Why Battered Biotech May Be Turning Around

Can good science that delivers good medical treatments also deliver good investment returns? Not always, but when it does, the reward is ample. Biotechnology has generated myriad medical wonders benefiting the world: human genome sequencing, disease-resistant crops, regeneration of organs, genetically driven mass production of insulin, and on and on.

Yet for investors in biotech, especially in the segment known as biopharma, life has seldom been easy lately. The sector as a whole has suffered from lagging performance since its glory days as the saviors of humanity during the pandemic. The market excitement around mRNA vaccines, developed to fight COVID-19, fizzled in 2021. Although biotech innovations have produced significant individual investing successes through time, biotech as a whole is a boom-or-bust stock category.

Nevertheless, there are signs it may be recovering, as long-suffering biotech shares began nudging north late last year. Is the worst behind biotech? Will the rally last, or be another false dawn, which this sector has endured in the past? And what will be needed to keep the boom phase rolling? The prospect of lower interest rates and a vibrant merger scene are among the factors that offer hope.

Innovating for the future is at the center of the biotech ethos. Biotech is centered on genetic technology, basically the manipulation of genes to cure human ailments and perform other wonders such as growing weather-resistant crops. After the mid-20th-century discovery that DNA carries a genetic code, new techniques to harness it have exploded.

Double Helix, Doubled Stock

The archetype for biotech investing success is Genentech Inc. Founded in 1976, its first groundbreaking product was synthetic human insulin. Many medical breakthroughs followed. Genentech found a ready reception on Wall Street. When it went public in 1980, the stock more than doubled in an hour. Investors did very well. Although Genentech, later bought by Roche Group, is no longer publicly traded, it set the table for biotech investors who piled into the sector in search of bonanzas.

Given biotech stocks’ volatile nature, these paydays do not always come. Just look at the wild ride of iShares Biotechnology exchange-traded fund, the largest ETF in the sector by assets. It gained 26% in the pandemic year of 2020 amid surges in Moderna Inc. and other companies treating COVID-19, then started to slide in late 2021 and plummeted 14% in 2022. Last year, the fund got slammed in the August-to-October market rout. But then came a promising note: Its recovery since has outpaced that of the S&P 500 (up 19% versus 14%).

Such erratic paths are nothing new for this roller-coaster business. The 1990s provided good times for the industry, but those crapped out with the dot-com bust of the early 2000s. More recently, biotech had a heyday that peaked in 2015, flagging amid rising interest rates and fears of a regulatory crackdown on drug prices by the administration of then-President Barack Obama. Its ascent resumed with the advent of the more regulation-averse administration of then-President Donald Trump.

These days, “a quarter of the unprofitable companies in the Russell 2000 are in biotech,” notes Ronald Temple, chief market strategist at Lazard’s financial advisory and asset management business. Biotech now has an historically high percentage of companies trading at or below their cash value, according to investment bank Leerink Partners.

While biotech’s volatile nature is a challenge to investors, advocates insist it is wise to stick with the sector through fair times and foul. Take the Alaska Permanent Fund Corp. (assets: $75.4 billion): It has done very well with biotech, which represents almost 10% of its $15.6 billion private equity portfolio. The fund started this endeavor in 2013.

The $500 million that the sovereign wealth fund’s PE team has invested directly in biotech firms has returned 4.4 times invested capital for a 97.5% annualized return, as of last June 30. The rest of the fund’s biotech PE segment is invested in private equity limited partnerships and over the same period has generated 1.8 times invested capital, for an 18.6% net yearly return.

Alaska Permanent’s first direct investment was in Juno Therapeutics Inc., an innovative immunotherapy enterprise, for $130 million—and that stake gained around $1 billion after Celgene Corp. bought Juno in 2018.

So despite biotech stocks’ woes recently, Allen Waldrop, the sovereign wealth fund’s director of private equity, says, “We continue to believe in the long-term return potential, particularly given the confluence of technology and science which are driving incredible advances in drug discovery.”

High Risk

The early funding for biotech businesses—genetic manipulation also has applications in agriculture and environmental defenses, but is mainly focused on medicine—depends a lot on venture capital. But VC has been in retreat lately, according to PitchBook data. VC investments in biotech were down to an estimated $24 billion in 2023, from a high of $54 billion in 2021. Meanwhile, biotech initial public offerings numbered just 10 in 2023, less than one-fifth of 2021’s total.

Some headwinds are the past two years’ high interest rates, with biotech high-yield bonds now having to pay more when issued. Health-care junk bonds—a category that includes biotech—now are yielding around 8% annually, up from 3% to 4% in 2021, observes Andrew Krei, co-CIO at Crescent Grove Advisors, which advises institutional investors. “That was a radical shift,” he says. Most biotech companies are below investment grade, although their main source of capital is equity financing. (The S&P Biotech Select Index has a debt-to-equity ratio of 0.47, while the S&P 500’s is higher, at 1.18, says Krei, quoting Bloomberg data.).

