Biotechnology: Where the Promise of Life Meets the Reality of Markets








Billy:    So you got a job, where you play with all these toys.

Josh:    Yup!

Billy:    And they’re gonna pay you for that!

Josh:    Yup!

Billy:    SUCKERS!

Big (1998)

“Youth comes but once in a lifetime.” – Henry Wadsworth Longfellow, American poet and educator

“Demography is destiny.” – usually credited to French philosopher Auguste Compte

“The rewards for biotechnology are tremendous – to solve disease, eliminate poverty, age gracefully. It sounds so much cooler than Facebook.” – George M. Church, professor at Harvard & MIT

“Price gouging like this in the specialty drug market is outrageous. Tomorrow I’ll lay out a plan to take it on.” – Hillary Clinton


Hollywood movies went through one of their many curious phases during the late eighties. It was a phase in which adults were becoming children and moviegoers treated to cinematic atrocities such as Like Father Like Son, Vice Versa and 18 Again. Big starring Tom Hanks also came out during this time and turned out not to be half bad.

Human fascination with reversing the vicissitudes of old age is nothing new. Tales of magical sources of water that could reverse the ageing process and cure sickness can be found in ancient folklore across civilisations.  Legend even has it that Florida was discovered by the Europeans while searching for the mythical “Fountain of Youth”.

Our search for the elusive elixir that can reverse the ageing process, increase our lifespans and cure all sicknesses known to man continues to this day. Only the means have changed, not the goals. We no longer set out on journeys to far-off lands in search of mythical bodies of water. Instead we have replaced the ships with laboratories, the sailors with scientists and the paddles with test tubes, in the process creating what is now known as the biotechnology industry.

The term biotechnology was coined by Hungarian engineer Karl Ereky in 1919 to describe the process of creating products using raw materials sourced from living organisms. The roots of the discipline, however, can be traced at least as far back as the nineteenth century and to the work of Gregor John Mendel, an Austrian Augustinian Monk. Mendel’s development of the “Laws of Inheritance” is at times recognised as the foundation on which the principles of genetics are built.

Today, biotechnology has become almost synonymous with the application of engineering and biological sciences in pursuit of delivering improvements to human health, the environment and agricultural production. It is a time-consuming, expensive, and risky pursuit that strongly divides public opinion. And one that requires the coming together of engineers, scientists, patient capital, and an accommodative regulatory environment to thrive. Even then success is not guaranteed.

Despite the challenges, the industry has made great strides over the last two decades. In 1997 the industry achieved two major, yet controversial milestones. The first was the cloning of Dolly the sheep and the second was the first set of tests of gene therapy on humans. In 2003 the Human Genome Project was declared complete. In 2015 the Mexican government approved the world’s first vaccine to treat dengue – the world’s fastest-growing mosquito-borne disease.

Notwithstanding all the progress, the need for much more remains.

The developed world, while rich, remains demographically challenged. Needing more effective drugs and better healthcare for its ageing population. While in low income countries, a half dozen or so deadly infectious diseases claim millions of lives each year. The spread of these diseases may be contained by the development of easy-to-use and accurate diagnostic tools.

The prospects for biotechnology are strong as ever, which makes its demand for capital just as strong.


Investment Perspective

At its simplest, money is made in capital markets by either clipping coupons or riding a wave of liquidity to capital gains. With interest rates as low as they are, correctly anticipating where liquidity is headed is critical for the health of investors’ portfolios.

Stock pickers follow all sorts of styles of investing. At their root, investment styles are heuristics for anticipating the flow of liquidity. Value investors position themselves based on price. Growth investors focus on the rate of change of revenues and earnings. Technical analysts search for repetitive behavioural patterns. And so forth.

Our approach to anticipating liquidity movements within equity markets is informed by Richard Bernstein’s earnings expectations life cycle framework, outlined in his illuminating book Style Investing: Unique Insight into Equity Investing. While Bernstein modelled the evolution of earnings expectations, in our opinion, his approach can just as easily be applied to sentiment. For expectations are ultimately fractals of sentiment.

