Horacio Coutino, Multi-asset Strategist
Overview
The biotech sector gained significant public attention during the global COVID-19 pandemic due to the rapid vaccine development by key industry players. This highlighted the immense potential for innovation within the sector.
While the biotech industry offers significant growth opportunities for investors, it is important to acknowledge the headwinds posed by macroeconomic factors, such as the prevailing interest rate environment, and regulatory challenges, including those stemming from the Inflation Reduction Act (IRA). The sector itself is inherently characterised by significant volatility due to its dependence on clinical trials, regulatory approvals, and commercialisation efforts.
Within this research, we focus on key features of the biotech investment landscape as well as the implications for investors of novel drug discovery technologies, including artificial intelligence and machine learning.
Finally, we assess how incorporating biotech investments can enhance portfolio diversification, and analyse the primary drivers of the industry's outperformance.
What is really considered biotech?
Biotechnology, broadly defined, encompasses the development of medicines derived from living organisms, in contrast to pharmaceuticals, which are traditionally based on chemical synthesis. However, the distinction between these two sectors has become increasingly blurred as companies use both biotechnology and chemical sources in their medical research and development (R&D) efforts, which has led to the emergence of the term ‘biopharma’ which is more likely to be used. However, it must be remembered that biopharma relates to the medicines that are produced as a result of those biological processes and products. All biopharma products come from biotechnology research and production, not the other way around.
Leading companies in this sector include Amgen, Regeneron Pharmaceuticals, Vertex Pharmaceuticals, Gilead Sciences, ArGEN-X, Alnylam, Moderna, Biogen, and BioMarin Pharmaceutical.
Small- and mid-cap companies now constitute a significant portion of the biotech industry, largely due to the surge of biotechnology companies entering the public markets during the COVID-19 pandemic. While these companies offer the potential for substantial returns, it is crucial to recognize the inherent challenges and risks associated with drug development, which is a long and complex process.
Key risks in Biotech: development, regulatory approval, and commercialisation
Research and Development
Drugs have to go through a variety of staged trials to ensure their safety. As a result of the extensive time and inputs required for a drug to pass through the requisite stages, estimates for the cost of developing a new drug vary significantly, ranging from $0.8 billion to $2.3 billion, according to a report by the Congressional Budget Office. This variation stems partly from differing methodologies. Furthermore, it is crucial to note that Research and Development (R&D) costs have been steadily increasing, with an annual growth rate of approximately 8.5% over the past decade.
The substantial R&D expenditure required to bring a new drug to market reflects the inherent risk of failure in the drug development process. Some estimates suggest that up to 60% of R&D costs can be attributed to attrition, or the failure of drug candidates during development. In fact, only about 10% of drugs that enter Phase 1 clinical trials ultimately gain regulatory approval. This success rate varies considerably across therapeutic areas, with haematology demonstrating the highest likelihood of approval from Phase 1 (26.1%) and oncology the lowest (5.1%).
The specific stages of drug development will be discussed in greater detail below. However, analysing success probabilities by stage, we observe a 63% transition rate from Phase 1 to Phase 2, 31% from Phase 2 to Phase 3, 58% success rate within Phase 3 trials, and an 85% success rate during the regulatory review process.
Given these challenges, biotech companies must allocate significant resources to R&D to both advance existing drug candidates and replenish their pipelines. However, if a drug fails to demonstrate adequate safety or efficacy, these investments may be partially or entirely lost.
Regulatory Approval
Biotech companies face a critical trade-off in clinical trial design. They must balance the need for expedited development with the generation of comprehensive data from a broad patient population, all while adhering to stringent regulatory standards for approval and reimbursement. To navigate this complex landscape, companies engage in ongoing dialogue with regulatory authorities throughout the development process, submitting applications for approval once all necessary data has been collected.
However, if regulators deem the clinical data insufficient, they may require additional studies to be conducted. Following a thorough review of the clinical data, regulators issue a decision on drug approval. In cases where approval is not granted, a complete response letter outlining the deficiencies is issued.
In the US, drug approval rates have improved significantly since the 1990s. As noted by Nature, the median Food and Drug Administration (FDA) review time decreased from 26.6 months prior to the Prescription Drug User Fee Act (1992) (PDUFA), which authorized the FDA to collect fees from drug companies to 9.9 months after the Food and Drug Administration Safety and Innovation Act (2012), which created new designations that eliminated the requirement for evidence of added therapeutic benefit for FDA expedited drug review. Between 1993 and 2003, the Food and Drug Administration (FDA) granted first-pass approval to an average of 37% of drug applications annually. This approval rate increased significantly between 2013 and 2023, reaching an average of 86% per year. This improvement is largely attributed to increased communication and collaboration between sponsors and regulators throughout the drug development process, including more frequent interactions and the availability of flexible and innovative regulatory pathways for specific indications.
