4:43 PM
Jan 12, 2018
 |  BioCentury  |  Finance

Choosy investors

Why 2018 will be a stock picker’s market in biotech

Despite losing steam in 4Q17, the broad-based recovery in biotech stocks last year has left investors generally comfortable with current valuations, and hence less optimistic that the sector indexes will outpace the broader market in 2018.

That doesn’t mean, however, that investors have turned bearish. Rather, the 17 buysiders who spoke with BioCentury about the coming year say prevailing headwinds should make it easier for stock pickers to outperform their benchmarks.

In fact, many investors told BioCentury the conditions for generating alpha are particularly favorable heading into 2018, and selectivity will be even more important than in prior years.

A big reason is that generalists aren’t expected to return to biotech in a big way in 2018. While their capital will be missed by some, avoiding a rotation that dangerously inflates equity values on the way in and pummels them on the way out is seen by most as a positive.

“You’re not going to see as large gains in the indexes because of the larger caps.”

Marshall Gordon, ClearBridge

Buysiders also expect M&A activity will rebound after a surprisingly slow 2017. Their reasons are both strategic and statistical.

In the former category are structural weaknesses among large cap biotechs and pharmas, which will increase the pressure on these companies to pick up new assets. The latter relates to the abnormally low level of deal flow last year, which suggests activity has nowhere to go but up.

The six bankers who spoke to BioCentury said the IPO queue is still chock full of high-quality candidates, and activity is expected to ramp up much more quickly than last year. Buysiders also said quality remains high, and indicated they are receptive to new paper.

The follow-on market is likewise expected to remain very healthy, with companies using key catalysts to secure capital at favorable prices.

Top heavy

Specialists largely agree that continued underperformance by the big caps this year will weigh down the most closely followed biotech indexes.

In the final quarter of the year, the NASDAQ Biotechnology Index (NBI) dropped 4% and the NYSE Arca Biotechnology Index (BTK) and the BioCentury 100 traded flat (see “Index Performance”).

In contrast, the Dow Jones Industrial Average (DJIA) jumped 10%, the NASDAQ Composite climbed 6% and the Standard & Poor’s 500 index increased 6%, largely driven by increasing certainty that the Tax Cuts and Jobs Act (H.R. 1) would be signed into law.

President Donald Trump signed the bill on Dec. 22, and it became effective Jan. 1.

While biotech is expected to derive fewer benefits than other sectors from the tax code rewrite, the bigger issue was its inability to recover from one high-profile clinical flop that was soon followed by weak 3Q17 earnings reports from multiple large cap bellwethers.

Celgene Corp. was the primary culprit, first announcing that mongersen failed a Phase III trial in Crohn’s disease on Oct. 19, and then following up with underwhelming 3Q17 results and a reduction in long-term guidance on Oct. 26.

Gilead Sciences Inc. and Biogen Inc. also reported weaker than expected top-line results that dented what was at best tenuously positive sentiment among the wider investment community.

ClearBridge Investments’ Marshall Gordon doesn’t necessarily expect the indexes to decline this year, but he is concerned about large cap performance and thinks it’ll constrain the space.

“You’re not going to see as large gains in the indexes because of the larger caps,” he said.

Carl Harald Janson of International Biotechnology Trust plc (IBT) believes the largest biotechs are now indistinguishable from their big pharma cousins, which skews the perception of the biotech sector’s growth profile.

“If you excluded the four largest companies in the biotech sector from the index, you would see a different multiple,” he said.

“A large pool of generalists are going to consider healthcare a particularly toxic environment to invest in.”

Otello Stampacchia, Omega Funds

For example, the NBI currently includes almost 200 components, but Amgen Inc., Biogen, Celgene and Gilead account for 31% of its weight. The iShares Nasdaq Biotechnology ETF (IBB) -- which is indexed to the NBI -- has a similar problem. The same four big caps account for 32% of its weighting.

On the other hand, the SPDR S&P Biotech ETF (XBI) relies far less on large caps to drive index gains, with the big four weighing just under 6%.

For the year, the XBI posted a 44% gain, more than double the NBI’s 21% return.

Until the big cap bloodletting, there was preliminary evidence that generalists were starting to nibble in these and other biotech names. Biotech fund flows totaled almost $1.4 billion between June and November, according to EPFR data, and there was increasing belief that the generalist crowd was on the cusp of a more significant rotation (see “Biotech Fund Flows”).

“That was fragile and it evaporated with Celgene’s updates,” said Linden Thomson of AXA Investment Managers.

EPFR reported December outflows of $276 million. Net outflows for the year were $1.1 billion, building on the $5.3 billion in outflows seen in 2016.

A separate analysis by Laura Chico of Raymond James using data from Lipper/AMG Data Services likewise showed $2.2 billion in net outflows in 4Q17 alone, which put 2017 in the red by $397 million.

EPFR data includes only biotech-specific funds totaling $38 billion in assets, while the Lipper/AMG Data Services data also include diversified healthcare funds encompassing $58 billion in assets.

Underperformance by the widely followed NBI and IBB benchmarks could serve as a gating factor for generalists. These investors almost always start in the largest cap names because they tend to have visible sales and earnings, and they meet market cap and liquidity thresholds mandated by generalist funds.

“If [large caps] continue underperforming and treading water then it might be a problem for attracting assets to the sector,” said Brad Loncar of Loncar Fund.

There are pros and cons to this dynamic, and the prevailing view is that it’s a net positive for stocks.

Without generalists, specialists wouldn’t enjoy the appreciation that comes with new money flows into the space. More fundamentally, the absence of generalist capital would mean less money was available to finance promising new technologies.

However, buysiders consistently told BioCentury they had plenty of capital heading into 1Q18. Some exited winning positions to recycle cash while others had just closed new fund-raising rounds.

On the other side of the ledger, the benefit of limited generalist participation is that valuations won’t...

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