructed a basket of the stocks of c 55 non-profitable technology companies across a range of industries, not just biotech stocks; between 31 March 2021 and 30 June 2022, it declined by 60.8%.

The manager explains that the SPDR S&P Biotech ETF is an equal-weighted index and is a proxy for small and midcap biotech stocks. It has outperformed the US bellwether S&P 500 Index since 2006, although there have been periods of underperformance. Each drawdown was followed by a recovery rally and outperformance by the SPDR S&P Biotech ETF. According to Hsu, prior to the recent drawdown, the worst period of relative weakness was -44%; however, the period between 8 February 2021 and 2 June 2022 saw the SPDR S&P Biotech ETF underperform the S&P 500 Index by 67%. This drawdown proved to be the longest and the largest in both absolute and relative terms in the period since 2006. Since the June 2022 nadir, the SPDR S&P Biotech ETF has started to perform relatively better, and the manager is hopeful that the latest drawdown is over, and that the biotech index will resume its long-term trend of outperformance.

Hsu highlights that biotech company valuations are at unprecedented low levels. Looking at market caps versus cash on their balance sheets, which he believes is an objective view as it does not include any probabilities of success or revenue projections, the ratio is lower than during the bursting of the dot.com bubble, the global financial crisis or the Hillary Clinton drug pricing debate in 2015–16. The manager says there are now more than 25% of biotech companies (c 150) with market caps greater than $10m that are trading below the net cash on their balance sheets, which compares to c 10% during the global financial crisis; hence, Hsu is very bullish on the prospects for a valuation reversion.

The manager comments that interest rates have increased in response to rising inflation. The US 10-year government bond yield rose rapidly from c 1.5% at the beginning of 2022 and he says that it appears to have stabilised around 3%, which Hsu says includes market expectations for further short-term interest rate hikes. He suggests that once inflation has been brought under control, interest rates will decline, and the manager does not expect incremental interest rate pressure on biotech stocks.

Hsu highlights the sharp disconnect between biotech shares’ price performance and industry fundamentals; in his opinion, the major drawdown is unwarranted. The manager opines that innovation is the primary driver of value creation within the biotech sector, and the innovation engine remains robust. This is evidenced by an increasing number of global launches of novel active substances across a broad range of therapy areas, from 35 in 2012 to 84 in 2021 and more than double compared with five years ago. Hsu says that novel technologies are driving the growth in the biotech industry pipeline including RNA therapeutics, CAR-T and cell therapy, gene editing and gene therapy. BIOG focuses on emerging biotech companies as these businesses provide the bulk of the biotech industry innovation (around two-thirds of its research and development pipeline). According to the manager, these firms originated 53% of the new drugs launched in 2021. Hsu notes that BIOG has exposure to a range of novel technologies: antibody-drug conjugates (14.1% of NAV at 30 June 2022); oligonucleotide therapeutics (11.5%); gene therapy/gene editing (10.6%); multi-specific antibodies/T-cell engagers (7.4%); cell therapy (5.2%); and liquid biopsy (0.7%).

The manager highlights that there is a very favourable US regulatory environment, and he expects this to continue. The new FDA commissioner, world-renowned cardiologist Dr Robert Califf, who previously held the post under President Obama, was confirmed in February 2022. He is viewed as ‘industry friendly’ and is expected to continue the FDA’s constructive approach towards new drug approvals. COVID-19 related delays have largely been resolved and the pace of new molecular entity approvals remains robust (50 in 2021 is broadly in line with the average over the last five years).

M&A activity has historically been a driver of the biotech sector’s performance. Hsu notes that there has been a relatively consistent number of public transactions in recent years, and he expects the pace to accelerate given biotech target companies are trading at lower valuations and their financing options are currently less attractive. The number of deals announced in Q222 was higher than in the previous two quarters, and the manager is hopeful that this is a sign that activity is picking up. In FY22, BIOG directly benefited from Pfizer’s bid for Trillium Therapeutics and Pacira BioSciences’ bid for Flexion Therapeutics. ‘There are a series of names in the portfolio that would make great M&A targets’, adds Hsu.

The manager highlights the Biotech IPO market has cooled considerably over the last 12 months, following a surge in 2020/21. Since 2018, more than 250 biotech companies have gone public, so the global investment universe is now more than 1,500 companies. He considers that a silver lining to the current challenging period is that BIOG can capitalise on investment opportunities at attractive prices.

Hsu reports that US drug pricing legislation is ‘back on the table’. It was part of President Biden’s ‘Build Back Better’ plan but was unable to gain unanimous Democratic support. The Democrats are now rushing to pass a stripped-down version of the legislation to score a win ahead of the November 2022 mid-term elections. The manager says that there is no guarantee that this strategy will be successful, and if a healthcare pricing bill is passed it should have a manageable impact on the healthcare industry. It would likely include Medicare price negotiations starting in 2026 for a limited number of drugs, with other provisions such as caps on out-of-pocket expenses and inflation caps on price increases, although a final bill could be watered down still further. Opinion polls indicate that the Democrats could lose control of both the House of Representatives and the Senate in the mid-term elections. If benign legislation is passed now, Hsu suggests it could eliminate the drug pricing overhang and lead to a relief rally in biotech stocks. However, if this does not occur, a Republic majority would mean that there is unlikely to be extreme drug price legislation, which is essentially a ‘win-win’ for the biotech sector, concludes the manager.

At end-July 2022, BIOG’s top 10 holdings made up 41.0% of the fund, which was a higher concentration compared with 31.9% a year before; just two names were common to both periods. There were 64 companies in the fund, which was a significant 30.4% reduction compared with 92 at end-July 2021.