Earnings Expectations Life Cycle

Earnings Expectations Life Cycle.pngSource: Style Investing: Unique Insight into Equity Investing, Richard Bernstein (1995)

An area where we find sentiment, and therefore earnings expectations, at a turning point is healthcare, specifically biotechnology and pharmaceuticals. The sectors peaked in July 2015 and as surely as night follows day, stories of fraud started surfacing after the peak. The bad news did not end there, politicians started taking turns to add to their misery – none more so than Hillary Clinton, whose “price gouging” tweet sent the sectors into a tailspin.

Nasdaq Biotechnology Index and S&P Pharmaceuticals Select Index

NBI Index

Source: Bloomberg

The under performance of the two sectors, since their peak, relative to broader market indices has been noteworthy.  Biotech has under performed Nasdaq by more than 40% while pharma has trailed the S&P 500 by more than 50%. Investor apathy can be brutal.

The under performance of biotech and pharma during 2016 has not been entirely unwarranted. It was a challenging year for new drug approvals, which fell to a six-year low. The US Food and Drug Administration (FDA) only sanctioned 22 new medicines for sale, down from 45 in 2015.

Nasdaq Biotechnology Index / Nasdaq Composite Index

NBI Relative

Source: Bloomberg

S&P Pharmaceuticals Select Index / S&P 500 Index

SPSIPH Relative

Source: Bloomberg

For biotech, earning expectations have duly followed price action as opposed to the other way around. Given recent price action, we expect earnings expectations to start getting revised upwards.

NBI Blended Twelve-Month Forward EPS Expectations vs. Index Level

NBI Index and Earnings Expectations

Source: Bloomberg

Investors have been fleeing the sectors without abandon. That is, until recently. Using the iShares Nasdaq Biotechnology ETF ($IBB) and the SPDR S&P Pharmaceuticals ETF ($XPH) as proxies, we find that investors are rushing back into biotechnology. $IBB shares outstanding have increased by more than 25% year-to-date. Although pharma has lagged, the bleeding has stopped and we expect investor interest to pick up.

 ETF Shares Outstanding


Source: Bloomberg

Although investor interest in $IBB has picked up, the move is still in its early stages. Comparing the annual rate of change of shares outstanding for $IBB and the PowerShares QQQ Trust Series 1 ($QQQ), we find that capital flows relative to stock remain biased towards Nasdaq over biotech. Our models suggest that the trend should be more favourable for biotech over the remainder of 2017 and in 2018.

Annual Rate of Change of ETF Shares Outstanding


Source: Bloomberg

Despite investor interest increasing, we have received significant push-back on healthcare, especially biotech, with one investor citing the adage “Growth under performs value in a rising interest rate environment”. With central banks becoming increasingly hawkish and with biotech squarely in the growth camp, the scepticism may be reasonable. Yet the recent out performance of healthcare stocks is eye-catching.

The current state of markets makes us question if the market is beginning to focus on the world’s need for better drugs and improved healthcare? We also wonder if liquidity will start to rotate out of the increasingly politicised and polarising technology plays such as Facebook, Google and Amazon and into healthcare and the other laggards.

The regulatory environment, despite the Trump administration’s challenges in passing healthcare reform (or any reform for that matter), should almost certainly be more supportive for healthcare than it was under the Obama administration. Ironically, in large part due to President Obama, who gave the industry a parting gift when he signed the 21st Century Cures Act into law in December last year. This legislation is intended to expand medical research and speed up the approval of new drugs and medical devices. Predictably, the pace of new drug approvals has picked up in 2017. By May, 20 new treatments had been approved as compared to 22 for all of 2016.

Reduced regulations around drug approval, especially those that make the process of getting new drugs to market faster and less expensive, can greatly improve returns on investment. Improved returns incentivise management teams to increase research and development budgets and embolden them to pursue mergers & acquisitions. We believe that Gilead Sciences’ decision to acquire Kite Pharma is just the start of the trend of increasing mergers & acquisitions within the biotechnology and pharmaceutical sectors.

If this bull market in equities is set to continue, and we certainly are amongst those that believe that it still has legs, we contend that healthcare will be one of the sectors leading it higher.

In sectors where individual companies are fraught with idiosyncratic risks, we tend to prefer a core and satellite approach as opposed to taking concentrated positions in a handful of stocks. In this case, $IBB and $XPH form our core while a basket of our most favoured biotech, pharmaceutical and healthcare stocks, identified in our trade ideas, makes up the satellites.

We are long $IBB and $XPH.