With the recent sharp plunge in the biotechnology sector, which exceeded the pullback in the broad U.S. equity markets (as represented by the S&P 500 index), I am getting investor questions about my outlook for the biotech sector over the next few months and long-term. In this article, I will provide my near-term and long-term outlook for the biotech sector as well as mention some top acquisition candidates over the next 12 months.
Let's first explore the political issues which seem to be behind the sharp pullback in the biotech sector over the past few weeks. The main reason for the plunge appears to be drug prices control becoming a political issue with both political parties in the US.
The plunge especially accelerated after the news of a House committee investigating President Trump’s possible involvement in Ukraine and finding a ground for possible impeachment proceedings. This is not a political platform and I will not go into much detail about the political views of both parties on the drug pricing issue; however, investors were pricing a possible Democratic victory led by Elizabeth Warren (if Trump is impeached) as negative for the biotech sector. The scenario gives me a déjà vu of a similar sharp plunge in the biotech sector in 2015 when Hillary Clinton made drug price control one of the key issues of her presidential election campaign. The biotech sector rebounded last week following the S&P 500 index after news of progress in the China trade talks. However, the sector remains significantly below its all-time highs and at this time I do not expect the biotech representative ETFs like IBB and XBI to exceed their all-time highs over the next 12 months. Some retracement of this sharp pullback in the sector is expected and in this post, I will also provide some views on a strategy to play the biotech ETF, XBI over the next few weeks.
While the sector may still see some downward pressure in the near-term, over the next 4 to 5 years I continue to maintain a bullish stance as I believe that the proposed political bills like the Pelosi bill in the house and the Grassley bill in the Senate are unlikely to find much progress this year. Overall, I see the drug pricing issue as more of a political issue going into the presidential election in 2020 and do not believe that a definitive decision upon the drug prices or other steps like allowing Medicare to negotiate drug prices from a manufacturer will materialize. The US leads the rest of the word in healthcare innovation, largely due to liberal government policies towards allowing drug manufacturers to set their own prices, which I believe is necessary to recoup the high R&D costs.
Much negative press has been written about the high prices of gene therapies like Novartis’ Zolgensma, which is the most expensive drug in the world at approximately $2 million. I have researched the pricing models for gene therapies in detail and most of the cost of the therapy is bound by the insurers. From the insurers’ point of view, various pricing models are in discussion, of which the most likely model to find a place in the real world is the total cost of the gene therapy in annual installments over five years. This model also allows an insurer to stop the payment to the drug manufacturer if the gene therapy stops being efficacious enough to show a significant clinical benefit after one or two years due to issues like immunogenicity. While immunogenicity to gene therapy is studied in clinical trials, the actual response of a person may differ according to various factors, which include the use of coexisting drugs or pre-existing antibodies to the viral vectors used in gene therapy e.g. adenovirus vector, AAV.
On the other hand, gene therapies have shown promise for a cure for possibly fatal gene therapies, for example, spinal muscular atrophy. Children with this disease develop debilitating muscular weakness in infancy which progresses during childhood. They are usually bed-ridden within few years and don’t live long. In pivotal clinical trials, Zolgensma (developed by Avexis which was acquired by Novartis) showed an excellent efficacy reaching almost 100% percent clinical cure rate, which was a major breakthrough in gene therapy. Various explanations have been given to why Zolgensma had such miraculous clinical efficacy, the most likely explanation seems to be a novel AAV vector with very low immunogenicity. I personally do not believe that the U.S. government (of either political party) will want to halt this scientific revolution by putting a cap on the drug prices since it will stop all the R&D by manufacturers if they don’t get an ROI on their R&D investment. Many of these genetic diseases have a very low prevalence of only a few thousand people in the whole of the U.S. and that is why gene therapy companies have to resort to expensive pricing to recover their R&D costs.
In addition, I have researched the process of manufacturing a gene therapy in detail and it is extremely complex. Each patient's gene therapy is manufactured individually and as a separate process. The process of manufacturing a gene therapy is also proprietary to most of the gene therapy companies and a unique and effective approach is often an incentive for a larger pharmaceutical company to acquire the platform and add to its assets, as we have seen with Novartis acquisition of Avexis, Biogen's acquisition of Nightstar Therapeutics, and Roche’s acquisition of Spark Therapeutics. At present, the top three gene therapy names on my list as acquisition candidates are Bluebird Bio (BLUE), Uniqure (QURE) and Sangamo Therapeutics (SGMO).
To add to the main context of this story, I also want to highlight a very illuminative investor sentiment survey, which was done by RBC capital earlier this month. The majority of the investors in this survey (72%) expect 4 major years of Trump administration, 16% are leaned towards Warren, and 12% towards Biden. Most investors maintain a bullish view on the biotech and plan to maintain their exposure in the sector regardless of whichever candidate wins the 2020 presidential election. Investors who also believe in Trump’s victory were slightly more inclined towards increasing their near-term biotech sector exposure. In the near-term, however, the majority of the surveyed investors (including whether voting for Trump or Warren victory) expected the sector to underperform vs. the S&P 500 index.
(Source: RBC Capital investor survey)
(Source: RBC Capital investor survey)
Short-term view on XBI:
A short-term bottom appears to be in but there is strong resistance at 79-80. Once this resistance is cleared. I expect the ETF to reach 83-84 level (the bounce will still be counter-trend in a larger degree downtrend since all-time highs). In the alternative scenario, if the ETF fails to clear 79-80 resistance, another lower low to 72-70 is possible.
The biotech sector has a high beta of approx. 1.5, and so is likely to fall further than S&P 500 to approx. 60 level if the S&P 500 index has a bear market in 2020-21. Signs of an economic slowdown are already visible and I believe that this economic expansion since 2009 is in the late stage. While I maintain a longer-term bullish view on the biotech sector with a timeframe of next 5-10 years, in the short to intermediate-term, my strategy is to hedge my core biotech portfolio (with a focus on gene therapy, gene editing, and cancer cell therapy) with a short position in the biotech ETFs. I believe that due to the potential of companies in gene therapy etc. to get acquired at a high premium over the next 2-3 years, this portfolio will outperform the broad market.
This article represents my own opinion and is not a substitute for professional investment advice. It does not represent a solicitation to buy or sell any security. Investors should do their own research and consult their financial advisor before making any investment. Investing in equities, especially biotech stocks has the risk of significant losses and may not be suitable for all investors. While the sources of information and data in this article have been checked, their accuracy cannot be completely guaranteed. Long BLUE.