Over the 12 months to the end of July 2022, the largest changes in BIOG’s geographic exposure were a lower weighting to quoted Chinese stocks (-6.7pp) and higher weightings to unquoted (+4.4pp) and North American companies (+3.6pp).

Having significantly outperformed the NASDAQ Biotechnology Index in FY21 (ending 31 March, its NAV by 30.0pp and share price by 50.1pp), FY22 proved to be a complete reversal in BIOG’s fortunes. Its NAV and share price total returns of -33.8% and -37.0% respectively were meaningfully behind the benchmark’s -7.4% total return. The broad reasons for the trust’s underperformance were its heavier weighting in small-cap biotech stocks and its Chinese exposure. On a stock-specific basis the three largest positive contributors to BIOG’s FY22 performance were: Trillium Therapeutics (it received an acquisition bid from Pfizer at a 203% premium); GH Research (which had positive Phase II trial data for its inhaled therapy for patients with treatment-resistant depression); and StemiRNA Therapeutics (a private Chinese vaccine company developing an mRNA-based COVID-19 vaccine). The largest detractors were: Singular Genomics Systems (early-stage tools businesses fell out of favour with investors and the company faced increased competitive threats); Guardant Health (broad pullback in the share prices of tools and diagnostics growth businesses and rumours of a bid for NeoGenomics); and Aptose Biosciences (which had disappointing data from its lead asset for the treatment of myeloid leukaemia).

Data from OrbiMed show that over the long term, from 18 May 2005, when the company took over the management of BIOG, to 30 June 2022, the trust’s 784.5% NAV total return has outpaced the NASDAQ Biotechnology Index’s 727.2% total return. However, as shown in Exhibits 7 and 8, the trust’s significant underperformance since early 2021 has had a meaningful negative impact on BIOG’s track record. Except for the last few months, its NAV and share price have lagged the benchmark’s performance over all periods shown. It is interesting to note that despite the trust’s recent performance pressures, over the last decade, it has significantly outpaced the performance of the broad UK market.

There are seven funds in the AIC Biotechnology & Healthcare sector. In Exhibit 9, we also include two Switzerland-listed funds, BB Biotech and HBM Healthcare Investments, to provide a broader comparison. BIOG’s NAV total return ranks ninth over the last 12 months as its performance continues to be negatively affected by its strategy of focusing on emerging rather than large-cap biotech stocks. The trust also lags the selected peer-group averages over the last three, five and 10 years. Its valuation is below average in a group where just one fund is trading at a premium. BIOG has a competitive ongoing charge, ranking fourth, and a level of net gearing that is above the mean. The trust is one of three funds in the selected peer group that does not pay a dividend.

BIOG aims 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 future growth rather than returning cash to shareholders. In FY22, the trust’s revenue return was 0.0p per share, compared with -0.2p per share in FY21. No dividend has been paid since 2001 (0.2p per share).

BIOG’s shares are trading at an 8.3% discount to cum-income NAV, which compares with a range of a 2.9% premium to a 12.7% discount over the last 12 months. It is wider than the 4.8%, 4.0%, 4.9% and 4.7% average discounts over the last one, three, five and 10 years respectively. There is scope for a higher valuation if BIOG’s relative performance gets 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% in normal market conditions. In FY22, a modest c 0.2m shares were issued at an average 1.0% premium raising c £2.1m, while c 0.6m were bought back at an average 6.6% discount at a cost of c £6.9m. So far in FY23, a further c 0.8m shares have been repurchased at a cost of c £7.7m.

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 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, 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 12 of his colleagues at OrbiMed working on BIOG (nine based in New York and four in Shanghai/Hong Kong) 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. Hsu may employ gearing up to 20% of net assets; net gearing was 9.0% at end-July 2022.

Hsu aims to generate long-term capital growth from a globally diversified portfolio of biotech companies across the market cap spectrum. He 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 manager seeks out the best potential opportunities across the globe, most of the portfolio is held in US companies (72.8% at end July 2022), reflecting its dominance in the biotech industry, although BIOG has a notable exposure to China (11.7%). 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 because of its large emerging biotech exposure, where stocks can be volatile around news about clinical results. The manager continues to invest in unquoted companies (9.5% of the fund at end-July 2022).

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 manager seeks to invest in reputable management teams and is 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 July 2022, the trust’s net gearing was 9.0%, 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. Prior to April 2021 Frostrow received 0.3% of the trust’s market cap, plus a fixed fee of £60k pa and a performance fee was payable (1.5% of outperformance versus the benchmark).

In FY22, BIOG’s ongoing charges were 1.1%, which was in line with FY21; no performance fees were payable, unlike in FY21, when ongoing charges including performance fees were 1.3%. During FY22, due to underperformance versus the benchmark, there was a reversal of prior period provisions of c £10.7m. At the end of FY22, no performance fees were accrued or payable compared with c £17.8m at the end of FY21 (c £7.0m crystalised and was paid on 30 June 2021).

BIOG is a conventional investment trust with one class of share. There are currently 40.4m ordinary shares in issue and the average daily trading volume over the last 12 months is c 94k shares. At the end of FY22, BIOG’s shareholder base was split as follows: 72.0% retail investors; 9.9% pension funds; 9.5% mutual funds; and 8.6% other.

The trust has a five-year continuation vote; the last was held at the July 2020 AGM when 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. Roger Yates became chairman following the retirement of Andrew Joy at the 19 July 2022 AGM.