Time for a small dose of smaller companies

A recovering biotechnology sector points IBT to a growing opportunity in small caps…by Alice Rigby

 
Over the last two years, the biotechnology sector has suffered. The emergence from the COVID pandemic was particularly painful as the trend-led support for the sector melted away amid a broader storm for equities. The NASDAQ Biotechnology Index has only just returned to the valuation it saw three years ago, following a 30% rise in 2021 and subsequent plummet in 2022.

However, some promising data is emerging for the sector. The most notable is a marked rise in the value of both M&A deals and IPOs coming to market in the first four months of this year and, in the case of M&A, throughout 2022 according to data compiled by Biopharmadive, after a stunted period for both across 2020 and 2021 due to COVID-19 restrictions and overheated valuations.

It is also notable that the bear market for biotechnology stocks has gone on longer than in any previous cycle. Although this should not be read as an indicator in isolation, combined with the deal data coming through it is suggestive of a market on the precipice of a new stage.
 

On solid ground

 
The team behind 12-month sector-leading trust, International Biotechnology Trust (IBT), have developed a distinct methodology for distinguishing where we are in the biotechnology valuation cycle. Their five stage cycle identifies the signals that show progression through each stage and helps indicate where co-lead managers, Ailsa Craig and Marek Poszepczynski, could seek opportunities.

The promising trends emerging in the first half of this year have led Ailsa and Marek to be cautiously optimistic, suggesting that the sector has reached an early ‘equilibrium’ stage; although they say it is worth remembering that biotechnology still rides the waves of the broader equity market and can therefore be impacted by trends within it, such as the banking crisis earlier in the year which was challenging for some earlier stage biotechnology valuations. These challenges also mean that generalist investors are still largely staying away from the sector.

Nonetheless, the changing context for biotechnology has prompted Ailsa and Marek to begin evolving the portfolio for a new stage in the cycle.

Earlier this year, we discussed how they were focusing on the kind of revenue-generating mid-caps that were key targets for larger-cap firms in the “recovery” stage of the cycle. While these kinds of companies remain a key part of the portfolio mix, with the patent expiration cliff edge meaning plenty of merger activity is expected in this area, Ailsa and Marek have begun to look further down the capitalisation spectrum to find new homes for the cash received from M&A deals in the portfolio.
 

Treading carefully among smaller caps

 
Given that risks remain for the sector, they are being very selective when allocating to smaller, riskier companies. One strategy is to focus on companies that have just been through a binary event – for example a clinical trial – as typically the next binary event will be some way off. At this stage, valuations are less impacted by investors seeking to make short-term profits off the outcome of these types of events.

Another tactic the pair apply is to avoid the most crowded markets, where too many businesses are trying to solve the same problem. In this early stage science, it can be challenging to determine which solutions will ultimately be successful, either from a scientific or commercial perspective. Instead, they focus on areas where technologies are broadly maturing and key players are already emerging, such as in gene therapies where they have made several investments.

As ever, Ailsa and Marek also seek businesses meeting unmet medical needs which are well-run and well-financed, with management and ownership structure particularly relevant for businesses of this size.

The outlook for biotechnology is brightening. Though further clouds could still colour the horizon, the IBT team is responding to the positive news cycle by slowly, carefully adding smaller companies to their portfolio. Crucially, this fits into their long-held investment strategy, which focuses on generating long-term growth while managing portfolio risk.
 
View the latest research on IBT here >
 

 

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_{Disclosure – Non-Independent Marketing Communication}

_{This is a non-independent marketing communication commissioned by International Biotechnology. The report has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on the dealing ahead of the dissemination of investment research.}