Page 27 - DIY Investor Magazine | Issue 40

Looking at metrics like enterprise value/peak sales, which are more appropriate for companies that don’t yet have earnings (either because their drugs are not yet approved or they have a newly approved drug which does not yet make a profit), there is still a substantial number of biotech companies which are trading at a value lower than the value of the cash they hold in the bank.
This prompts the question: what factors have been weighing on biotech valuations? It’s worth saying at the outset that the heady valuations seen during the biotech sector’s glory days in the pandemic were arguably a mixed blessing. The indiscriminate flow of passive money propped up the weaker companies
and, as we discussed in a recent note, prompted a necessary consolidation and restructuring of the sector.
Macroeconomic challenges, and interest rates in particular, have undoubtedly proved one of the strongest headwinds for the biotech sector. Debt financing has become more expensive for biotech companies and higher interest rates have increased the appeal of lower-risk assets for investors. This inverse relationship between the biotech sector and interest rates is shown in the graph below, with the smaller-cap XBI biotech index rising during the period of ultra-low rates and falling ahead of the base rate hikes in early 2022.
Volatile stock markets and geopolitical issues have also prompted a risk-off period for investors, which has hit the more speculative biotech sector particularly hard. Investor nervousness has heightened sensitivity to adverse news flow, such as clinical trial data, and has underpinned a tendency to overlook more positive developments, leading to a growing divergence between valuations and sector fundamentals.
‘THE BIOPHARMA INDUSTRY IS HOLDING NEAR-RECORD LEVELS OF FINANCIAL FIREPOWER FOR ACQUISITIONS’
POSITIONING FOR THE UPTURN
None of this will come as any surprise to seasoned biotech investors as biotech is, after all, a cyclical investment sector. And it’s a cycle that Ailsa Craig and Marek Poszepczynski, managers of International Biotechnology Trust (IBT), have seen
repeatedly during their collective tenure of more than 25 years managing the trust.
They divide the cycle into five stages, from despair, recovery and equilibrium to euphoria and correction.
One of the attributes of the recovery phase is an increasing level of M&A activity as large, cash-rich pharma companies take advantage of depressed valuations to supplement their product portfolios.
This trend has been evident over the last year, with EY reporting that life sciences M&A soared to more than $190 billion in 2023, a year-on-year increase of more than a third, with the pharma mega-caps accounting for almost 70% of deals by value. The biopharma industry is holding near-record levels of financial firepower for acquisitions and M&A is likely to remain a key source of alpha generation for biotech funds.
The uptick in equity financing in 2024 so far has led Ailsa and Marek to regard the sector as just having entered the equilibrium stage, where an improvement in investor appetite helps to drive a re-rating in valuations, supported by positive stock market performance.
Fears of ‘higher for longer’ interest rates have also been tempered by optimism that falling inflation may give the Fed the wiggle-room to cut interest rates in the coming months, which could support an uptick in valuations.
‘THIS ALSO SHOWS THE MERIT OF ACTIVE MANAGEMENT BY SECTOR EXPERTS, WITH IBT COMFORTABLY BEATING THE EQUIVALENT 34% RETURN FOR THE FUND’S BENCHMARK’
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April 2024
DIY Investor Magazine ·