In many ways the past two years has been an overwhelming experience in witnessing the changes in our healthcare systems due to the COVID pandemic. One aspect of the broader healthcare context however, that has remained resilient and even accelerated, has been the development of new treatments and methods within the biotechnology sector. Since pre-pandemic days at the start of 2020 we have seen the emergence of mRNA vaccines, CRISPR gene editing proving itself in human clinical trials, novel drugs approved in rare diseases were previous treatment options were mediocre at best, new cancer drugs targeting disease mechanisms with impressive outcome data in patients, to name a few highly positive developments.
During this period of considerable development in multiple arms of therapeutic biotech development, some of the progress has been translated into value appreciation and several individual company valuations have been resilient to negative sentiment of late. On the other hand, the ‘risk-off’ behavior during most of 2021 has also led to stark disconnect between solid execution in many biotech companies that has led to fundamental progress but often diminishing market valuations.
During 2021, there has been an historically severe sell-out of biotech stocks, with XBI being down more than 22% year to date. Many companies are trading below cash values. From a top-down perspective, navigating publicly traded biotech equities have been challenging, as day to day reports regarding the COVID development, spread and mutations have been in investors focus and vaccine stocks have been trading detached from the sector and regardless of valuation. Meanwhile macro pressures of looming interest rate increase and stagnant economies have added more uncertainty into the mix.
For a biotech specialist investor, we have during the last two years witnessed two adjacent periods of first ‘everything works’ including more speculative approaches that fundamentally have been skewed to the downside – be it either high-risk projects with unproven therapeutic approaches or cash-flow assumptions of existing products that did not match reasonable estimates. This was followed by the ‘nothing works’ period where even positive clinical development outcomes were met with a cold shoulder by the market. Even though such outcomes will lead to considerable patient and healthcare system benefits, and ultimately, commercial value for the companies.
Our firm foothold to ensure long-term value growth is to use our expertise to focus on fundamental value, be it in drug development projects or commercial products, regardless of changing winds in the equity market. The short-term reason for this approach is simple, as we have seen historically downturns in biotech (particularly in the small-mid cap segment) have reversed sharply to the upside with low predictability on timing. We have also seen that the best approach for long-term excess return in biotech over time is to focus the selection process on quality and a meticulous analysis on fundamentals.
This way, we ensure both continued value growth for the aggregate biotech group that goes alongside profound innovation and development progress, but also an amplitude effect due to selection within the group. This is something we have shown with Arctic Aurora LifeScience since inception, where our biotech sub-portfolio has outperformed biotech benchmarks, and we are investing along the same principles in Arctic Aurora Biotech Select. At the same time, the relative overweight in this small mid cap segment, due to significant sell downs, has harmed total relative performance during the year.
One such fundamental factor we consider during the selection process is the company’s attractiveness to large pharmaceutical companies. Historically, when valuations have gone depressed in the biotech sector, pharma and large biotech companies have stepped in to acquire smaller innovative firms often at a significant premium. Currently, after the last months heavy sell out of the small mid cap segment, there are multiple signs that M&A could pick up again. Cash balances of large pharmaceutical companies are close to all-time highs and many of them will face patent expirations to key products during the next couple of years. To ensure pipeline sustainability, they are expected to do acquisitions, which will support an improved sentiment of the biotech sector.
Patience and long-term perspective are not always possible, but the underlying theme with transforming innovation and demand for medicine and treatments for large patient groups, to us signals a sustained investment theme with remarkable value creation.