Halfway through 2016 – one year into the deepest drawdowns in the history of the biotech sector – a major healthcare and life sciences investment fund wants to explain its performance, rated as one of the best by one study.

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RA Capital, down -16.4% year to date, says the political rhetoric will subside

After starting the year down more than -21%, but since recovering to down -16.4% as of the end of June, RA Capital Healthcare Fund says mean reversion could be upon us. The drawdown – and the political reaction against healthcare in the wake of Martin Shkreli and Valeant Pharmaceutical scandals – has reached an extreme.

“Regardless of political rhetoric, we believe that our industry will overcome its image problem and be seen and valued for the engine of good that it is,” RA Capital managing directors Peter Kolchinsky, Rajeev Shah and Andrew Levin wrote in their second quarter investor letter, a copy of which was reviewed by ValueWalk.The pendulum has swung too far and will swing back.”

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Specifically, the hedge fund states:

A year ago, at what would prove to be the tail end of a long biotech rally, we thought we had entered a new era in which generalist investors understood the proven ability of biotech to systematically solve important healthcare problems. We thought that generalists appreciated that biotech was no longer a recreational zone in which to gamble from time to time, as had been the case for the decades prior, but a bona fide investable sector that warranted an allocation at all times. After all, biotech was innovating at an unprecedented pace, proving new technologies effective and therefore expanding everyone’s toolkit for solving problems. There were many more experienced management teams, more knowledgeable and accommodating regulators, insights from a maturing genomics field launched 20 years earlier, and a critical mass of funding not only from investors but also from strategics (i.e., big pharma and big biotech). Even at the peak in 2015, one year of cash flows of just the top 20 biopharma companies were enough to acquire for a 100% premium all public biotech companies with a valuation up to $1 billion (and three years of cash flow would be enough to acquire everything up to $10 billion in valuation), illustrating that the innovative engine at the heart of the biotech sector was still small, despite having climbed in value from 2009-2015.

In retrospect, it’s clear that we were in a bubble in 2015, not because valuations were unreasonable, since at any point in time one can point to examples of companies valued too high (even now) or too low (even then), but because generalist investors likely did not know what they were buying. Or maybe, to be fair to those of our peers who manage long-only mutual funds, their own investors may not have known what they were buying when they poured into those funds.

Fundamentally, nothing has changed except that valuations are lower, yet generalists seem reticent to acknowledge that biotech can generate real and sustained value. Whether it’s the elections or perennial pricing concerns, generalists seem determined to find a reason to believe that the US will reject what biotech has to offer, even though, in our opinion, it is probably America’s most innovative industry — and in addition among the hardest to offshore and to automate.

Stock picking alpha important in smaller biotech firms

The focus of RA Capital tends to lend itself to stock picking alpha. Development-stage companies, typically with a market capitalization under $1 billion, are note typically swept up in the momentum-driven stock price persistence that occurs with larger issues. This can be both positive and negative.

“This market-cap segment had given up all of its 1H15 gains by end of 3Q15 and ultimately fell further by 20-30%, roughly shaving ~50% from its peak in July 2015, dropping to levels last seen in early 2014,” the RA Capital letter noted, pointing to larger cap issues. “Furthermore, while average and median performance is similar for the two larger-cap segments ($1-10B and >$10B), the same was not true for small-caps (<$1B). Positive outliers kept average performance of small-caps from being worse than it actually was, confirming the importance of stock-picking in this segment.”

The fund increased long exposure towards the end of the year and has outperformed the sector benchmark (IBB index). The Brexit stock market displacement generally had nothing to do with their biotech investments and the firm picked up exposure during this time.

The future is bright, they say. “The days of drug monopolies are gone; the game has become far more complex, advancing from solitaire to chess over the course of our investing career. The companies best positioned to compete are those that offer the greatest benefit to patients, particularly if those benefits are so great that it would be medically and even politically unconscionable to deny a patient access to treatment.”

(The) biotech sector continues to innovate and build on its accomplishments, addressing humanity’s insatiable need for solutions to its healthcare problems. We draw our optimism from the long-term relevance and value of our sector, from its productivity, growing experience, increasing versatility, and importance to the US economy. Regardless of political rhetoric, we believe that our industry will overcome its image problem and be seen and valued for the engine of good that it is. The pendulum has swung too far and will swing back.

In the last year, the overall sector has fallen dramatically, essentially giving no credit for roughly 2.5 years of progress during the most innovative period of our 4-decade-old industry’s existence; the small-cap segment has fallen further still, creating significant opportunities, particularly as M&A of innovation by big pharma and big biotech continues unabated. RA Capital has held true to its strategy of maintaining an original portfolio of development-stage, small-cap stocks, outperforming biotech in general (as measured by IBB) and small-caps this year, last year, and therefore over the last 18-months, with modest correlation.