Biotech: Resurgence in Innovation amid Policy Uncertainty Dec 1, 2017

2018 Outlook: “We are seeking to invest in innovative biotechnology companies at the cutting edge of research and development, whose products have limited competition, address areas of significant medical need and have clear clinical value.”

Working through Consolidation, Volatility and Evolving Political Pressures in Health Care

Biotechnology stocks generally bounced back in 2017 after becoming largely oversold, in our view, during the US election cycle rhetoric of 2016. However, they still struggled to retrace their all-time highs reached in July 2015. By some measures, the biotechnology industry in late 2017 was less expensive on a forward price-to-earnings basis than it has been during most periods over the last 20 years.

We believe biotechnology and pharmaceutical industry fundamentals have remained strong despite the recent equity volatility and political uncertainty within the health care sector. Although investor interest in the sector has been challenged at times since late 2016, due mainly to concerns about drug pricing, competition and valuation, the long-term growth prospects for the biotechnology and pharmaceutical industries have not changed.

Fundamental improvement was also noticeable on a wider scale. Essentially we saw more new drugs reach the market in 2017 versus 2016, and higher prices. The biotech and pharmaceutical industries have benefited from the resurgence of new drug approvals, including the US Food and Drug Administration’s (FDA’s) approval of a first-of-its-kind (and potentially game-changing) cancer therapy.

Innovation Drives 2017 Resurgence in Novel Drug Approvals

FDA Novel Drug Approvals
1997–2017 (through November 10)
Number of Approvals

Source: US Food and Drug Administration Center for Drug Evaluation and Research. As of 11/10/17.

Political pressures have occasionally taken the air out of the health care sector’s performance over the past year, and may resurface in 2018. Uncertainty about the ultimate impact of legislative changes arising from recurring Republican efforts to repeal and replace the Affordable Care Act has at times depressed sentiment and sparked an exodus of investment capital from the health care and biotechnology spaces. Although US President Donald Trump has repeated his dissatisfaction with the high price of prescription drugs, his more recent signals suggest that the administration’s health care policy may be surprisingly benign. While it’s hard not to sympathize with his outrage, it’s also tough to pinpoint a solution unless the FDA wants to get into the business of setting prices. Ultimately, we think there’s no use in investors panicking about drug price legislation until a credible plan is put forth.

Recent reform proposals have focused on initiatives like reducing the personal “out of pocket” drug costs and exploring “value-based” pricing models that reimburse drug-makers based on the efficacy of their medicines. These proposals enjoy wide support in the pharmaceutical and biotechnology industries. Meanwhile, a bevy of new medical breakthroughs—along with some merger-and-acquisition (M&A) activity—have at times re-ignited biotechnology stocks based on fundamentals.

Looking Ahead to a Potentially Long Innovation Cycle for Biotechnology

Innovation within the industry has reached unprecedented levels, in our view. We are particularly interested in the significant advancements in gene therapy, immuno-oncology and bispecific antibodies. We are encouraged by companies that have focused their efforts on new drug discovery platforms and novel compounds.

One of the most fascinating new therapies being developed involves genetically altering patients’ cells so they can fight cancer. The FDA recently approved a therapy that uses this technique to fight acute lymphoblastic leukemia in kids and adults up to 25 years old, a therapy broadly known as CAR-T. During this therapy, white blood cells, or T-cells, are extracted from a patient. Genes that recognize specific cancer cells are inserted into the T-cells using an inactive virus. The genes produce receptors on the surface of the T-cells that are attracted to malignant proteins on the surface of cancer cells. The modified T-cells are grown in a lab for 10 days. The patient undergoes chemotherapy to kill off some white blood cells to help the body accept the modified T-cells. Then the modified T-cells are injected back into the patient, where they multiply, target and kill the cancer cells. Some patients who received the treatment in trials seven years ago remain cancer-free.

Beyond the clinical data, looming policy uncertainty further complicates the 2018 outlook for biotechnology M&A deals. Shifting corporate tax rates, uncertainties about health-care policy and the outlook for high prescription-drug prices gave acquirers pause in 2017, and we believe a similar atmosphere may linger into 2018. Elsewhere on the regulatory front, we do not anticipate major changes coming from the FDA, which continues to work closely with the biotechnology and pharmaceutical industries and seems more committed than ever to getting important new drugs to patients quickly.

There also are several big-picture trends we continue to think support health care and biotechnology. One relates to demographics. The world’s populations are aging (particularly in developed markets), and the elderly as a group consume significantly more health care products and services than younger generations. And at the individual company level, we continue to see big research advancements in areas such as gene therapy and cancer, as outlined above. Major waves of innovation are reflecting the exponential leaps in basic research and understanding of human biology that are now bearing fruit. At the same time, while cutting-edge developments are exciting, we remain disciplined and selective in our investment approach.

CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute.