After seeing the successes of the likes of Pfizer (PFE) and Moderna (MRNA) in the news practically every day during this second year of the pandemic, the casual observer could be forgiven for assuming that the biotech sector is having a banner year in 2021. Such an assumption would also seemingly fit, one would think, with the fact that the broader stock market has been regularly making new highs this year. However, if you are the casual observer, you might be surprised to learn that the reality is far from it. Not only is biotech not having a rip-roaring 2021, but the sector is in fact arguably having its worst year in a decade. We biotech investors are really feeling it.
Below is the harsh reality laid out in a chart. While the total return of the S&P 500 Index is up 29.4% year-to-date through December 27 (as represented by the SPY ETF that tracks it), the S&P Biotechnology Select Industry Index is down -18.2% over the same period (as represented by the XBI ETF that tracks it). In fact, biotech is the worst performing of any of the 11 S&P 500 sectors this year (note: XBI is equal weighted. Within the biotech community, it is generally believed to represent the performance of typical mid-to-small cap biotech stocks). As a biotech investor, it is honestly bad enough to be having such a challenging year, but to be having it at a time when the broader stock market makes all-time highs is about as frustrating as it gets. So, what in the world is going on here?
If you are surprised to see the chart and want to better understand the context and the drivers causing it, I’ll try to bring you up to speed by explaining what I think are the elements that have contributed to this year’s challenging environment for biotech. Also, I’ll try to inject some optimism throughout my analysis. While this has been a year we biotech investors would like to forget, I am personally optimistic heading into 2022 (note: I generally wasn’t heading into 2021) and will explain why I think things might be much better next year regarding these elements.
1. The Honest Truth: Many biotech stocks started 2021 in a bubble valuation territory
If one looks back on the year with an open mind, I think you realistically must accept the fact that a large portion of biotech, which peaked on February 8, entered the year in a bubble valuation territory. I was worried about the possibility of this happening heading into the year because the pandemic and other factors put biotech in the spotlight, and too much money was flowing into the sector as a result. It is of course generally a good thing when investment in biotech increases. However, given the scale of the sector, it is best when it flows in with moderation and over a reasonable period. Biotech can only handle only so much at a time, or otherwise dislocations occur. That is what I believe caused a mini bubble this time last year.
For example, there is a genomics ETF that grew from $2.5 billion in assets to $12.5 billion over a three-month period from mid-Nov 2020 to the mid-Feb 2021 biotech peak. Approximately $7 billion of this was due to pure cash flowing into the fund. This kind of explosion in AUM (assets under management) for one fund is unprecedented in our sector. While it is a nice accolade for the manager, it caused a big problem for stocks. Biotech is a shadow of the tech sector and individual biotech companies do not have the scale to take in the kind of money that comes with those inflows over such a short period of time without stock prices being significantly moved. That is how a genomics company like Editas Medicine (EDIT) tripled from $30 to $90 during the same three-month period with no change in fundamentals, to illustrate one dislocation out of many.
I believe what has been happening ever since February 8 is simply a rationalization of prices as they come back down from the inflow-fueled mania. XBI is now down -34% since then, which I think is essentially a hangover effect from all the attention. While it has been painful to experience, the good news is that I personally do not believe this is the type of dislocation that takes years to recover from such as some of the bigger bubbles we have seen in history like the internet bubble of the 1990’s. The fundamentals of biology today are too strong for that to be the case, I believe. I think this is more likely the kind that results in roughly a bad year like we have been experiencing lately. A lot of good companies have been dragged down with it, and I believe there is compelling value in certain areas of the sector today if you follow the right science.
2. It has been hard for the sector to digest the numerous IPOs that have been happening
The last two years have seen an incredibly strong IPO market for biotech. Just as with inflows into already public stocks, a strong IPO market is generally a good thing, but this is another element that is best when played out in moderation and over a reasonable period, or dislocations occur. In 2020, there were over 75 biotech IPOs, and in 2021, there have been over 100. These numbers do not even include the numerous SPAC mergers that have taken place. This IPO volume is twice the typical rate for our industry. That’s too many new companies over too short a period, in my opinion, for the biotech market to be able to efficiently handle. It is going to take time for specialist investors to digest all of that. There are approximately 700 publicly traded biotech companies on U.S. markets today vs. approximately 125 in 2012. It is a great thing overall, but this type of explosive growth at times can cause natural growing pains.
Another issue with the IPO market lately is not just the sheer number of companies going public, but how early stage they generally are in their development. In fact, many biotech IPOs today are preclinical companies, meaning they have not yet started the human stage of testing of their drugs. A handful of years ago it was unusual, if not taboo, for a preclinical company to go public, but today it is quite common. This is a sign that many companies going public lately are immature and have not yet reached a proof-of-concept moment that helps investors gain a higher conviction through data that their drug or platform might work. It also means that the failure rate of such companies is likely to be high. Earlier stage companies also typically have much thinner liquidity than later stage ones and can get dragged down hard in a bad market like we have today.