Commercialisation
Upon regulatory approval, biotech companies initiate the commercialisation process, introducing their drugs to the market. This involves deploying a sales force, which can range from dozens to hundreds of individuals, establishing patient support services, and in certain cases, utilising direct-to-consumer advertising (permitted only in the United States and New Zealand). While drug developers are prohibited from promoting off-label use, physicians retain the discretion to prescribe approved drugs for any medically appropriate purpose.
To incentivise drug development, governments grant patents, conferring limited-duration monopolies, typically lasting 20 years from the patent filing date, which may precede regulatory approval by a considerable period. In addition to patents, regulatory authorities may grant market exclusivity for specific durations.
Drugs that demonstrate substantial clinical value, offering significant improvements over existing standards of care, command considerable pricing power. This is reflected in the high and relatively stable gross margins observed across the biopharma industry.
However, drug pricing remains a persistent focus of attention for policymakers, payers, patients, and other stakeholders. Notably, the Inflation Reduction Act (IRA) of 2022 introduced a provision for Medicare price negotiation for certain drugs after a defined period of market exclusivity. This legislation is anticipated to have a significant impact on pharmaceutical pipelines, M&A decisions, and therapeutic/technology focus areas.
Strategic patience: biotech investing
Investors assume the inherent risks of biotech investing in pursuit of potentially outsized returns. Even within the context of the protracted biotech bear market, which has now extended for over three years, companies achieving clinical, regulatory, and commercial success can still generate substantial returns, underscoring the importance of active stock selection within the SPDR S&P Biotech ETF (XBI).
However, the primary factors driving the biotech market's performance from 2021 to the present are macroeconomic uncertainty and negative earnings estimate revisions. Persistent inflation, coupled with rising interest rates, has created a challenging environment for long-duration and risk-sensitive assets. Both the XBI and IBB (iShares Biotechnology ETF), with their inherently high-risk profile, have been particularly vulnerable to these macroeconomic headwinds. The prevailing ‘higher-for-longer’ rate environment has also constrained funding within the sector, which is heavily reliant on equity markets, and has hindered M&A activity, a key driver of performance for the industry.
Additionally, the past three years have witnessed a trend of negative earnings estimate revisions across large-cap biotech companies. This has driven underperformance for the largest constituents of the index, as generalist investors have been reluctant to allocate capital to a sector facing downward earnings revisions. This sentiment has had a cascading effect on the small- and mid-cap segment of the market. While the two leading Biotech ETFs, XBI and IBB, generally followed similar trends, a divergence emerged in June 2024. Specifically, the XBI broke with the prevailing trend.
Source: Factset
Therefore, a forward-looking perspective reveals compelling investment opportunities within the biotech sector. This optimism is justified by several key factors.
Firstly, sustained innovation. Despite industry headwinds, the Biotech sector continues to demonstrate robust innovation, leading to the development of novel therapies for unmet medical needs and advancements in drug discovery and clinical trial efficiency.
Furthermore, the recent emergence of groundbreaking anti-obesity medications perhaps best exemplifies the potential of new product cycles within large addressable markets. Similar advancements are anticipated in therapeutic areas such as Alzheimer's disease and pain management, promising to drive significant returns for the sector.
Finally, M&A is a strategic imperative. While funding for M&A has faced challenges, pharmaceutical companies possess substantial balance sheet capacity for acquisitions, and many are facing patent cliffs in the coming years. We anticipate these companies will need to deploy significant capital through the next decade, with returns accruing to the biotech companies engaged in drug discovery and early-stage development of new agents.
Decoding biotech value: frameworks and catalysts
Biotech valuations are heavily influenced by the prevailing interest rate environment. This is because valuations are primarily determined through discounted cash flow (DCF) analysis over extended periods, often spanning 15-20 years, reflecting the typical drug life cycle. In low-interest-rate environments, the cost of capital decreases, leading to lower discount rates and higher valuations, all else being equal. Conversely, a rising rate environment increases the cost of capital across the sector, which is characterised by frequent capital infusions, exerting downward pressure on valuations.
