The “Golden Age of Biotechnology”? by Jean Fonteneau
The full article can also be viewed and downloaded here
July 29, 2015
On April 16, 2015, interviewed on a popular financial news television channel, Nasdaq OMX CEO, Robert Greifeld, welcomed the arrival of “the Golden Age of Biotechnology”, a couple of weeks earlier Credit Suisse Equity Research department had published a report detailing the advent of a new paradigm, the “Biotechnology Nirvana Model”.
While the enthusiasm for the advances in science and technologies, and the prospect of treating or curing previously incurable and difficultly treatable diseases is justified, it may not translate in desirable long term investment returns given the prices that have now been reached in every corners of the biotechnology sector.
In mid July 2015, the S&P Biotechnology Index and the corresponding ETF (XBI) was up 100% in a year since July 2014, a 100% advance coming on top of an 80% gain from the start of 2013 to July 2014.
An incredible move in prices that investors, institutional and individual, are definitely eager to be part of or fearful of missing, but it begs the questions: has the long term earnings power potential of the entire industry doubled in such a short period of time after having already more than doubled in the preceding years? and what returns now lie ahead?
Investors desire to replicate the performance of the last 5 years has triggered an absolutely unprecedented rush of capital in biotechnology through the public and the private markets.
The 1st half of 2015 saw a new record broken in the amount of capital raised by biotechnology companies on the public equity markets, via secondary stock offerings, initial public offerings and convertible debt, a new record in the amount of funds raised by biotechnology/life sciences venture capital firms and a new record in the amount of capital deployed by these VC firms.
The first half of of 2015 also saw record inflows in biotechnology themed mutual funds, that were almost double the amount that flowed into these funds for the entire year 2014.
The sum of human experiences and research builds upon itself, aided by increasing globalization and information sharing, if you combine it with the advance in computing power and other technologies allowing for safer and faster drug development and testing, you get an acceleration of innovations and efficiencies that has participated to the current boom. With 7 billion humans on the planet, the life sciences industry is not about to run out of customers and it is easy for investors to find reasons to overweight healthcare and biotechnology.
In a field requiring the most highly skilled labor and scientific innovation to bring products to market, at any given time, the number of “good” opportunities to deploy capital that will be successful and offer a superior investment return is finite. Nevertheless the institutions that have raised record amounts of money to invest in the sector have pressures and incentives to put this capital to work. With the incredible amount of capital flowing through the industry today almost any biotechnology asset or project can be financed at a very high valuation and at an increasingly early stage.
An extreme example of this in the public markets would be the recent Axovant Sciences IPO (a company with virtually no other assets than the rights to a drug development project abandoned by a pharma giant, after multiple trials, for showing a lack of efficacy) raising $300 million(the “largest biotechnology IPO ever”) at a multi billion dollar valuation.
In the private market, the launch of Denali Therapeutics (a startup venture that at this stage is not much more than a small team of brilliant people with an idea and a plan) in May 2015 with the closing of a $217 million Series A financing round is unprecedented for biotechnology or any industry for that matter.
Invariably, among the vast number of ventures, public and private, being financed by this massive amount of capital chasing returns, are going to be ventures that: have limited economic prospects, are going to be outright technological failures, or deliver mediocre or negative investment returns given the initial valuation. In recent previous cycles you could have found that mis-allocation of excess capital in some E-commerce ventures or Las Vegas condo towers.
These spikes of enthusiasm for a theme in financial markets, accompanied by a very rapid advance in assets prices are often the result of a distortion in the perception of time by investors in their chase for outsized returns.
In the early 1840s, hundreds of railway companies were listed on the London Stock Exchange offering to connect within just a few years different destinations by rail and reap the profits of this new revolution, the only problem: these railway routes would take a lot more time and capital than investors had anticipated and priced, some taking 20 or 30 years before they were completed. Also a lot of the ventures were overambitious uneconomical projects from the start and some others just downright fraudulent promotion schemes. After more than doubling in 2 years, railway stocks underwent a steep multi-year correction sinking a sizable portion of affluent British investor’s savings, and many of the new ventures failed to survive.
The valuation of the “dot com” boom priced at it’s peak in 1999-2000, the internet ecosystem that we have seen come to fruition only in recent years. It took 10 to 15 years more than investors had anticipated and priced at the time for that ecosystem to be born and many investors in late 1990s “new economy” companies realized large losses, with the NASDAQ composite only reaching its 2000 highs just earlier this year – 15 years later. A lot of the ventures that crashed and spectacularly failed when the boom ended in 2000 exist today in a new and profitable iteration.