I expect the IPO market to rationalize in 2022 and believe this will be a good thing for the sector overall. For years, crossover investing, which is when funds invest in private companies shortly before they go public and often also participate in the actual IPOs as well, has been like printing money in biotech. Earlier this year, I heard crazy stories about funds that are new to biotech fighting to get in on crossovers since the market has historically been so lucrative. However, the music finally stopped and many of those crossover investors are now underwater in the companies they have helped bring public, and in many cases they are stuck in less than ideal liquidity situations. Approximately, 80% of the 100+ class of 2021 biotech IPOs are currently underwater today. After being stung for the first time in many years, I think many of these crossover investors will be more discerning about the companies they take public in the future, and this will reduce the overall numbers of them. That’s not necessarily a bad thing for the overall sector.
3. Uncertainty raised by the Federal Trade Commission (FTC) put a chill on mergers and acquisitions earlier this year
Mergers and acquisitions (M&A) is always an important contributor to the overall health of biotech markets. Because biotech is so risky and volatile, a part of owning any smaller biotech company is your hope as an investor that there is at least a chance it could be acquired by a larger pharmaceutical company for a premium. In investing we call this a call option, and it has value. Take the call option away, and the risk vs. reward ratio of investing in these smaller companies changes dramatically. Therefore, it is always important for there to be a healthy level of M&A activity in the sector. When one company gets acquired, investors think they know what other companies might be acquired, and this dynamic tends to lift all boats and creates a healthy valuation floor when M&A news is regularly happening.
Unfortunately, 2021 has been one of the slowest years for biotech M&A in a decade, and I believe this has been a big factor in biotech’s mediocre year. One reason for this is because large companies have been focused on COVID, but also another key reason is because of something else that unexpectedly arose in Washington in March that threw extra uncertainty into the mix. On March 16, the Federal Trade Commission (FTC) issued a press release saying it was going to create a working group with its European, Canadian and other global regulatory counterparts to study whether pharmaceutical sector M&A was contributing to high drug prices, and therefore, whether deals should get a higher level scrutiny in the future. The problem is that it was announced in a very vague way that created a lot of uncertainty in the market.
Biotech industry people and investors realistically understand that FTC may want to scrutinize mega mergers more closely, such as when Bristol Myers Squibb acquired Celgene, for example. What is less clear is whether this announcement was also referring to smaller, bread and butter type deals where a large pharma buys a mid-cap or smaller biotech company. One such deal when Roche bought a gene therapy company called Spark Therapeutics in 2019 took many months longer than expected to be reviewed and made some of us wonder if there was change afoot at FTC. In March, the acting FTC Commissioner was asked about the Roche/Spark category of deals on a press call and she inferred that the FTC’s new interest was not about size and that those kind of deals could in fact be fair game for increased scrutiny in the future. If true, I believe this could be problematic because, as I described above, the biotech sector needs call options on companies like Spark to be funded robustly.
Ever since the announcement in March, I think the uncertainty of the messaging by FTC made pharma companies a little apprehensive about doing deals. Second quarter M&A volume plunged by the most in a decade and the third quarter was not much better. However, the good news is that pharma companies did in fact begin to test the waters starting with relatively safe deals over the summer, and we have seen them all go through smoothly. These include Sanofi acquiring Translate Bio, Sanofi acquiring Kadmon, Pfizer acquiring Trillium Therapeutics and Merck acquiring Acceleron. The recent Pfizer for Arena Pharma deal could be a little more of a close call. If deals like these continue to go though, I think biotech should be fine over the long term. It is good news for our sector that they are happening, and I think this could open the flood gates to more deals in 2022.
In fact, the number one element I think could catalyze a positive year for biotech in 2022 is that I believe it might be a mega year of M&A ahead. Large companies like Pfizer, Novartis and Sanofi have a lot of cash on the balance sheet that they need to spend to earn a return on capital. Consider the many billions that Pfizer will likely be bringing in from both covid vaccines and treatments in years to come. They need to spend a lot of it in the relative near term to be financially efficient. I believe a perfect storm is coming together to spark an M&A boom: large companies will have billions to spend, targets are generally trading at materially lower prices than they were a year ago, and the FTC issues appear to be improving (though not going away entirely) for the kind of deals that are so important for the health of the sector. In my view, this alone can spark a generally strong year for biotech in 2022 if M&A roars back to fruition.
