Drug prices pose an ethical dilemma. On the one hand, treatments should be affordable to those who need them, but on the other, companies will have to finance many failed drug development attempts in order to uncover the successful few, so each life-saver may carry a hefty price tag.

While pharmaceutical companies tend to deal with well-known generic drugs, biotech companies focus on developing new drugs made from living organisms, aimed at treating conditions and diseases that have no cure as yet.

US INNOVATION

For a drug to be approved on the US market – the largest in the world – it has to go through three phases of clinical trials, as set out by the Food & Drug Administration (FDA).

Phase I tests a drug’s safety on healthy volunteers, looking at dosage and side effects. Phase II assesses effectiveness, and phase III involves large-scale trials.

Biotech firms burn through cash on research and development (R&D), but only around 8 per cent of drugs make it through the clinical trials to achieve FDA approval. Accordingly, biotech has never been an investment for the faint-hearted.

The majority of healthcare innovation still comes from the US, where most biotech firms are based.

‘US consumers pay more for drugs than the rest of the world, and that subsidises the R&D to develop these drugs. The rest of the world benefits from that, without having to pay those high prices for the exact same drugs,’ says Geoff Hsu, manager of Biotech Growth Trust.

In his book Bad Pharma, the academic Ben Goldacre criticises pharmaceutical companies for spending a large proportion of their budget on marketing rather than on R&D. Does the same apply to biotech?

Hsu says that in contrast to pharma, biotech companies deal with more niche drugs, such as those to treat ‘orphan diseases’ (conditions that affect fewer than 200,000 people). As a consequence, they focus their resources on R&D rather than marketing and sales.

Biotech companies tend to have one lead drug that drives the bulk of their value, so pharmaceutical companies are keen to incorporate innovative biotech start-ups in their business. Mergers and acquisitions are a regular feature in the sector, pushing up prices during the sector’s growth periods.

From 2010 to July 2015, the biotechnology sector had a remarkable bull run. The Nasdaq Biotech index surged by 350 per cent during that time.

DRUG PRICING SCANDALS

It was drug pricing that precipitated the trouble that began in September 2015, when hedge fund manager and pharmaceutical executive Martin Shkreli acquired HIV drug Daraprim.

He raised the price of a tablet from $13.50 to $750 (£10 to £564), increasing the cost of treatment for patients to hundreds of thousands of dollars.

Gilead, which produces hepatitis C drugs, was also taken to task for its high drug prices. In response to the scandal around Daraprim, presidential candidate Hillary Clinton tweeted in September: ‘Price gouging like this in the speciality drug market is outrageous. Tomorrow I’ll lay out a plan to take it on.’

Clinton’s tweet was seen by many analysts as a turning point for biotech fortunes.

But what has really destabilised the sector, according to Jason Hollands, managing director of Tilney Bestinvest, is her plan to cut patent exclusivity periods from 12 years to seven years, so generic manufacturers can make cheap copy-cat versions earlier, helping to drive down drug prices.

But this also reduces the period when biotech firms can make profits to recoup costs.

Sentiment was further dampened by the share price collapse at Valeant, a highly acquisitive drug firm laid low by its debts and (as yet unproven) allegations of accounting irregularities. As a result, investors lost confidence and the Nasdaq Biotech index crashed by 35 per cent.

It could also be argued that the sector was ripe for a reversal because valuations had run so far ahead of reality, and Clinton’s comments merely provided investors with an excuse for the pullback. In addition to outflows in 2015, biotech saw another large drawdown in 2016.

This was due to general market weakness, China’s slowdown and the falling price of oil, says Hsu, ‘even though, when you think about it, biotech has nothing to do with growth in China or the price of oil’. Managers pulled out of biotech to reduce risk.

M&A OPTIMISM

Now, investors need to make a call on whether to return to a sector that is so intricately related to US policy.

Despite the very public discussion around drug pricing in the run-up to the US presidential election on 8 November, Hsu does not expect any major legislative changes to happen given Republican control in the US Congress is likely to continue.

