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There was a time when biotechnology stocks and exchange traded funds were reliable participants in growth equity rallies, but these days, it feels as though that time is a bygone era.
Take the case of the widely followed NYSE® Arca® Biotechnology Index. For three years ending Aug. 26, that index decline 0.8% while the S&P 500 gained 31.1% and the S&P 500 Growth Index jumped 23.7%. In fact, biotech stocks were drags on the broader healthcare sector over that period as the S&P Health Care Select Sector Index rose nearly 20% during that span.
Translation: the Covid-19 vaccine bubble that propelled many biotech names during the 2020 market rebound popped and investors moved onto other growth outlets, namely artificial intelligence (AI). All of that is to say that biotech stocks have been enduring an unusually lengthy period of subpar performance – one that belies the industry’s innovative reputation and the fact that many stocks residing in the group are inexpensive.
At the moment, there are somewhat positive ways to view the biotech trade. First, it’s a contrarian idea. Second, some patience will be required, but that patience could be rewarded over the long-term.
Biotech Bets Require Fortitude
There are myriad factors supporting a biotech rebound. Some have been widely discussed, but that may not be reflected in current share prices for attractively valued large-cap names in the space.
“The long-term secular growth story for biotechnology stocks is compelling, in our opinion. Over the next several decades, an aging global population will support massive demand for cures and treatments for a variety of diseases, especially those associated with old age,” according to First Trust research. “At the same time, innovation is flourishing for biotechnology companies racing to meet these needs, supported by new technologies such as artificial intelligence/machine learning, which enables researchers to analyze massive amounts of data more efficiently, or cloud-based infrastructure, which provides virtually unlimited computing power.”
As First Trust notes, biotech stocks are inversely correlated to interest rates. That’s a byproduct of the industry’s capital-intensive nature – hey, it’s expensive developing drugs – and goes a long way toward explaining why biotech equities have been duds over the past several years. That implies the asset class could be a prime beneficiary of a September rate cut by the Federal Reserve.
“Many biotech companies do not have any marketed products and are cash flow negative, making them reliant on capital markets and larger pharmaceutical companies to fund development,” adds First Trust. “As interest rates and the cost of capital rise, the hurdle rate for funding lower probability projects increases as capital becomes scarcer. Conversely, if rates continue to trend lower over the next couple years, we believe biotechnology companies may benefit as capital begins to flow toward riskier projects.”
Waiting on M&A to Return
Beyond Food & Drug Administration (FDA) approvals, the next most significant catalyst for biotech equities is mergers and acquisitions activity, which is showing signs of life. In the first quarter, the pace of biopharma consolidation activity doubled the year earlier pace.
With blue-chip pharma companies sitting on hundreds of billions in cash and with plenty facing marquee patent expirations over the next several years, biotech deal-making could return in earnest in the years ahead. Lower interest rates would help on that front, too.
“In our opinion, lower interest rates may also increase M&A activity as large pharmaceutical companies focus on replenishing their drug-development pipelines,” concludes First Trust. “M&A activity has historically been an important contributor to the returns of biotechnology stocks. Over the past decade, the average premium paid for an acquired biotech stock has been roughly 80%. Though the total dollar volume of deals remains below levels seen recently, the number of deals exceeding $1 billion has been robust following COVID-19. In addition to lower interest rates, we believe a combination of government-related price pressures and looming patent cliffs provide strong incentives for increased M&A activity over the next few years.”
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