While DCF analysis is prevalent, multiples-based approaches, such as EV/EBITDA or P/E ratios, can be valuable for assessing profitable, large-cap companies. These metrics facilitate comparisons among peers and against historical trading ranges. In the current biotech bear market, EV/cash multiples can be particularly informative for out-of-favour, clinical-stage companies. This approach can identify companies trading below cash value and assess the validity of such market valuations. While undervaluation may be justified in certain cases, such as following a clinical trial failure, this methodology can also uncover companies trading at a discount relative to the potential value of their cash reserves and pipelines.
Biotech performance, particularly for clinical-stage companies, is heavily influenced by catalysts—events that provide investors with crucial insights into a drug's potential for success. These catalysts offer critical information on a drug's efficacy, its likelihood of market entry, and its anticipated competitive positioning.
Foremost among these are clinical trial results, which can be disseminated through various channels, including press releases with topline data, presentations at medical conferences, and publications in peer-reviewed medical journals. Additionally, competitor results, disclosed through similar mechanisms, provide crucial context and shape investor understanding of the competitive landscape. Finally, regulatory actions, encompassing activities throughout the drug development and approval process, such as regulatory meetings, clinical holds, filing acceptances, advisory committee meetings, and PDUFA dates, all contribute to investor assessment of a drug's potential.
Patent cliffs & FTC’s antitrust concerns in M&A
A significant driver of M&A within the biopharmaceutical industry is the impending patent cliffs of key products in existing pharmaceutical pipelines. As numerous products face the loss of market exclusivity in the latter half of this decade, sustained revenue growth for pharmaceutical companies hinges on their ability to acquire and develop new assets with robust commercial prospects. These acquisitions must collectively offset the anticipated revenue decline from patent expirations of blockbuster drugs such as Merck's Keytruda, Bristol Myers Squibb's Ocrevus, and Johnson & Johnson's Darzalex.
Consequently, there is a premium on de-risked, commercial-stage, or near-commercial assets that can generate substantial revenue within the next 3 to 5 years. This has led to a concentration of acquisitions in this category over recent years, such as the $924 million acquisition of Revance Therapeutics by Crown Laboratories this year, in addition to Pfizer’s $43 billion acquisition of Seagen, and AbbVie’s $10.1 billion acquisition of ImmunoGen in 2023.
Source: Factset
Generally, small- and mid-cap biotech companies are more likely to be acquisition targets compared to their large-cap counterparts. This is attributed to a variety of factors including ease of integration (smaller companies often have a more focused product portfolio).
Despite the clear need for acquisitions to fuel revenue growth and the availability of ample capital, large-cap biopharma companies have demonstrated a degree of reluctance to deploy capital for M&A in recent years. This hesitancy is partly attributed to increased scrutiny and more restrictive policies from the Federal Trade Commission (FTC). The FTC, tasked with enforcing consumer protection laws and preventing unfair business practices, has intensified its focus on M&A activity within the biopharma sector. Draft guidelines introduced in July 2023 highlight concerns regarding mergers that either eliminate potential competitors in concentrated markets or further increase concentration in already concentrated markets.
This heightened scrutiny was evident in the FTC's challenge to Amgen's acquisition of Horizon, despite limited precedent for such action, and the extended review of Pfizer's acquisition of Seagen. With antitrust considerations at the forefront, there may be a shift towards ‘bolt-on’ acquisitions, favouring the acquisition of small- and mid-cap companies over mergers between similarly sized entities.
AI/ML’s promise in accelerating drug discovery
The convergence of biotechnology and advanced technologies, such as neural networks, natural language processing, generative AI, and cloud computing, is poised to revolutionise drug discovery and development. These technologies offer the potential to analyse massive datasets, identify promising drug candidates, predict protein structures and drug-target interactions, elucidate disease pathways, and optimise clinical trial design and commercialisation strategies. This convergence promises to reduce both the time and cost associated with traditional approaches.
While biopharma companies have historically employed computational biology and data analytics, the advent of large datasets, advancements in human genomics (including next-generation sequencing and the Human Genome Project), and rapid technological progress have fueled increased interest in and adoption of artificial intelligence (AI) and machine learning (ML) for predictive modelling in drug development.
Despite the nascent stage of this field and the limited number of approved AI-discovered drugs, evidence supporting the integration of AI/ML in drug discovery and development is emerging. Analyses of AI-discovered drugs indicate an 80-90% success rate in Phase 1 clinical trials, significantly surpassing the historical average of 40-65%. This suggests that AI can effectively identify and design molecules with promising drug-like properties. If these early success rates are maintained, the probability of successful drug development could significantly increase, noticeably enhancing biopharma R&D productivity.
