The biotech sector has strong fundamentals and is poised for long-term growth. Concerns amongst investors regarding drug pricing have lessened as Donald Trump recently marked 100 days in office. Share prices have begun to recover, under the assumption that ‘business friendly’ Republicans are unlikely to vote for price controls.
Furthermore, innovation in biotech continues apace with various breakthroughs in areas like cancer immunotherapy, rare diseases and gene editing. Also, the demand for biotech is strong and increasing as the population of the world is aging. In fact, global health care expenditure is projected to reach $8.7trn by 2020.
Performance of MSCI World Biotechnology index over 3yrs
Source: FE Analytics
Another key trend in the sector is the continued strength of the healthcare merger and acquisition (M&A) market. Demand for mid-size biotechnology companies with high-growth prospects is increasing. Not only are large pharmaceutical companies interested in snapping up smaller rivals but so too are large biotechnology companies as growth starts to slow at these giants.
While M&A activity in other industrial sectors is affected by macro-economic factors, the pace of acquisitions in the healthcare sector tends to remain at a steady level with an average of 300 companies either merged with or acquired every year. These companies tend to be acquired at a 30 per cent to 60 per cent premium.
This steady demand is driven by the need of larger companies to boost their earnings with new products. As these larger firms struggle to develop enough in-house compounds to maintain growth, they instead acquire smaller rivals with the products that have high sales potential.
These larger firms have a fairly specific wish-list. They lean towards drugs which address areas of unmet medical need with minimal risks: in other words, products which are towards the end of clinical trials. These firms also prefer companies that have wholly owned assets.
Mid-sized companies are more attractive acquisition targets than larger firms. Firms with a market-capitalisation in the range of $5-$30bn tend to be acquired as these companies have the capacity to move the needle for the larger acquirers. In recent years, Actelion, Pharmacyclics and Medivation have all been bought – these were all companies in that market cap sweet spot.
As well as these industry trends, US government legislation could also provide a further boost to M&A activity. Any policy which enables companies to repatriate their cash to the US without facing a heavy tax bill could result in firms using these funds to go on a spending spree.
The impact of this cash repatriation on the M&A market could be significant. For example, Gilead has around $40bn of cash stashed in overseas subsidiaries. Cash-rich biotech giants like Gilead could use these funds to carry out large share buy-back programmes but there is little incentive as investors rarely reward such actions.
In addition, growth at biotech giants, like Gilead, is slowing so they are more likely to use any repatriated cash to acquire innovative mid-sized rivals. They will be competing with other larger pharmaceutical companies for these firms. The increase in demand is likely to cause prices of these companies to spike on M&A as a bidding war ensues.
Also, companies do not have to rely on cash repatriation in order to make acquisitions. The low-interest rate environment makes it cheap for companies to buy rivals using debt.
Strong M&A activity will also create further support for healthcare valuations as those investors who have been bought out will have cash to re-invest in the market. For example, when Johnson & Johnson acquired Actelion, $30bn of cash was freed up to potentially be reinvested back into the sector.
Investors looking to capitalise on this M&A trend should not deviate from their usual investment process. After all, it’s impossible to know when a particular company will be acquired. The best investments are those companies which have innovative drugs which address unmet medical need. Stocks that appeal to both long-term investors and larger rivals will have similar investment characteristics.
Investors could also focus on those characteristics which appeal to acquiring companies such as choosing firms with innovative drugs in late-stage clinical trials to reduce the risk of failure. Acquirers also look for firms which retain the worldwide rights to their assets – those that have not already found a partner or licensed their product to another company.
Selecting firms with these criteria, however, requires in-depth knowledge of a highly technical industry. An easier way to benefit from healthcare M&A would be to invest in a portfolio of names, such as an investment trust, which capitalises on this trend.
Carl Harald Janson and Ailsa Craig are investment managers at International Biotechnology Trust. The views expressed above are their own and should not be taken as investment advice.