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4Q20 Financial Markets Preview

Election volatility may drive investors toward low-risk opportunities in 4Q

Election volatility likely to pause IPO run, push investors toward low-risk or undervalued options

With volatile markets increasingly likely post-election, investors who’ve already made their profits this year may seek low-risk or harder-hit buying opportunities.

October 2, 2020 10:08 PM UTC

The increasing likelihood of a contested U.S. presidential election means the markets could be in for a high dose of volatility in 4Q20, pushing the pause button on a record year for IPOs and sending buysiders looking for companies that are either low risk heading into year-end or have seen their valuations dip.

One maxim of the public markets is that investors hate uncertainty, yet as they head into the fourth quarter, buyside investors find themselves in the position of needing to plan for a scenario in which most of November and December could be embroiled in the highest degree of political uncertainty in generations.

The good news is that many investors have already made their year in terms of performance. From the bottom of the market in March through mid-July, the biotech indexes rose more than 50%, outpacing the general markets, which added about 35% over the same period. 

The following two months saw mixed performance as investors took profits to lock in their gains ahead of the U.S. election.

“If you’ve made a bunch of money, or at least reversed a pretty big loss, you tend to take a few chips off the table. I think that’s inevitable,” Tekla Capital Management’s Daniel Omstead told BioCentury. 

Generalists appear to have taken a similar approach, as biotech fund flows have dropped considerably after a record run of inflows into the sector in the second quarter (see “Record Fund Flows”).

According to eight biotech investors who spoke to BioCentury, the strategy headed into the fourth quarter is risk mitigation. The goal is to maintain outperformance through year-end — via many likely to overweight stocks without a 4Q20 catalyst or more stable stocks such as mid- to large-cap names — while reserving some cash to buy back into any companies that get beaten down by the high volatility post-election.

The IPO market is, like everything else, subject to potential post-election chaos, but even if IPOs come to a grinding halt, 2020 has already more than doubled the aggregated capital raised versus the full year 2000, the high-water mark just before the dot.com bubble burst to which most biotech IPO classes are still compared. 

Almost all the candidates wanting to go out this quarter may have to wait until early 2021 to make their public debut if market volatility ramps up in the last two months of 2020, say investors.

Investors also expect the fourth quarter to mark the peak of investor interest in COVID-19-related companies. With positive Phase III data for COVID-19 vaccines already priced into the market, buysiders see little upside in the complex and unprecedented task of manufacturing and distributing the vaccines in 2021.

The one bright spot in 4Q outside of COVID-19 could be a positive decision from FDA on Alzheimer’s therapy aducanumab from Biogen Inc. (NASDAQ:BIIB), though that decision may not come until next year.

Contested volatility

Investors see no upside in the upcoming U.S. elections, and some think the worst short-term outcome for the public markets is the most likely — a contested result where who’ll be inaugurated on Jan. 20, 2021 remains unknown through the end of the year.

While a few buysiders view a continuation of the current administration as an incremental positive for the biotech sector, others see almost no benefit in either result.

“I can’t see how the election can be a positive for biopharma,” AXA Framlington’s Linden Thomson told BioCentury. “If Biden wins, ‘oh no, the Democrats are in.’ If Trump wins, ‘oh no, we don’t know where we stand.’ If contested, we don’t know where we stand at all. So I’m struggling to see the upside.” 

The silver lining is that many funds don’t need to generate strong returns through the end of the year to reach their performance metrics for 2020 — most of those metrics were hit over the summer. 

“I suspect many investors may have made good relative outperformance in this sector by buying in March those good quality companies that had come down way too much. There were a lot of mid-caps that had been quite expensive for a while, which just got hammered alongside everything else,” Thomson said. “Buying those quality companies and then seeing them outperform on the upside has been a way a lot of people have played this.” 

While biotech indexes were largely flat through 3Q20, they are still outperforming most of the broader market, apart from tech-heavy NASDAQ Composite.

“I’ve been in the lucky position where performance has been pretty good this year, so I’ve been taking profits on a lot of those trades, particularly the small- and mid-caps that have done well,” Thomson added.

She said one strategy investors may adopt is to set aside some of that cash so that if the markets do drop after the election, they’ve got firepower to buy at a lower price, similar to what investors did in March.

“I imagine there will be a lot of people like me sitting there thinking that you don’t need to be involved for a bit, keep some ammunition and then if there is additional volatility, you can start adding to some of those names again,” Thomson said.

Omstead and ClearBridge Investments’ Marshall Gordon both agreed.

“I do think people will take advantage if there’s a pullback on volatility,” Gordon said. 

Omstead noted that if a company doesn’t get rewarded for a positive catalyst, “we might buy some. Similarly, if something overreacts negatively on a small negative event, we’d be buyers there. Such situations can provide a good risk/reward opportunity, so we’d want to be able to buy.” 

International Biotechnology Trust’s Ailsa Craig thinks some investors may opt to ride out the volatility by overweighting in healthcare. But, she said, that will depend on how much the rhetoric on drug pricing and healthcare heats up as the election approaches.

If Democratic nominee Joe Biden chooses to focus on other topics, “healthcare might be a place investors would want to hide if the general markets are volatile,” she said. 

Venrock’s Nimish Shah believes political uncertainty could keep generalists on the sidelines. “For generalists, you could say that until they have more clarity on the election they might have other sectors they want to invest in like tech,” he said.

Omstead agreed. “If I’m a generalist I probably do take some chips off the table in anticipation of increased uncertainty.” 

Loncar Investments’ Brad Loncar was more bullish. “There may be some air coming out of the COVID stocks and there may be some rotation going on, but in general it’s not enough to make me think the party is over,” he said.