4. The changing of administrations in Washington has naturally caused and other regulatory uncertainties
FTC is not the only source of uncertainty in Washington that has impacted biotech lately. Given how highly regulated biotech is as a sector, it is only natural that investors and the industry at large would take a cautious stance during a transition period in administrations like has happened this year. Unfortunately, in addition to the more common issues you might expect to arise during such a time, this year has also been marked by a few unexpected surprises in policy that I think have negatively affected investor sentiment as well.
First, it was unexpected in May of this year when the United States Trade Representative publicly spoke in favor of waiving intellectual property (IP) on Covid-19 vaccines. IP is the lifeblood of biotech. If you have no IP, then you have no biotech sector. Therefore, it was disappointing to see the United States, the world leader in biotech, not firmly stand behind IP. Given the sophistication required to manufacture Covid-19 vaccines, it is unlikely that such a waiver would accomplish anything tangible, and I believe it was therefore unnecessarily damaging to even suggest it publicly. Other nations such as Germany came out against the policy and stood up for IP.
Second, also relating to IP protection, President Biden signed an executive order in July that lifted a ban on using “March-In-Rights” to lower drug prices. March-In-Rights are a tool where if the federal government believes it has contributed to the creation of intellectual property of a company’s drug through federal grants or research, it may be able to waive the IP and allow another company to manufacture the drug for a lower cost. Utilizing March-In-Rights has been floated in the past as an idea to cancel the IP on innovative HIV and prostate cancer medicines, for example, but was ultimately not followed through on. It is such a touchy subject for the industry that the Trump administration formally banned March-In-Rights as a lever to give owners of IP peace of mind on this. To potentially put it back on the table erodes confidence in a fundamental core principle of the business.
Third, the administration and congress have increased efforts to enact policies they believe will lower drug prices. We all strive for more affordable prices for patients, but we also strive to ensure it is done wisely. I believe the most potentially damaging idea floated recently has been to allow Medicare and other government purchasers to negotiate drug prices unilaterally. The idea of drug price negotiations is not unworkable, the problem is that congress’s initial idea on how to structure it would have been to impose large fines on companies if the government believes they are not negotiating in good faith. The problem here is that it creates an atmosphere that is not a true negotiation. While this specific element has been discarded for now, the future direction of drug pricing reform seems clear. All of it has likely contributed to the weakness of the sector in 2021.
These issues aside, I do think the Washington factor might quiet down next year. It is not uncommon for new administrations to aim high with new policies in their first year and then come back to a more rational position during back and forth of negotiations. We have already seen this play out to a certain degree on elements of drug pricing, and I think we will likely see it occur on some of these other issues as well now that the negative impact has been clearly felt and communicated.
5. Financial sector issues may have affected biotech prices
There are also a handful of other issues relating to the financial markets that some people believe have contributed to biotech’s difficult year in 2021. I think probably the most legitimate one is inflation. Most biotech companies have no revenue today and therefore are valued based on the present-day value of revenue (risk adjusted) that is far off into the future. This means that if the present value of a future dollar becomes worth less today due to inflation, it will be these companies with far out revenue that are most affected in valuation today. Unfortunately, there isn’t anything an investor can really do about inflation, but it is something to be aware of. My philosophy is to mostly ignore it and to focus virtually entirely on a company’s scientific merits, because science is make or break and something like inflation will at best affect the periphery.
Related to inflation is deciphering what kind of moves the Federal Reserve will be making and how it might affect the sector. For years the Fed has flooded the market with dollars via an easing policy, which has benefited risk assets like biotech. Alternatively, as the Fed pulls back on the money supply through tapering, it might make some elements of investing in our sector a little more of an uphill battle. Again however, my policy is to focus on finding good companies conducting the best science and to not obsess about something that is out of my control like the Federal Reserve. A company that succeeds for patients is likely to do well regardless of the interest rate environment.
Another issue that some people think has impacted biotech stocks lately is the idea that cryptocurrency mania has lured away speculators from biotech who look for high risk areas. I personally think this theory is bunk and is not material enough to have a tangible impact on the sector’s long-term success. I am not sure it is the type of capital we want in the sector anyway. In my opinion, biotech can thrive no matter how big crypto becomes (or not) and I believe the two are entirely unrelated.
6. Biotech is naturally volatile and years like this do happen
Lastly, I will conclude with a closing thought relating to this challenging year. Biotech is a rollercoaster. It is not uncommon for years like this to happen. In fact, two of the prior five years were down not unlike this one. It always feels difficult when you are going through it. Past performance is no guarantee of future results, and nobody can predict what will happen in the future. Challenging year aside, I have never been more excited about advances in science that are happening today. I cannot wait to see where science takes us next year.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
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