However, he expects M&A activity in the second half of 2016 to help turn the sector around. ‘We’ve already seen some hints of that: Pfizer just acquired Anacor at a 55 per cent premium; Sanofi is in the midst of making a hostile bid for prostate cancer drug company Medivation.’

His optimism may not come as a surprise – after all it is counter-intuitive for fund managers to talk down the prospects of the assets they manage.

To what extent do other fund managers echo his optimism for the sector? David Coombs, head of multi-asset investments at Rathbones, holds biotech giant Amgen in his medium-risk fund and the Biotech Growth Trust in his higher-risk fund.

Coombs likes biotech because it is not cyclical, which means the sector can perform well in a low-growth environment. In the run-up to the US presidential elections biotech stocks might continue to fall, but Coombs sees that as a buying opportunity.

Jake Robbins, manager of Premier Global Alpha Growth fund, points out that the more mature businesses in the sector such as Gilead, Amgen and Celgene, which already generate huge profits from successfully developed drugs, ‘now all look extremely attractively valued’.

‘Strong cash flow generation enables these companies to invest in many potential new drugs, whilst also offering the investor reasonable dividend yields in the meantime as their pipelines mature.’

STOCK AND FUND PICKS FOR EXPOSURE TO BIOTECH

Daniel Greenhough, investment manager at Lumin Wealth Management, likes the Polar Capital Biotechnology fund: ‘The lead fund manager is a specialist in this area and supported by a particularly strong team.

‘We currently hold the less speculative Polar Capital Healthcare Opportunities fund, run by the same team, in our model portfolios.’

Danny Cox, chartered financial planner at Hargreaves Lansdown, says the primary argument for investing in healthcare companies is simple: people are living longer but obesity, cancer and other illnesses are becoming more prevalent, triggering a growing demand for treatments or cures.

‘Although there are a number of actively managed funds which focus on investing in pharma or biotech, few of these have added value over the long term. However, there are a number of exceptional managers who invest within a wider remit but are heavily skewed to the healthcare sector.’

Currently 29 per cent of Woodford Equity Income fund, 26 per cent of Jupiter European and 23 per cent of Threadneedle European Select are invested in this area.

Carl Harald Janson, lead investment manager at International Biotechnology Trust, has some tips for those looking for direct equity exposure.

He says good areas to invest in are businesses that ‘are exposed to strong top-line growth such as Genmab (which recently co-launched a new drug, Darzalex, for the treatment of cancer of the bone marrow), and companies that could be taken over such as Medivation, which is in the middle of such a process’.

UP-AND-COMING STOCKS

The well-established biotech firms, including the 10 largest constituents of the Nasdaq Biotech index, trade at a discount to the broader US market, at around 13.4 times earnings for this year and 12 times for next.

But it is a different matter when it comes to up-and-coming biotech stocks with drug development still at early stages.

Taking the S&P Biotechnology Select Industry index as an example, its 10 biggest firms are forecast to generate a combined net profit of around $1.5 billion this year and $2 billion in 2017, says Russ Mould, investment director at AJ Bell.

However, nearly all those profits come from just one of the 10 – a powerful indication of the gamble taken by investors in this arena.

‘The larger biotechs do generate cash and have the potential to be dependable core elements of the equity portion of a portfolio. The start-up stocks are really only suited to very risk-tolerant investors in search of capital gains, who have a high tolerance for loss,’ says Mould.

He says they are best accessed through a fund to get the benefits of diversification and, therefore, lower risk.

Although the sector has bounced back since the February lows, Hollands thinks further comment from presidential candidates could spook the sector. Also, a Fed interest rate rise may negatively impact speculative and leveraged stocks such as biotech.

While it is easy to get excited about the pace of medical discovery, and it’s certainly the case that some of the returns investors have enjoyed in biotech have been astronomical, Hollands urges caution, as the sector remains extremely volatile.

But given the ageing populations of the West and developments such as antibiotic resistance, biotech is likely to remain a productive area of healthcare for many years to come.

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This article was originally published in Money Observer on 19 July 2016: http://www.moneyobserver.com/our-analysis/it-time-to-invest-biotech