Notable examples include the role of AI/ML in the rapid response to the COVID-19 pandemic (Moderna, Pfizer, AbCellera) and encouraging early clinical data from companies like Relay Therapeutics (positive efficacy data in cholangiocarcinoma and breast cancer) and Schrödinger (software contributed to the approvals of Tibsovo and Idhifa). However, other AI-enabled companies are perceived as less de-risked due to limited clinical data (Exscientia, Recursion Pharmaceuticals, Absci) or have faced clinical setbacks (BenevolentAI).
Larger biopharma companies, such as Amgen and Regeneron, are actively pursuing these technologies through internal R&D and external collaborations. The partnering landscape is expected to remain robust, given the inherent risks of acquisitions in this early-stage field characterised by rapid innovation and the potential for technological obsolescence.
Continued monitoring of proof-of-concept data, successful implementations, and business development activities will be crucial for assessing the potential of AI/ML in drug development. Key factors to consider include the integration of biological and computational expertise, effective execution of milestones, and platform validation through clinical data demonstrating the ability to reproducibly develop innovative therapies. The advantages of AI/ML are anticipated to drive widespread adoption, conferring a competitive edge on companies that effectively leverage these technologies.
IRA’s regulatory challenges and the potential impact of the US elections
The US has a higher per capita drug expenditure than other developed nations, primarily because most countries with nationalised healthcare negotiate pharmaceutical prices as a single payer. Another distinguishing feature of the US pharmaceutical market is the significant role of private insurance in covering drug costs.
However, the US recently adopted a limited form of government price negotiation for Medicare under the Inflation Reduction Act (IRA). Medicare is a US federal health insurance for people 65 or older, and some people under 65 with certain disabilities or conditions. A US federal agency called the Centers for Medicare & Medicaid Services runs Medicare. This initiative will initially affect pricing for ten Part D drugs, starting in 2026. Medicare Part D, also known as the Medicare prescription drug benefit, is an optional United States federal-government programme to help Medicare beneficiaries pay for self-administered prescription drugs. The programme will gradually expand to include more drugs: 15 Part D drugs in 2027, 15 drugs across Part B and Part D in 2028, and 20 drugs across both programmes from 2029 onwards. The Centers for Medicare and Medicaid Services (CMS) will select these drugs based on spending levels and specific eligibility criteria.
Looking ahead, investors generally consider health policy less influential than factors like taxes and tariffs. This suggests that major healthcare reform is unlikely, regardless of the upcoming presidential election results. However, there is investor interest in how a potential Trump administration might impact drug pricing. It is widely assumed that a Democratic administration would maintain the current approach, although Vice President Harris's platform proposes expanding the number of negotiated drugs to 50 annually.
Further developments in drug pricing policy are likely to arise through two primary avenues: legislative action and executive action. While major legislative reforms, including significant alterations to the IRA, are improbable even with a Republican electoral sweep, executive action offers a more viable path. Specifically, a Trump administration could revive the CMS’ Most Favoured Nation (MFN) model through the Center for Medicare and Medicaid Innovation (CMMI). This approach would likely target high-expenditure Part B drugs initially, with potential expansion to Part D .Medicare Part B covers outpatient prescription drugs and biologicals under certain conditions, for example, drugs provided as part of (or incident to) a physicians' service, and drugs furnished for use with covered durable medical equipment.
However, the MFN model faces potential legal challenges and could be affected by the recent overturn of the Chevron doctrine. Furthermore, implementation raises several unresolved questions. Another key consideration is the potential interplay between MFN and the IRA, particularly regarding the incorporation of international prices into Medicare price negotiations, as many drugs could be subject to both programmes.
A Trump administration would likely increase uncertainty around drug pricing policy, particularly concerning the MFN model. Conversely, if the MFN is not pursued, a less aggressive approach to price negotiation could emerge under new CMS leadership.
Key considerations in the biotech landscape
Assessing the potential efficacy of a drug begins with understanding its mechanism of action (MOA)—how it exerts its therapeutic effect. This understanding allows for a critical evaluation of several key questions: Does the drug effectively engage its intended target? Is the target relevant to the disease process? Is the chosen drug modality optimal for engaging this target and addressing the disease?
