This sector is booming - but have investors missed the boat?

With biotech and healthcare stocks making massive gains, interactive investor's senior fund content specialist talks to Ailsa Craig, manager of the International Biotechnology Ord (LSE:IBT) trust, about what has happened - and what might come next.

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Dave Baxter, senior fund content specialist at interactive investor: Investing in something that does good in the world has an intrinsic appeal to it, and that's even more appealing when it's accompanied by strong investment performance. That is fortunately something we've seen in the last year or so from the biotech and health care space. We've seen some very, you know, frankly stunning returns from companies and funds in that sector after a period of more tricky performance. So that's exciting for investors, but the question, of course, is can it continue? If you're interested now, have you already missed the boat?

And if you haven't, what should you be bearing in mind when getting involved? So welcome back to On The Money, the show where we look at the issues affecting your savings and your investments. I'm Dave Baxter here at ii. We're going to be looking at this sector and we have a great specialist with us to talk it through. That's Ailsa Craig, one of the managers on the International Biotechnology investment trust.

So Ailsa, many thanks for coming on today.

Ailsa Craig, manager of the International Biotechnology Trust: Thank you for having me.

Dave Baxter: So let's start with some context for those who haven't been kind of monitoring this space before. As I mentioned, we've had some enormous gains in the last year or so after a period of quite challenging performance. What have been, I suppose, the kind of main drivers if you were to sum it up?

Alisa Craig: Okay. So if we take a step back, going back into the Covid era, it's now quite a while ago.

Dave Baxter: Many years back.

Ailsa Craig: Exactly, it really is. We had a lot of hype in biotech. The sector rallied really strongly on the back of discoveries around the vaccines and the treatments to do with the pandemic. We also saw a period of time at the same time when people were at home and we called them armchair investors, so a lot of retail interest. And to summarise, the sector did get a little bit overheated.

So we had this overheated valuation setup, we expected a correction at the time, our fund, International Biotechnology trust, moved into more stable, profitable names at the time just to weather any storm that was ahead. And then going into 2022, we saw a correction in valuations, as expected. We then had a second punch, so if you think of the first punch being valuations, the second one was interest rates. So interest rates started to ratchet up after a long period of loose money policy. These are long dated assets.

So, biotech companies don't have debt. They do, however, have cash flows in the future and when you discount those cash flows back by a higher interest rate, you're going to get a lower valuation.

And that's what we saw in 2022/23 time. Then the third punch was politics. So Trump won the election and the previous time he was in power, this sector did really well, it was up like 40%. So we saw a recovery emerging and then he announced quite a controversial head of Health and Human Services, so the healthcare division in the government in the US, RFK, and that sent our sector into a bit of a spiral down.

That also coincided, at the same time coincidentally, with the tariff announcements. And in April last year we had this day called Liberation Day and the whole of the equities market pretty much were hit by these tariff headlines and then superposed on top of that we also had this health and human services controversy.

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So we had a nadir. Now the beauty of investing in this space in a closed ended manner is we can gear up. So we geared up to 20%, which was our highest level since Bear Stearns blew up in 2008, that really is going back.

So we felt very strongly that the sector was oversold, and we've had a strong move since that period.

Now that recovery has taken us back to similar levels we were in the pandemic era. Yet behind the scenes, these companies have been growing and maturing and generating earnings and profits, many of them.

So although on an absolute basis we've seen this huge move, valuations certainly in the names that, we're very valuation sensitive, are looking really attractive to us. So the boom that we've had has been driven by a number of factors aligning. The politics has become a lot more palatable, so we've had some turmoil in the regulator, the FDA, and some changes there and that's kind of been normalised.

The tariff issue we've had deals struck by 16 major pharma companies with the US administration and we've also had some deals with the SMID cap-ey names with the US administration as well, so that seems to have abated.

