The contribution of biopharma in mitigating the COVID19 pandemic and boosting the economic recovery has been undisputed. Lives are being saved, livelihoods restored, and economies rebuilt.
However, the glow from the unmitigated success on the pandemic front has not translated into boosting the biotech group's fortunes last year and so far this year. An uncertain interest rate environment, which hurts high-risk investments, the near-absence of deals, which are an important element to fueling performance, and a surplus of biotech IPOs, were a few of the key reasons that hurt biotechs. With the absence of a favorable industry tide and a miasma of uncertainty shrouding biotechs, the investment focus shifted to mitigating losses from seeking gains. It was a stock picker's market in 2021.
The healthcare sector overall did perform well and in line with the broader market, with a 24% gain for the S&P Healthcare Index. In the 2021 biotech outlook, we had expected the Nasdaq Biotechnology Index (IBB) to be up 20% for the year. That was still possible by mid-year, but the possibility quickly faded away in the final four months. The Nasdaq Biotechnology Index gained less than 1% during 2021, while the broader S&P Select Biotechnology Index (XBI) lost 20%. The Prudent Biotech model portfolio gained 49% in 2021.
Rising Interest Rate Environment Remains The Primary Risk for Biotechs
The economy is in a growth mode, unemployment is heading lower, and inflation has become a more prominent focus for the Federal Reserve. A series of rate increases is being priced in by the market with the first increase occurring as early as March. An upward-leaning rate environment is a challenge for risky assets, like biotechs, even though not an insurmountable one. But it will get messy.Risky assets perform well in a stable and low-interest-rate environment. The market needs to be able to project when the Federal Reserve will reach a point where rates can once again be steady and still remain relatively low, thus allowing for risky assets to outperform over a prolonged period. Such a point may not be reached at least till later in the second half.
Interest Rates During 2016 to 2019
To some extent, the present interest rate environment can be compared to the 2016 to 2019 period when the Federal Funds Rate rose consistently. Biotechs advanced but remained range-bound, and reached new highs only after the interest rates peaked. During that period, while the biotechs lagged, the broader market kept advancing to new highs, overcoming the interest rate concerns as economic growth remained steady.
Where the historical scenario diverges in today's context is inflation. During the 2015-2019 period, the rate increase cycle was to primarily reduce the accommodating stance, as its need dissipated, and to allow the Federal Reserve with maneuvering room in its monetary policy for the next crisis. In 2022, the objective is to not only reduce such unneeded accommodation, but to also urgently address the issue of inflation.
This will be the first time in over 30 years that the Federal Reserve will be using its toolkit to combat material inflation. And it is this chapter of taming inflation where the risk lies, particularly for high-risk market segments like biotechs. Bringing inflation within expectations can lead to unexpected or prolonged interest rate moves. While the Federal Reserve has shown its ability to pivot fast in recent crises, a faster pivot to curb inflation runs the risk of an over-tightening and sap the economic momentum.
If the market begins to observe progress on the inflation front and the projected pace of rate increases drops off sharply in 2023, then investors can witness a stronger second-half for biotechs. However, getting to that point will be a road paved with significant volatility for riskier assets, as biotech rallies will emerge, but would be hard to sustain.
Biotechs Can Be The Undervalued Play Later in 2022
A pendulum that swings to one side eventually swings back.
With the S&P and Nasdaq biotech indexes down over 50% and 30% respectively from their peaks, we are approaching a point where the steep decline begins to moderate in the second quarter. That will provide investment opportunities, though the industry group is unlikely to make a new high this year. The biotech investing landscape will be an even more selective one during 2022.
M&A and Licensing Deals
Last year started strong with multiple transactions but then tapered off. There were about 24 major public and private transactions in 2021. During December 2021, there was a spurt of licensing and acquisition activity led by Pfizer's (PFE) purchase of Arena Pharmaceuticals (ARNA) for nearly $7 billion. This followed the purchase of Dicerna Pharmaceuticals (DRNA) by Novo Nordisk (NVO) during November. In January, Zogenix (ZGNX) was acquired by a European pharmaceutical company.
Many pharmaceutical companies have expressed strong interest in acquisitions. Pfizer intends to be aggressive as it deploys its huge cash resources generated from the COVID-19 vaccine business. And Pfizer is not alone in its interest to acquire. Other major pharmaceutical companies, including Johnson & Johnson (JNJ), Merck (MRK), Elly Lilly (LLY), Bristol Myers (BMY), Novartis (NVS), and Sanofi (SNY), have recently expressed strong interest as well.
Biotech valuations eroded last year and have slipped further since, which contributes to a more favorable environment for M&A activity. A shift in some other key elements may also assist M&A.
A surge of capital influx over the past few years for biotech companies created an environment where deal activity was not eagerly sought by these companies due to easy access to financing for funding trials and programs. When private biotech companies sought liquidity for investors to cash out, the public market access provided such liquidity through the IPO route. There has been no urgency to negotiate on the part of biotechs.
Even after Phase III successes, a growing number of biotechs are launching products directly instead of selling out or entering into marketing alliances. The number of first-time launchers remains at an all-time high. In a report from early last year, McKinsey estimated that the share of first-time launchers since the great recession has nearly tripled.
Deal activity is hard to predict, but it is an important driver of industry valuations. A combination of a valuation meltdown, a tightening of public and private market access for capital, and hopefully a greater willingness to negotiate and sell on the part of biotechs now in a tighter financial environment, can provide the momentum to spur more deal activity as the first half matures.
Scientific Advances Keep Coming
The success of Moderna (MRNA) and BioNTech (BNTX) over the past two years has showcased the positive impact of relatively newer, front-line approaches. The scientific frontiers have continued to advance at a rapid pace, pushed forward by a gush of funding to support innovative approaches and paradigm shifts.
The rapid development of mRNA vaccines has demonstrated the relentless pace of discovery, which is generating new treatments in a shorter time. The pace of advancing treatments from discovery to Phase 1 trial has accelerated over the years, shrinking to about 3 years from what used to be about 5 to 7 years historically.
The cornucopia of platform-driven approaches from gene editing to RNA to allogeneic CAR-T cell therapies for cancer, underscore the transformational nature of the treatments and the relentless quest for new drug discoveries for old maladies. By 2035 or perhaps even earlier, we may close in on a first trillion-dollar US healthcare company.
Healthcare is a defensive industry and relatively outperforms during periods of volatility and market stress. However, biotech is a high-risk, speculative segment of healthcare and is amongst the most affected in a risk-off environment. While the interest rate policy remains unsettled, at least for the first half, the high-risk segments of the stock market will remain under pressure and find it harder to sustain an advance.
In our opinion, biotechs will begin to consolidate and build a base after the first rate increase in March. Second-quarter performance will be relatively better than the first, and the performance will keep improving in the subsequent quarters of the year. Biotechs will witness sharp rallies and retreats during this period of consolidation as the indexes grind higher. For the year, we anticipate the biotech indexes to be in the range of -5% to +5%. This assumes that the FED's inflation targeting strategy will include 3-to-4 quarter-point rate increases this year. This return expectation is simply a general framework and will need to be adjusted if market conditions deviate significantly from current expectations.
After the sharp biotech sell-off in January, the Prudent Biotech model portfolio is presently 25% invested. Fundamentally, biotechs continue to be well-positioned based on promising scientific advances. There will be meaningful opportunities to materially outperform the biotech indexes. But there will be times when reducing the exposure may be best in a hostile investing climate, based on the investment approach. The contraction of P/E multiple and the tendency for exaggerated moves in a volatile period will require patience to negotiate. This year will again be a stock picker's market for biotechnology.