Portfolio managers of Arctic Aurora LifeScience reflect on a year with ups and downs for the fund, with historical low valuation levels of biotech companies affecting the performance.
2018 has been a year of two halves for the fund. On the back of the US tax reform, the year started with expectations of M&A activity coming back to the sector, optimism further supported in April by Novartis bid on gene therapy company Avexis. Investor enthusiasm regarding the scientific breakthroughs by the new technologies was high and the fund outperformed thanks to our holdings in the Small and Mid (SMID) cap segment.
In the second half, more precisely in the last four months of the year, focus shifted. Rising interest rates, global political and macro uncertainty and the political turmoil in the US, created a massive risk off sentiment in the market. Investors fled from high beta biotech stocks to what is perceived as safe havens, Big Pharma and cash. Sentiment for the sector further deteriorated after the US mid-term election, when the issue of drug pricing reentered into the discussion. The last two months of the year, sentiment turned extremely nervous and companies were no longer priced on fundamentals. Reinforced by ETFs, shorts and program trading, this nervousness resulted in a sell off of SMID cap biotech driving prices of many companies down 20-50% on no news. Regardless of market volatility, our portfolio companies, with a few exceptions, have continued to build value by scientific progress and development in the companies.
In accordance with our investment philosophy with focus on creating value by investing in unique innovations, Arctic Aurora LifeScience has a structural overweight in SMID cap companies. It is our conviction that this investment strategy over time will generate excess return, but in the current market this strategy does not pay off and this punishes the relative performance against the benchmark, with its heavy bias towards large cap pharma. Important to note is that the underlying value creation in the companies are progressing and innovation has never been stronger. We have seen significant progress and positive clinical and regulatory data in many of our smaller biotech companies during 2018 to the benefit of patients suffering from cancer, kidney diseases, rheumatoid arthritis and rare diseases. When AALS was started, cancer was an area where we saw great innovation from several companies and we still do. Cancer is also the area that will grow the most the years to come. Kite Pharma and Juno lead the CAR-T area bringing new breakthrough treatments to blood cancer patients. We invested in both companies and followed their path to the market and eventually acquired by Gilead and Celgene respectively. Today their treatments are saving lives in cancer centers around the world.
So called Triple negative breast cancer (TNBC) is a devastating disease in women with no effective treatment today. Immunomedics is one of our convictions in the AALS portfolio because of very convincing clinical data in TNBC. The company has progressed their clinical pipeline in 2018 and the US regulatory authorities FDA will make a decision in January 2019 if they want this treatment to the market. Further, we have witnessed transforming progress in our other companies such as Loxo, Array and European Argenx, among other. So for 2019, what do we expect and what do we wish for?
We foresee a number of approvals for important products in our portfolio companies’ pipelines as well as key late stage clinical data. The strong innovation in cancer, the orphan space and other diseases with unmet medical needs is stronger than ever. Our portfolio companies are well funded and can focus on the operations, while capital markets are challenging.
In general biotech valuations, for both big and SMID have come down to historical low levels. On an absolute basis the forward P/E and EV/EBITDA multiples for the revenue generating companies are well below their historical levels. Biotech's forward P/E is currently at a ~20% discount to the market, levels not seen since 2010. For EV/EBITDA, the sector is trading at a ~10% discount to the broader market (Morgan Stanley estimates). Thus, compared to the broader market, biotech remains attractive on a valuation basis. On a relative basis, biotech's forward P/E and forward EV/EBITDA are both at discounts to pharma and healthcare for the first time since 1998. In the SMID segment valuations have been significantly reduced as mentioned above.
In light of the low valuations, and supported by statements from Big Pharma Executives, we could expect M&A to come back into the scene, reverting focus to the value in the SMID segment. The need to rejuvenate the Big Pharma product portfolios is still there, and the cash piles up in the large companies. Ultimately, we believe fundamental drivers will prevail, hence we would expect our investments in the SMID cap segment to start performing again. However, we have to acknowledge the political and macro headwinds as well as the drug pricing debate continuing in the political discussion. There is no way of predicting when focus will change back to fundamentals, but what we can say is that the need for medicines is great and growing, innovation is very strong, regulatory authorities are supporting the development of innovative medicines and the technological development is positive.
To sum up, we of course wish for sentiment to turn and that good companies will be appreciated accordingly. We wish for further breakthroughs in cancer and other debilitating diseases, saving or improving lives.
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Arctic Aurora LifeScience is an equity fund investing in global biotechnology and pharmaceutical companies. The fund is run by former portfolio manager in the Swedish Governmental Pension Fund AP3, Ulrica Bjerke, as well as Dr. Torbjørn Bjerke, both with 20 years of experience from the market. Arctic Aurora LifeScience was launched in May 2016 with both hedged and un-hedged share classes.
Past performance in Arctic Aurora LifeScience is no guarantee for future returns. Future returns depend on the market, fund manager skill, fund risk level, costs, among others. Performance in the fund may at times be negative and may for this fund vary considerably within periods.