And then on the positive side, on a macro level, we've had a lot of M&A. Now, that's really been a massive driver. So, we actually had our fiscal year end at the end of August, so a week or so ago, and I've just been doing the numbers for the annual report, and over a quarter of our fund has been acquired across 13 companies, and that's been peer-leading in the number of companies that have been picked up.

We've had great premiums in those deals, and that's behind a lot of this move that you've seen, like you say. So we are where we are, we've had a nice recovery, the IPO window that's been closed for a long period of time is now opened.

Generalists are closing their underweights, they're not fully loaded, they're closing their underweights. So there's a lot of positive factors here. However, biotech is a small ship on the big sea of equities, you know you can't, looking forward, assuming we have a normalised equities market, we're very happy with the valuations we're seeing.

We have taken profits in a lot of the names that have done well coming out of Liberation Day. We've obviously reduced our gearing because it's something we actively manage. We love having this facility to use in a downturn or a sharp sell-off that's more often than not, has nothing to do with our companies, so it's a great tool that we have in the box. But that's, we are where we are, like we said, we've moved the fund into kind of commercially launched names, so clinically de-risked, and we think those look great value.

Dave Baxter: Yeah, so, it’s striking that you talk about like a quarter of the portfolio being kind of taken out. I was thinking earlier of the kind of M&A spree. It weirdly reminds me of, you know, if you're a kind of long-suffering UK equity investor, you've seen the market pick up very nicely in recent years, but a big chunk of that as well has been M&A. And at least here, there's, you know, concerns about, I guess, what's left and whether the market is shrinking. You mentioned the kind of IPO window opening in your sector.

Like, how…how is the balance working out between companies getting taken out and new companies emerging, and what's the, I suppose to use the jargon, what's the kind of “opportunity set” like?

Ailsa Craig: Yes, so what I'm gonna to answer this question. We get asked this a lot. I'm gonna take a step back and talk about the evolution of a new pharmaceutical drug.

So the way we see it is that ideas, especially in recent decades, generally come out of university. So you get new target discoveries, say for a specific cancer, what have you, they bud out of university, they get venture backing, seed funding, and then they mature and list on the stock market, and then they either remain independent and, you know, hire a load of salespeople, hire and develop manufacturing facilities, or they sell themselves. Now, big pharma are the ones that pick them up. They have already in place huge sales and distribution and they're very good at it, and manufacturing.

Now, we see this evolution as like a life cycle of innovation, like converting innovation from smart people at universities into new therapies for patients with diseases. And this is going to your original point about doing good for society. And we like seeing our companies go into pharma, you know, it obviously gives us great returns for our shareholders, but it means that there are synergies with what they've already got in place. The demand from the pharma side is that they're facing a massive patent cliff, this is why we're seeing this boom in M&A. So, the whole branded drug market is sort of a trillion, say, in branded sales.

400 billion coming off patent in the next handful of years is a major, major problem. And then when you look at their own productivity internally this is pharma their own internal R&D departments are losing productivity.

So over time they've been cutting back costs internally, and they're beginning to recognise that innovation isn't something you can force an R&D team to do. It comes out of unis and academia. So they've recognised that, they've stepped back a bit on that sort of area of investing and they're looking to acquire in assets once biotech have done the job.

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So that's what we're seeing, this really neat, efficient evolution of a new therapy. Suffice to say, the skillset of discovering a new target, taking it through clinical development and then launching it, those skill sets are very, very different. We want to see this in the right hands. We're fine with them staying independent as well. So we have a number, 30% of our fund, actually, is invested in companies that could absolutely stand on their own two feet and continue with the launch of their product.

But again, equally they could get picked up. And what we've done is we've replaced that 25% of our fund with similar companies that are also moving through development or already launched and approved. There's plenty of opportunities out there and we particularly at the moment like these emerging commercial stage names because that's where we think pharma have to go shopping, because they need these revenues tomorrow. They haven't got time to wait 10 years, they need them tomorrow.