Today, curing diseases by modifying a patient’s faulty gene or getting rid of cancer via an injection turning on our immune system to attack malignant tumors, are some of the themes capturing our imagination. The promise of breakthroughs in the current standard of care are what investors hope to translate in outsized returns. Potentially revolutionary gene and cancer therapies are attracting vast amounts of capital, but in their enthusiasm investors may be ignoring and mispricing the amount of time and capital it will take for these new promising technologies and ventures to deliver an economic return.
Immunotherapy and the CAR-T technology is currently one of the hottest items in the biotechnology sector, with a number of multi-billion dollar market capitalizations like Juno Therapeutics and Kite Pharma.
While the technology is very impressive, shows promising results in the treatment of refractory acute lymphocytic leukemia (ALL), it has had limited success outside of ALL, in solid tumors cancers, and while ALL is a sizable market it remains limited, and probably could not support the valuations of these companies by itself. The CAR-T technology at this stage also still faces a number of complex safety challenges.
In dealing with cancer and immunity you deal with two incredibly complex and evolving systems that are unique to each individual case. When you combine the two you reach a staggering level of complexity. In this particular case it is likely that investors, while dreaming about the injection that will kill cancer, currently misprice the amount of time and capital that will be required to solve this incredibly complex puzzle and turn the technology into profitable enterprises.
Many development stage biotechnology companies valuations are underpinned by M&A potential and the idea that acquiring development stage assets is the way to grow for the large cash generating biotechnology heavyweights, as well as big pharma, as a result a large part of the biotechnology market is already trading at valuations close to what they would fetch in an auction were they to become the target of an acquirer. Recently the sector has undergone a record number of M&A transactions helping to “justify” the current valuations.
One of the biggest mistake investors made in 1999-2000 was to think that some of the tech/telecom/dot.com valuations were justified because of the level of M&A activity, the thinking then being that valuations can’t be too far off if blue chip corporations and their executives are making all these acquisitions – spending hard cash to acquire “valuable” assets, they must know better, right? Well that assumption was completely wrong.
They didn’t know better and equally misjudged the economic potential of these assets, or were just caught up in the frenzy and felt “the fear of missing out” pressures, making acquisitions to hedge their bets and justifying them with new metrics, or had strong personal and other incentives to make deals happen. The largest volume of transactions happened at the peak, at the worst prices.
It is unclear if the same phenomenon is taking place here but a lot of data points are lining up the same manner.
The “takeout” valuations are often the result of analyst’s estimations and a “special flavor” of biotechnology math and logic, automatically assuming the capture of a large market share, involving a lot of “if” “but” “%” with numerous scientific and economic variables. Analysts ultimately landing on valuations of a multiple of peak sales, that are often 10 years away, of a product that has yet to exist. Given the number of variables in the equations there is room for a very wide range of outcomes, but analysts and investors have chosen to increasingly favor only the most positive of outcomes in their assessment. In that assessment traditional economic forces and competition are often ignored, with the ever increasing number of ventures going after the same indications and the same share of the pie it seems like it should not.
Wall Street by nature tends to go where the money flows and currently a lot of money is flowing in biotechnology. The demand from investors for the “product” is tremendous, so the incentives for Wall Street investment banks to deliver extensive research to support the theme are very strong. (As an aside, while research is deemed to be independent from investment banking, biotechnology companies are the best possible type of clients investment banks can dream of having, with no to little revenues, they need to raise money all time which is how Wall Street gets paid.
In a lot of the Wall Street analyst’s research you can find the term “de-risked” to qualify some new drug or therapy development which is ironic when, traditionally, biotechnology used to be one of the riskiest areas of the market to invest in.
With ever increasing stock prices, the notion of risk in biotechnology has been progressively receding in the background and retail investors are increasingly involved in actively trading and investing in biotechnology stocks.
Given the level of complexity in ascertaining the medical and economic potential of early stage drug and therapy development ventures, biotechnology investment used to be the exclusive domain of a relatively small group of specialized funds, with most other professional investors shying away from the sector.
The seemingly unstoppable advance in stock prices of the past 5 years has given birth to innumerable biotechnology stocks “experts”, some of them having a very short experience of financial markets and of the biotechnology industry, dispensing stocks tips and the way to biotech riches to retail investors on various platforms, forums, via social media, and selling newsletters and subscription services.
