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Should you invest in biotech?

A hotbed of innovation, the biotechnology sector has been through many boom and bust cycles and has frequently experienced rapid changes in investor sentiment. What are the prospects when you invest in biotech?

| 9 min read

When it comes to investment risk, it doesn’t come much more adventurous than the biotech sector. Scientific and technological innovations in healthcare have the potential to reward brave investors, but the high failure rate of smaller biotech companies developing only one or a small number of drugs is an ever-present danger.

Frequently, smaller companies that develop drugs from an early stage have little or no revenue, so they are reliant on markets to provide them with the fresh capital they need. That means they can simply run out of funding if unsuccessful, dashing their dreams of creating a lucrative blockbuster drug, or they make a partial breakthrough only to fail during clinical trials.

Yet given the ready demand for breakthrough drug and medical treatments from a growing and aging global population, the industry is uniquely positioned to harness growth. Biotechnology companies are constantly developing new drugs and treatments that can address a wide range of medical conditions, from cancer to autoimmune diseases to genetic disorders. The sector's continued ability to innovate and bring new products to market is critical to meeting the growing demand for healthcare solutions.

Is biotech a good investment?

Biotech can be an interesting, specialist long-term investment depending on your individual goals and circumstances; however, it’s important to pay attention to the specific risks and characteristics of this sector, such as volatile performance and potential for both successes and failures. Here are some of the most important factors to consider.

1. Biotech performance can be erratic

Investors are sometimes drawn to the sector by exceptional short-term returns, only for them to experience a brutal downturn. It thus becomes a classic ‘risk on’ sector, sometimes fuelled by excessive speculation. Yet those staying the course for longer while maintaining a diverse portfolio of companies have generally experienced strong returns – although past performance is not a reliable indicator of future results.

Twenty-year performance of the Nasdaq Biotechnology Index vs MSCI World Index

Source: FE fund info, % total return in £ with income reinvested, data to 29/02/2024

The level of speculative activity in a given sector is always hard to gauge. However, there doesn’t seem to be a lot of it at the moment given the weak sentiment surrounding many higher risk growth stocks, especially those yet to generate profits. Since the post-Covid stock market boom, melted away in 2023, investors have preferred to stick with companies that have more certainty of earnings outlook.

They have also been scarred by many ‘concept’ stocks that caught the imagination during Covid lockdowns but subsequently failed to deliver or have been adversely affected by higher interest rates that increased their funding costs.

Valuations in the biotech space are therefore undemanding relative to history, investors perhaps concerned companies will find it difficult to secure funding in the tighter economic environment. Sector specialists Orbimed found that around 15% of companies in the sector trade below the value of net cash on their balance sheet, well above the longer-term average over the past 20 years of their research, but lower than the 25% recorded in 2022 and 2023 when the sector was under pressure from even greater negative sentiment.

There is always a risk that businesses burn through cash without generating sufficient sales, but in other circumstances it can mean even a modest amount of clinical and commercial progress can deliver upside to shareholders.

2. The nature of biotech innovation leads to acquisition

While it is hard to argue investors are currently overpaying for the potential, companies still have to deliver in terms of successfully formulating and the commercialising drugs and therapies. Orbimed report the pace of innovation is robust with record numbers of drug approvals and the pipeline of new drugs is as large as it has ever been. Importantly, that pipeline is highly concentrated in biotech specialists rather than in the larger pharmaceutical companies – as much as two thirds – which implies some pharma giants are running out of road for new drugs to replace older ones whose patents are expiring.

When this ‘patent cliff’ occurs, the drug owner face competition from generic copycats and must innovate – or acquire – other drugs to grow profits. It is common for pharma giants to gobble up smaller businesses making breakthroughs, and if valuations are low the temptation is all the greater. When larger companies acquire smaller ones in order to access new technologies and products it can lead to gains for shareholders of the acquired companies, and following a period of muted activity this trend has picked up in the past six months and could help underpin valuations in the space.

3. Stay informed on the regulatory risks

Worries of recession might be putting investors off higher-risk areas such as biotech, although interestingly the area does have a decent record of performing in difficult economic times. This makes sense when you consider that spending on healthcare is not particularly sensitive to the economic cycle. Instead, the risks of biotechnology investing are more industry specific, relating to the regulatory environment and drug pricing.

The threat of regulatory changes in the all-important US market are a perennial risk to investors in the sector and can have a significant impact on shorter term sentiment and share prices.. The industry has historically faced challenges from regulatory bodies and lawmakers, and with a US election around the corner the presidential candidates may talk about their desire to lower drug prices.

Despite any rhetoric to the contrary, substantive legislation that would adversely affect drug prices in the near term is not expected, especially if there is a split government after the election with no party controlling both chambers of Congress and the presidency. Orbimed point out that legislation regarding drug pricing was recently passed in 2022 as part of the Inflation Reduction Act and does not anticipate the issue will be revisited in the next couple of years. Overall, it seems likely there will be a constructive stance towards the approval of new drugs regardless of who is elected president.

Biotech funds to consider

These funds are provided for your information but are not a guide to how you should invest. Before investing in any fund please read the relevant Key Investor Information Document or Key Information Document, and Prospectus to ensure they meet with your objectives and risk appetite.

While a passive approach of investing in global pharmaceutical and biotechnology companies is one way to try and capture opportunities while spreading risk, given the complexities of the sector we believe there is scope for specialist active managers to add value.

  • Worldwide Healthcare Trust is one option. Managed by Orbimed, the largest dedicated healthcare investment firm in the world, it is presently tilted towards biotech but contains a mix of companies across the pharmaceutical and medical technology and services spectrum. This tends to make it less volatile than pure biotech investments such as Biotech Growth Trust, which is managed by the same team. This more specialist trust offers pure exposure to biotechnology firms, but should be considered even higher risk as a result. Biotech Growth doesn’t form part of the Charles Stanley Direct Preferred List of funds for this reason, but our Collectives Team hold it high regard for adventurous investors willing to dedicate a small segment of their portfolio to this sub-sector alone.
  • Meanwhile, other options for broader growth investments with a significant weighting in innovative healthcare include Baillie Gifford Positive Change and Scottish Mortgage Trust, also run by Baillie Gifford. Investors already owning either of these popular investments, or similar global funds with lots of earlier-stage healthcare exposure, should be careful not to unintentionally double up in this area through other holdings.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

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