A more systemic problem for biotech investors and companies is that the U.S. Food and Drug Administration, the gatekeeper that approves new drugs, is very tough. Some believe the agency is even tougher under President Joe Biden. The upshot is that “90% of drugs that enter human clinical testing will never receive FDA approval and make it to market,” observes Agustin Mohedas, an analyst and portfolio manager at Janus Henderson Investors.

Hence, “It’s hard to predict what will happen in medicine,” says Brian Dana, a principal in Meketa Investment Group. Biotech companies typically go for years until they become profitable, if they ever do. That makes for a perilous existence. A record-breaking 28 U.S. biotech and pharma companies filed for bankruptcy protection last year, a 10-year high.

Part of the jump in bankruptcies is a consequence of the good times in 2020 and 2021, according to Michael Perrone, a biotech specialist at financial services company Baird. “Biotech companies were flush with cash and were able to invest in lower-probability assets,” he says. “The ultimate result was poorer than historical clinical trial outcomes.”

A Test Tube Full of Hope

To some, another system-wide biotech stock surge is not in the offing anytime soon. Biotech, says Jay Woods, chief global strategist at Freedom Capital Markets, “will remains a stock picker’s sector, trying to find that diamond in the rough, instead of a sector that runs on all cylinders.”

Others see the beginnings of a turnaround. Right now, says Baird’s Perrone, “biotech investor sentiment can be most accurately described as cautiously optimistic.” For one thing, a lot of cash remains on biotech companies’ books: $199 billion, per RBC Capital Markets.

Biotech is one field that appears poised for a boost from artificial intelligence. AI could “lead to novel drug creation,” says Dylan Desai, an associate product manager at investment firm Van Eck. A McKinsey & Co. report declared that AI could be harnessed to discover new treatments undreamed of today, more quickly and efficiently than human researchers could deliver. AI could aid biotech, the study stated, with its ability to “automate previously manual tasks and generate new insights at an unprecedented pace.”

A prime example of this is AI company insitro Inc. (it prefers the lowercase). Funded by the likes of the Canada Pension Plan Investment Board and VC kingpin Andreessen Horowitz, insitro employs machine learning to help researchers comb through data to find useful patterns that can be developed into medicines.

Meanwhile, the sector enjoys another enduring advantage. The tendency of Big Pharma to buy out promising innovators has always been a boon to biotech. Deal value in 2023 was healthy, despite all the gloom and doom—totaling $140 billion, the highest level since 2019, by RBC’s count.

Large drug companies on the order of Pfizer Inc. “see patent cliffs” approaching, as some of their biggest sellers are slated to lose their exclusivity, says Julie Biel, chief market strategist at Kayne Anderson Rudnick. “So they have to invest and innovate.” The easiest way to gain those qualities, of course, is to buy smaller biotech outfits.

True, such deals can be difficult and costly to pull off, especially given the heightened regulatory scrutiny of the Biden administration. Pfizer last year paid $43 billion to buy Seagen Inc., founded in 1997, whose first drug went on sale in 2009. The acquisition doubled the pharma giant’s oncology pipeline. To mollify federal regulators and head off antitrust objections, Pfizer agreed to donate royalties from its Bavencio, which treats bladder and urinary tract malignancies, to a nonprofit, the American Association for Cancer Research.

Certainly, large pharma concerns can and do develop pioneering products by themselves. Denmark’s Novo Nordisk (market cap: $474 billion), for instance, created its type II diabetes treatment, Ozempic, which morphed into a revolutionary weight loss drug.

Hot, Then Cold, Then …

Sometimes, winner biotech firms can run into trouble, then thrive again. From early 2020 to the end of 2021, Moderna Inc. saw its losses turn to profits, its revenue vault and its stock expand more than 21 times. In 2023, however, Moderna, whose lone major product is the vaccine, dipped back into the red for two quarters, its sales sank, and the shares suffered a 52% downdraft. This year, it is off 2.6%. “Nobody knew what was going to happen after the pandemic in terms of volume,” CEO Stéphane Bancel admitted to Barron’s.

Now, the company is placing a lot of hope on its new vaccine for skin cancer patients, which it wants to start selling in 2025. Helping that quest is that a lot of cash from the vaccine rush remains to cushion the company.

If the skin-cancer vaccine goal is reached, the result will demonstrate once again how biotech’s promise can bring great rewards and that the risk of these hard-to-understand products is worthwhile. Says Mark Steed, CIO of the Arizona Public Safety Personnel Retirement System ($20 billion), with 5% of its portfolio devoted to biotech, “I don’t know how an airplane works, but I still get on it.”