These questions inform expectations regarding both the drug's efficacy and safety, collectively referred to as the clinical benefit/risk profile. Ideally, a drug demonstrates efficacy at doses that do not cause significant safety concerns, achieving a favourable therapeutic index. However, acceptable safety thresholds are influenced by disease severity and the magnitude of therapeutic benefit. The risk assessment encompasses target risk, biological risk, and technological risk, each reflecting uncertainty along different axes of drug development.
Pursuing multiple high-risk areas simultaneously, such as utilising a novel technology against an unproven target, can increase the likelihood of clinical trial failure. A comprehensive assessment of these factors informs the assigned probability of success for each drug candidate in a given disease.
Beyond efficacy and safety, evaluating the market opportunity is crucial for determining a drug's potential value. As with any product, this assessment hinges on projected pricing and anticipated sales volume.
What might an ETF biotech portfolio look like?
For investors seeking diversified exposure to the Biotechnology sector, two prominent exchange-traded funds (ETFs) offer distinct strategies, both with over $7.4 billion in assets under management (AUM). The iShares Biotechnology ETF (IBB) tracks the NYSE Biotechnology Index, providing investors with exposure to a market-cap weighted selection of established Biotechnology companies. Conversely, the SPDR S&P Biotech ETF (XBI), tracks a modified equal-weighted index. This approach offers investors a more balanced exposure across large, mid, and small-cap stocks within the Biotechnology industry.
This difference in weighting methodologies is reflected in the concentration of their respective portfolios. The top 20 holdings in XBI constitute 47.0% of the fund, indicating a more evenly distributed allocation. In contrast, the top 20 holdings in IBB represent 65.5% of the fund.
Source: Factset
Source: Factset
How have they performed this year?
Both the iShares Biotechnology ETF (IBB) and the SPDR S&P Biotech ETF (XBI) have lagged behind the S&P 500 year-to-date, underperforming the broader market by over 10 percentage points. However, XBI has demonstrated superior performance relative to IBB, outperforming it by 4.5 percentage points during this period.
Interestingly, when extending the timeframe to one year, XBI's performance shows a significant upswing. With a return of 42.8%, it surpasses both the S&P 500's 33.6% return and IBB's 19.7% return over the same period. This highlights the potential for greater returns from a more equally-weighted approach to Biotechnology sector investing, particularly in a dynamic market environment.
How does it compare to the S&P 500 in terms of returns and volatility?
Given the inherent volatility of the Biotechnology industry, one might expect both ETFs to introduce significant risk to a traditional portfolio. However, a closer examination of their betas against the S&P 500 reveals a nuanced picture.
IBB’s beta stands at 0.88 and XBI's beta is notably higher at 1.20. This suggests that a portfolio with greater exposure to small- and mid-cap Biotechnology companies, as represented by XBI, carries significantly more risk than a market-cap weighted portfolio like IBB, which is more heavily influenced by larger, more established companies.
This difference in risk profile underscores the importance of understanding the underlying index construction methodology when selecting a Biotechnology ETF. Investors seeking higher potential returns may be drawn to XBI's equal-weighted approach and its greater exposure to smaller, potentially high-growth companies. However, they must also be prepared for the heightened volatility that accompanies this strategy.
Summary
Investments in biotechnology provide exposure to a dynamic sector that continuously pushes the boundaries of healthcare innovation. However, this sector presents unique challenges and complexities for investors.
Biotechnology investments are characterised by a fluid and often unpredictable timeline, with progress punctuated by key catalysts such as clinical trial results, regulatory decisions, and commercialization milestones. Investors must carefully evaluate a company's pipeline, management track record, and the evolving regulatory landscape to assess the potential for success.
The development of new therapies is a complex and resource-intensive process, demanding rigorous scientific research and adherence to stringent regulatory frameworks. Beyond the inherent scientific and clinical risks, companies face challenges in navigating the regulatory approval process and successfully commercialising their products. These challenges can include shifting policy priorities, manufacturing scalability, and market access hurdles.
While large, established Biotechnology companies offer a degree of stability, diversification into smaller, potentially higher-growth companies can provide exposure to innovative pipelines and breakthrough therapies. However, investors must be mindful of the risks associated with smaller companies, including patent expirations, competition, and the potential for clinical setbacks.
Successful investing in biotechnology requires a comprehensive understanding of the scientific, clinical, regulatory, and commercial factors that drive success in this complex and evolving sector. Diligent research and a long-term perspective are essential for navigating the risks and capturing the potential rewards of Biotechnology investments.
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