In June 2015, the ETF company Proshares launched the UltraPro Nasdaq Biotechnology ETF(UBIO), a triple leveraged product designed to deliver 300% of the daily swings of the Nasdaq Biotechnology Index, earlier, in May, another ETF company, Direxion had launched the Direxion Daily S&P Biotech 3X (LABU), another triple leveraged product replicating 3 times the daily performance of the S&P Biotechnology Index (XBI). Both products designed to feed the speculative appetite of active retail traders, routinely moving 5% or more in a single session.
Today a lot of the investors chasing returns in the biotechnology sector, are doing so because of the performance of the past 5 years and not because they have a firm grasp of the science, the economic challenges involved or the earnings potential going forward, and are taking on a lot more risk than they assume they are.
Risky development stage biotechnology ventures with no revenues have now gone from the private VC market, where they used to be valued for tens of millions, or from public market valuations of a few hundred million in some cases, to now being pushed onto the public markets with multi billion dollar valuations on the back of Wall Street analyst’s narratives.
A very large number of ventures trading in the public markets would have qualified as VC only investments just a couple of years ago.
Today a lot of investors are engaging in VC type biotechnology investments in the public markets, if you combine the venture capital risk(historically high rate of failure) with the early stage biotechnology risk(historically high rate of failure), you not only get an investment with a very high risk profile but at a price that no venture capitalist would ever pay.
A notion of risk that has been obscured recently by ever increasing stock prices and the never ending spigot of money that biotechnology companies, even with sketchy prospects, seem to be able to go back to in case they run out of cash.
All these observations point to the biotechnology sector going through a period of tremendous excess and overinvestment, creating a widening disconnect between asset prices and long term value that will eventually be corrected.
Correction can occur through sharp declines in prices, long drawn out shallow declines in prices or just time, it is difficult to ascertain at this point which one will happen, but it augurs very poorly for the return on investment prospect you may be faced with if you decide to invest in biotechnology at the current levels.
From 1998 to 2000 Human Genome Science (HGSI) stock went from $10 to $100 on the promises of DNA sequencing and technological breakthroughs, the technological breakthroughs were delivered and have made possible a lot of novel therapy development today, did that translate in an attractive return for long term investors?
HGSI was acquired by Glaxo-Smithkline in 2012 for $14.25 a share, even if one bought HGSI at $10 in 1998, it is not the kind of 14 years return investors would have hoped for.
The probability that investors in a large number of biotechnology ventures will be faced with the same kind of mediocre or negative returns going forward is high.
Biotechnology may also be facing a number of other headwinds, as healthcare costs, and in particular drug pricing concerns (pricing that has fueled a lot of the earnings growth of the biotech heavyweights in recent years) makes it’s way into the public debate and becomes a popular social issue (an initiative such as the one undertaken by Kyle Bass, while it may take a while to unfold, may also play a part in that equation).
If the perception of the future earnings growth was to shift ever so slightly it would trigger a re-rating by investors of the entire sector and a lot of volatility. (Some clues of that potential can be found in the recent action in Biogen Idec BIIB stock.)
Biotechnology, sitting at the extreme edge of the “risk-on” curve, also tends to underperform when rates are rising, in spite of the current easing and stimulus policies around the world, that seems to be the directions the Fed has been signaling we are headed.
The technology/telecom boom of the late 1990s, while it decimated investors’ portfolios, was not complete value destruction as the massive amount of capital deployed in the sector allowed for the very rapid built up of infrastructure and thanks to this massive wealth transfer from savers we enjoy a mostly free internet today.
Likewise, the current biotechnology boom, while it may not participate to deliver investment returns to savers going forward, given the unprecedented amount of capital that is being made available to drug development and life sciences research (capital that likely dwarfs any public funding), will certainly give birth to a lot of innovations that one day will be central in improving quality of life and curing diseases.
For Nasdaq OMX CEO, Robert Greifeld, it has been and is indeed “the golden age of biotechnology” as recently a large portion of his new customers(companies looking to list their shares on an exchange) have been coming from that sector. It is also “the golden age of biotechnology” if you are a team of biotechnology PhDs looking to raise money to finance the research of potential novel therapies, a life sciences venture capitalist raising a new fund or an investment banker; but, if you are an investor looking for a return on investment(or simply the return of your investment) going forward, the next few years will not be so golden.