Dave Baxter: And if we were to talk about, I suppose, I don't know, areas of treatments and kind of specialisms, that kind of thing, which areas are looking, I suppose, promising, or I guess from both a scientific and investment perspective, and which areas are perhaps now less exciting than they once were?

Ailsa Craig: Oh, okay, so the first one I always get asked, I rarely get asked the second one. Okay, so the first answer to your question is generally the areas that are “hot” is oncology we've seen a lot of oncology M&A, is still a very high unmet medical need, and there's so much innovation going on addressing areas that are still looking grim for patients.

So this year, another reason why done the sector well, is there's been a major development and that's in pancreatic cancer. And a company called Revolution Medicine, for the first time, had end stage, so phase three, late stage clinical readout that was positive, it doubled overall survival in pancreatic cancer patients in a target that previously was undruggable. This is game changing.

There was oncology, the American Society of Clinical Oncology medical meeting in The US and when they presented the data, there was a standing ovation and the presenter started crying.

It was emotional and absolutely rightly so. There's been so much effort and bio dollars put to try and find something for these patients. The prognosis is grim and finally something's been discovered. So there are lots of companies on the heels of Revolution trying to do better than them, you know, the Revolution drug does have nasty side effects, so if we could get even better efficacy using a similar approach or fewer side effects, that too would be a really exciting acquisition target.

Because of the excitement around Revolution, the valuation is big. Not many people could even afford to buy that company now because it's done so well. So what we've done at IBT is, instead of backing a company that we think is looking fully valued, which is part of our process, is we're buying companies that could displace them in the future, so the next generation RAS(ON) inhibitors, if you like, which is the target they're going after.

And we do that by, instead of just backing one horse and sticking with it, we have a basket of names, so we'll buy a few of them, wait for the data to read out, we'll reduce our positions into those readouts, we don't want to lose our shirt, and if the data are positive and interesting, we'll buy more and sell the one that's less interesting. And that's our day job, if you like, is following the evolution of what's going on in this space.

Another area of excitement is psychedelics, and people love talking about this. RFK, the MAHA, Make America Healthy Again movement, have called this out as an effective, potentially, treatment for very serious treatment-resistant depression.

So these are patients that really can't function at all, and they've now had clinical trials actually in the UK, in the Maudsley in South London, if anyone knows that. They ran a trial looking at this approach in very seriously depressed patients and it's worked. So they are filing with the regulator in the US and this could be on the market in the coming months, years. They're not the only ones and like I mentioned we have this basket approach, so we will have a number of these sorts of companies, so that's a particularly interesting area again.

Now, what I'd say, okay, so you asked me what isn't interesting or what generally, or become less interesting?

Dave Baxter: Yeah, I guess anything that's perhaps lost its gloss or maybe there's perhaps less from a purely investing perspective, less potential.

Ailsa Craig: I think, so the long the answer that I would have given you 10 years ago as well would be antibiotics. And I call that one out because it's such a high unmet medical need. It's, you know, many people will die of an infection that we haven't got an adequate treatment for, and that situation is just going to get worse over time, we've all learned about this at school and the situation hasn't changed.

Why isn't that area attractive for the capital markets? And that's because if a new antibiotic drug is ever discovered, it will be locked in a safe under lead flooring, you know, we will not want to use it because it will be so…everyone will be so careful around it because the more you use antibiotics, that's when resistance occurs. And it's very difficult, unfortunately, with this business model that we have currently, to justify working in an area where you don't want to sell the drug at the end of the day.

So that's a quandary about how do we try and encourage innovation in this space, it's something I don't have the answer to, but it's certainly like a more of an ethical debate, but always interesting.

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Areas that have become less interesting recently, I think probably 'me too' type drugs, so when I say 'me too' I mean things like, we've got a perfectly good therapy out there for patients, treating them adequately, and a company is proposing an alternative that has a very marginal benefit.