Gordon said he’s seen portfolios that have performed well this year pass on new investments with high volatility on the basis that “it’s a risky idea so I’m not touching this until next year.”

“If you’ve done well year-to-date and have either generated significant profits or outperformance vs. your benchmark, you are less inclined to expose your portfolio to bigger downside risks in the fourth quarter,” said Gordon.  

Omstead also plans to avoid taking on much risk if the market becomes highly volatile.

“We’d look for companies that have a little less volatility, maybe we might reduce our exposure to things that have big events coming because in a very uncertain time, you get paid less for taking risk on events,” he said. “A failure gets pushed harder down more than a success gets pushed up.” 

COVID’s peak

Even if investors do shy away from major catalysts in the fourth quarter, two events are on everybody’s radar: Phase III data from multiple COVID-19 vaccine candidates, and an FDA advisory committee meeting to review Biogen’s BLA for aducanumab to treat Alzheimer’s.

Every investor BioCentury spoke to called out the COVID-19 vaccine data as a major milestone, yet the data, they say, are unlikely to drive momentum in the sector for two reasons.

The first is that a positive outcome is already priced into the vaccine developers’ shares.

“I wouldn’t want to be chasing those much after the data,” Gordon said. “After you get positive data and an EUA, I’m not sure how much upside will be left, given already high expectations.” 

Thomson argued that while the industry response to COVID-19, including the unprecedented speed at which companies are developing therapeutics and vaccines, has helped to draw interest and goodwill into the sector, the sentiment may not last beyond the Phase III data.

“I don’t know how vaccine developers will uncouple themselves from the politicization of it all. They are desperately trying to,” she said. “But even if the vaccines are effective, I think there will be a lot of political debate about who gets the vaccine first and how that is decided.” 

Most investors pointed out that the rollout of a COVID-19 vaccine will present industry and governments with unprecedented logistical challenges where the downside risks appear to outweigh any benefit.

“It wouldn’t surprise me if the Phase III data for COVID-19 vaccines are the peak of vaccine euphoria,” Thomson said. 

The other reason a positive Phase III result won’t drive positive momentum for the sector is that it will be viewed as a signal that the broader economy will start to recover, prompting generalists to rotate out of biotech and into tech or more cyclical sectors that have been harder hit by the pandemic, such as banks, retail or hospitality.

That rotation, combined with profit-taking, has already started.

Fund flow data show that while money continued to pour into biotech in July, with net inflows of nearly $1.6 billion, it flattened out in August and late September had net outflows of over $500 million.

The first look at COVID-19 vaccine data is likely to come in October when partners Pfizer Inc. (NYSE:PFE) and BioNTech SE (NASDAQ:BNTX) are expected to announce the first interim analysis from the Phase III trial of mRNA vaccine BNT162b2. Phase III data for mRNA-1273 from Moderna Inc. (NASDAQ:MRNA) and AZD1222 from AstraZeneca plc (LSE:AZN; NYSE:AZN) are expected later in the quarter.

Aducanumab’s advisory committee meeting on Nov. 6 and FDA’s decision between then and the March 7 PDUFA date may represent one of the biggest events in the history of biotech, according to Craig.

“Is this the biggest binary event ever? It feels like it is,” Craig said. 

There are currently no disease-modifying treatments available to the more than five million Alzheimer’s patients in the U.S., and given the devastating nature of the disease, even a small effect on disease progression could easily propel aducanumab to standard of care.

A positive decision on aducanumab is by no means a slam dunk, however, given the divergent results of the mAb’s two Phase III trials, which means the catalyst fits the mold of the type of high-risk event that buysiders may be looking to avoid ahead of year-end.

Whether buysiders hold the stock will depend on their fund structure. Those that operate based on absolute returns may avoid it altogether.  Funds that have their performance benchmarked to a healthcare index that includes Biogen — as most those indexes do, given the company’s large-cap status — may need to be neutral weight in Biogen to avoid getting burned by either a positive or negative outcome. 

Pushing pause on IPOs

Nearly everything about 2020 has been atypical, and that includes the IPO market. A normal election year would see IPOs tail off in the second half, ahead of a presidential run-off, but that hasn’t been the case this year.

In September alone there were 11 IPOs that collectively raised $1.5 billion.

The first three quarters have already set a record for aggregate money raised in IPOs going back to 1993, according to BioCentury’s BCIQ database. 

So far, this year’s 87 deals have raised an aggregate of nearly $18.4 billion, 55% above last year’s peak of $11.8 billion and more than double the $8.7 billion raised in 2000.

“The capital markets activity has been astounding,” Gordon said. He thinks the only thing that might stop or slow the pace of IPOs is a strong pullback in the biotech sector.

“As long as biotech is relatively healthy, I don’t see that changing,” he said.

Thomson noted that given how many investors are playing the IPOs as an asset class and looking to flip the stocks after a short-term bump, it has become difficult for long-term investors to get an allocation.

Still, the investors agreed that a ramp up of volatility post-election could push the pause button on IPOs, causing many companies to wait until the new year rather than try to go out in November or December

The increasing likelihood of a contested U.S. presidential election means the markets could be in for a high dose of volatility in 4Q20, pushing the pause button on a record year for IPOs and sending buysiders looking for companies that are either low risk heading into year-end or have seen their valuations dip.

One maxim of the public markets is that investors hate uncertainty, yet as they head into the fourth quarter, buyside investors find themselves in the position of needing to plan for a scenario in which most of November and December could be embroiled in the highest degree of political uncertainty in generations...