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The Biotech Rally: The Drivers & The Impact on Fund Returns

While the market has continued to climb higher over the past fifteen months, a consistent standout has been the biotechnology sector. As the stocks of such companies have soared to new heights, with the share prices of some more than doubling during this timeframe, the IPO market has been flooded with a rash of new biotech offerings. To put all of this exuberance into perspective, mid-way through the first quarter of 2014 the market value of the biotechnology sector was close to $600 billion. While this figure puts it on par with other leading economic sectors, it equates to only a small percentage of the overall market cap of the S&P 500 Index. Clearly though, the frenzy surrounding these stocks has been significant, with the S&P 500 Biotechnology Select Industry Index returning close to 70% for 2013. As the first quarter of 2014 came to a close, however, some of the momentum fueling the biotech rally dissipated, as evidenced by a sharp decline in the above Index from March through mid-April. Until March, mutual funds with higher exposure than peers have seen returns buoyed significantly by the strong performance of these names, while funds less exposed to the sector have lagged. However, that trend has reversed over the past couple of months as the sector has pulled back. Given how impactful the sector has been to relative fund returns over recent periods, it is important to examine the drivers of the biotech rally, as well as the reasons why some managers have continued to avoid these names.

Throughout the early to mid-2000’s, the biotech sector appeared to be in hibernation. Companies in the space faced significant headwinds, such as a fairly restrictive FDA and a plethora of extended patent lives on many key drugs. As the 2000’s progressed, key events and changes within the healthcare industry brought this “sleepy” sector back to life. These notable events included: the mapping of the human genome and the benefits of this endeavor being realized in practice today, the transformation of the FDA to a more accommodative or transparent entity and the arrival of the “patent cliff” characterized by several notable patent expirations. These key internal or industry driven events have been the force behind many biotech companies’ rush to reinvigorate pipelines either through internal endeavors or through acquisition. While these events have served to rejuvenate the sector and drive the prices of some of its stocks to record levels, the sustainability and strength of some of these drivers remains a topic of debate.

Arguably, the most notable driver of biotech outperformance over the last year and a half has been the real world application of the mapping of the human genome and the effect this has had on how drugs are prescribed and patients are treated. The Human Genome Project has created a new era in the healthcare industry – that of personalized medicine. The information obtained from human genome sequencing has enabled biotechnology companies to begin developing genetic-based diagnostic tests geared at administering more personalized treatments with higher efficacy rates. In examining the sustainability of real world applications of human genome sequencing, it is likely that the mapping of the human genome was a true “game-changer” for the overall healthcare industry.

The transformation of the FDA to a seemingly more transparent entity has also been supportive of higher biotech stock prices, as companies have been able to move drugs to the market more quickly, thus garnering revenues from their drugs sooner than in the past. While the communication has been clearer between biotech companies and the FDA with respect to what the administration is looking for to grant approvals, there also appears to exist a bit of an accommodative bias on the part of the administration as many of the products in development have been breakthrough drug therapies. While the pendulum of regulation has swung in favor of companies over the past few years, highlighted by the FDA’s hefty approval of 39 new medicines in 2012, there are signs that this more accommodative stance may not be sustainable. In 2013, the number of new drug approvals dropped to 27. This may indicate a more cautious stance by the FDA, which would be a potential reversal of fortune for biotechnology companies.

While internal or industry related events have been supportive of the recent biotech rally, external drivers in the form of favorable demographics and strong fund flows have also played a key role. From a demographics perspective, the current environment is characterized by an older developed world and a richer developing world driving increased healthcare utilization globally. This trend has clearly driven demand, but has been met by an increased pushback from insurance companies, global governments and employers on the reimbursement front, as each entity strives to contain healthcare costs. Putting reimbursement risk aside and turning to the extremely strong fund flows into biotechnology stocks evidenced over the recent months, it may be likely that this trend is more fickle. As is typically the case when sectors run and experience a prolonged period of outperformance, the early investors are usually those with specialized backgrounds somewhat related to the sector, while the latter investors are typically generalists. It is this second set of investors that are likely to liquidate positions quickly when negative sentiment arises given limited sector specific knowledge.

While some fund managers have benefited from their exposure to these recent trends in the sector, others have consciously limited exposure to these stocks. A common reason behind this is the general lack of consistency in free cash flow and earnings generation found in many of these companies, which are two factors paramount to many managers’ investment process. Many biotech companies are highly dependent on the outcome of one or two key drugs, which increases the event risk of their business models and thus results in a “boom or bust” lifecycle. Also, many times these companies may not be generating positive earnings. These characteristics can make the inclusion of these companies into a manager’s portfolio challenging. In addition, as stated previously, some managers have not bought into the idea that these recent trends in the industry are in fact longer-term changes. For example, some managers have expressed concerns that these businesses will not be able to maintain their current pricing power, and that the FDA will not remain as accommodative as it has been in recent years.

As the market ebbs and flows, it is important to keep in mind how impactful biotechnology stocks have been on recent mutual fund returns. A fund manager’s decision regarding exposure to this sector has been clearly linked to relative performance over the past year and a half. Time will tell whether the market is in the midst of “the bursting of a biotech bubble” or just a much needed pullback in a “hot” sector. However, given all of the recent volatility with respect to these companies, it is important for investors to be well aware of a fund’s overall healthcare and underlying biotech exposure, how consistent the manager has been with that allocation, and the overall impact it has had on returns.