So instead of taking two tablets a day, you can take one tablet a day or instead of injecting once a month, you can inject once every six weeks. There is a case for administration and convenience, you know, say one month, no, now you can have once every six months, that would be, there is a case for that, it helps compliance. But the ones that just are on the margin, think that's something that is becoming less interesting as an investment proposition.

Dave Baxter: Interesting. So I'm interested in the, I suppose, kind of practicalities of the investing.

As we mentioned at the start, there have been some big gains recently, but, you know, some very challenging periods as well. It can, like many single-sector plays, it can be quite volatile.

So I guess it would be interesting to hear your thoughts on what some of the key risks are that investors should be aware of, and also ways in which one can try and mitigate against them. For example, earlier, you were talking about a basket of companies rather than just trying to pick out one winner.

Ailsa Craig: Yeah, really genuinely believe this is a sector that you want to go via a fund, obviously I'm going to say that, but I really genuinely, I have never myself bought or invested in a single biotech company. I only invest in funds.

And the reason being is that we live and breathe this sector and you might hear a really super exciting story from an individual company and not necessarily think about where it sits within all of the competition that's out there, for example.

And you do need to live and breathe this sector, there's news flow coming out every day.

So we are aware this sector goes in and out of favour, there are fits and starts, but over the long term, the returns are really strong versus the broader market and versus healthcare broadly, for example, because it's an innovative sector and that's what you would expect.

So, what we say to our shareholders is we take on board that day-to-day management, our strategy is if we're facing a big clinical readout, we'll reduce our position going into that binary event, we speak to the management teams regularly so that we can establish when those events will be, sometimes we'll buy a competitor if we don't want to sell our position to hedge, just in case the competitor data is going to go which way or the other.

So in terms of mitigating risk, you can absolutely mitigate risk by having a diversified portfolio. You can mitigate risk by reducing positions into events that you can't predict. So there's lots of sort of ways of thinking about it. Now, there's upside risk as well. So the sector tends to go into favour when there's a new discovery.

So if you think about the Western world, what we still do really well is in sectors such as this we can discover genuinely new compounds to address diseases. It's absolutely fantastic and we can still do that.

Now when you generate new sales, so let's say for pancreatic cancer, there's no displacement of a current therapy there, there are no targeted pancreatic cancer. That tends to tally with when the sector becomes back in favour again.

We had obesity for example a few years ago, prior to that we had the vaccines and the treatments for Covid, and before that we had immuno-oncology, Hepatitis C was cured, HIV made chronic. This is, you know, really what the sector is good at.

Now, what's the major, the biggest medical problem we have facing society in the cost and health-wise? And that's dementia, I would argue. So we're getting older, the population of over 65s is going to double in the next generation. We have a really serious problem. Diseases that we used to keel over from in our 50s, like heart attacks, have been dealt with quite well.

What does that mean? Well, you know, dementia. Exactly! And so this is a major problem and we all know, you know, you've all heard stories about people selling their houses to pay for elderly care, it's really expensive. And by delaying even just by six months, say, delaying going into a nursing home is material for everyone.

So if the industry and my goodness they are trying, find something that moves the needle on progression for dementia, that's going to be massive. And this is something that multiple companies are working on.

And so, in answer to your question, what we say to shareholders is, it's one of those sectors that, yes, it's volatile, but you want to kind of…I'm not giving financial advice here but you would want to have in your portfolio. Tuck it away and forget about it because you just can't predict when these discoveries are going to be.

And, you know, you can build upon that position if we have, you know, Iran war, for example, those sorts of headlines had nothing to do with the fundamentals of the sector, you can kind of drip it in that way. Suffice to say, this is one of those situations where you want to have a position, otherwise you could miss out on the upside, as well as saying, you know, yes, it's risky and there's downside risk and there are things that you can do to mitigate on the downside.

Dave Baxter: So it's an interesting case of always looking at the problem first and then kind of thinking at some point hopefully a solution will emerge and then that will -

Ailsa Craig: Absolutely. I mean we've got, there are just continuous, we've got some quite major readouts coming in this space in the next sort of one to two years, and it will be interesting and hopeful, you know, fingers crossed we see something. There have been drugs approved in this space, then they don't work very well, the bar is very low, there are side effects as well, so it's definitely a watch this space situation.

Dave Baxter: I was interested to also pick your brains on, I guess, this is very broad, but any kind of interesting new developments or coming developments to watch. I mean, one thing I did think about, and, I mean, obviously, this gets discussed to death by any investor at the minute, but is AI and, like, how that's affecting the space? This morning, I glanced at a story about, you know, some kind of committee looking into it in tghe UK and talking about this idea you should have “L plates” on kind of AI tools and so on. So I'm not sure how, you know, how it's working out.

Ailsa Craig: Okay, so AI well, it used to be called machine learning, and this sector has absolutely used machine learning for a long time already in drug discovery.

So being able to screen compounds and maybe select compounds in a more efficient way than maybe before machine learning was started. AI has certainly improved dramatically with its capability, but we're still in the drug discovery stage with that particular use, so in order for us to establish whether AI's abilities can select compounds more efficiently, we won't know that until sort of five, 10 years' time, at least. However, it is being used and at various different pinch points along the drug development cycle. So designing clinical trials, crunching the data after a clinical trial, finding patients, diagnosing patients, AI absolutely plays a role.

And the finger in the air assumption is that it takes circa 10 years to develop a drug, we could see that being reduced to, say, seven. And that's material.

So if you think about a drug launching, it gets 10 years’ patent life approximately once it's launched, the growth at the beginning is sort of hockey stick, but the profitability is towards the end when it's already reached, you know, good peak sales.

So if you increase those three years because you've gained three years from the timeline and development through AI efficiencies, that's going to help with profitability for these companies and these drugs. What AI can't do is replace human clinical trials, because AI all the data and the know how is from historical clinical trials, whereas a clinical trial is trying to address something we don't already know: is this drug safe and effective?

So it can make the clinical trials more efficient, but those trials still need to be done. It's a regulatory requirement.

Dave Baxter: And AI chat aside, are there any other kind of exciting developments in the industry that you would sort of highlight for people to keep an eye on?

Ailsa Craig: Yeah, I mean we've had some data very recently, although very limited data, from Moderna who is a familiar name, that is using their mRNA technology to address cancer.

So what they've said, they're partnered with Merck, which is a major pharma company in this programme, and they have a personalised cancer vaccine.

This isn't a vaccine that you and I would day to day understand as a vaccine in terms of preventing infectious diseases. This is a vaccine you give to patients who have melanoma, so they have cancer, they've had surgery and what they do is, just before surgery, take a biopsy of the tumour, send that off to Moderna and in about six to eight weeks Moderna identifies the mutations in that patient's tumour that's specific to them, sends it back an injection basically that trains your immune system to tackle and kill that melanoma.

And they announced very recently that their late-stage trial had hit and it was clinically relevant, clinically significant. Their phase two data was outstanding, they had what called a hazard ratio of 0.5, so incredibly strong.

If they show a similar hazard ratio in phase three, that's going to cause a lot of excitement. It already has. I was talking to a doctor last week who said she hasn't had a patient not call her about this particular new treatment.

So it's very well known and super smart technology. What would be even more interesting is if they can roll this out to other solid tumours such as lung cancer or renal cancer, then things get really exciting. So, you know, watch this space on that as well.

Dave Baxter: Yeah, brilliant. Well, that is all we have time for, but thank you for coming on.

Ailsa Craig: No problem, thank you for having me.

Dave Baxter: And thank you for watching and listening as ever. Hope you found it interesting and useful. Do remember you can contact us directly. You can email otm@ii.co.uk.

Let us know what you think. Let us know ideas for future shows. Thanks very much and take care.