243. Biotechnology: the innovation engine of big pharma

2 March 2023 (pre-recorded 27 February 2023)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRODUCTION]

Staci West (SW): Welcome back to the Investing on the go podcast brought to you by FundCalibre. Today’s episode covers a specialist sector — biotechnology. In simple terms, this is technology that uses biological systems and living organisms to develop or create different products. The most prominent area is production of therapeutic proteins and other drugs through genetic engineering. Arguably it’s one of the few winners from the impact of the Covid pandemic, and today’s guest has nearly two decades experience and is one of the early specialists within the biotechnology sector. 

Darius McDermott (DM): I am Darius McDermott from FundCalibre, and today I’m delighted to be joined by Linden Thomson, the manager of the AXA Framlington Biotech fund. Linden, good morning.

Linden Thomson (LT): Morning. Nice to be here.

DM: Thank you for taking the time to come and talk to us about a specific sector.

[INTERVIEW]

DM: And maybe we could start just with a generalist question about what exactly is biotech? How is it different from sort of pharmaceutical companies that people may be more familiar with?

LT: Yeah, I mean, very loosely, it can be considered as the innovation engine of biopharma and of the drug sector more generally. It’s often sitting at the cutting edge of the next medical breakthrough, for example. 

I think the definition of biotech is most often compared to pharmaceutical peers. And I think that that, to your point, has drifted over time as largely the traditional pharmaceutical companies have become more like biotech; they’ve acquired biotech assets, they’ve built the technology out, not unlike AstraZeneca for example, to harness the innovation that’s intrinsic in the biotech sector. So, for example, in the early 2000s, the sector was very much in its infancy. And then since then, it’s evolved hugely such that in 2021, the top 10 selling drugs globally, were all biotech derived. So, I think it’s transitioned significantly over time. And actually, interestingly, recently pharmaceuticals have become more like biotech and now we generally classify some of the large caps as biopharma.

DM: So, let’s delve in then because it’s a very interesting broad subject, biotech. What sort of themes are driving the sector today? What type of drug areas? What [are] the driving forces?

LT: Yeah, so as you said, drugs are the main driving force and, largely, innovation. I mean that’s a tenet that runs all the way through and has done over the last 20 years of the sector and will continue to do so. So, scientific advances in our understanding of diseases, new drug technologies, I think they’ve really accelerated the innovation actually in the sector since the main sequencing of the human genome, and certainly the cost of sequencing over time coming down so much has really helped there. So, this really is the still the centre for growth in the sector. And in my view this isn’t going anywhere. 

Another one to think about is also demographics; that remains a long-term tailwind to both pharma, biotech and actually the broader healthcare sector. Populations are getting older on average, prone to more age-related diseases such as dementia, cancer, heart disease and, as we age, we also use more healthcare.

That’s also a rise in lifestyle diseases. We’re all generally leading more sedentary lives. And again, this also drives things, chronic conditions like heart disease, diabetes, liver diseases and actually obesity in itself, which is becoming more widely accepted as a disease area in its own right. So, these chronic conditions require safe, effective long-term treatments. 

Of course, given the Covid pandemic, there’s also a focus now on disease prevention and thinking about vaccines. And so, there’s focus on that in terms of themes for the sector. And I think another theme to think about is also geographical expansion. And I think in that case, China in particular. So, this is not just a US opportunity anymore for biotech, we’re also looking at China in terms of potential opportunity there. 

And then on the risk front, obviously side by side with R&D development success, there’s also failures and development failures. So, it’s our aim within the fund to invest in those successful companies, [and] try to avoid those that aren’t successful. And one of the key concerns that’s been an overhang for the sector for a number of years now, and is also considered in the short term, and that’s pricing dynamics, particularly in the US. Outside of the US, we’ve been used to seeing price declines year on year, but this hasn’t been typical in the US. Actually, in the US, we’ve seen price increases year on year. And so, although we think the value of the US market remains very attractive for companies, especially those producing effective drugs that patients and doctors want to use, the risk to pricing does need to be carefully monitored going forward.

DM: Maybe then that links me into another question I want to touch on, which is about politics and maybe the US electoral cycle. How does that affect the sector? And again, you’ve touched on China with a sort of general increase in tensions between the US and China. Are those areas that cause concern or is the opportunity set greater?

LT: I mean the opportunity is still – for biotech – very much US-based with, as I said, China, longer-term, a very interesting market to monitor and to kind of look at from an investment point of view but bearing in mind there’s geopolitical certainly near-term risks.

In terms of the US, there’s long been concern, as I said, stretching over probably five years now, from stakeholders as to what the US government could do to lower prices for drugs in the US. And this – just as a bit of background – stems from the fact that the US is the largest market by quite some way for biopharma. And so, as many I’m sure of the listeners know, the Inflation Reduction Act last year covered much ground. But there was a focus for healthcare within that, among other things. And one important area that it’s opened up, from a biotech remit perspective, is the fact that US government can now negotiate the prices of some drugs which cost the system most each year. 

So, historically the US government could never get involved in drug pricing directly. And from 2026 they will be able to do that, as I said, for a specific number of drugs each year. Information on how they’ll plan to choose those drugs systematically, we expect within the next few months, and the list of the first 10 that they will negotiate from 2026 onwards, will be available around September of this year. So, I think there’s still quite a lot to be fleshed out. And, as I said, there are a number of check boxes that drugs will need to show in order for them to be even considered within the price negotiation. For example, they will have needed to be on the market for at least nine years. So yeah, it’s a way off, but I think that just the introduction of some of these lists etc. may just bring the risk into the view of quite a lot of investors.

I think from a biotech specific point of view, the risk is likely manageable at the moment. In some ways also, we’re in a position now where we have at least some certainty over the outcome and how things will be managed going forward, which in equity markets is often better than the unknown risk potential that’s been an overhang for the last, as I said, five years. But you know, 2023 and [in particular] the next six months there will be a lot more focus on this. And so, there could be some volatility around it.

DM: So, I do historically – and you are here to correct me where I’m wrong – think of biotech as quite a volatile sector, sort of a high beta sector. Do you think that’s fair and [are] there times in the cycle when biotech tends to outperform the broader market? And are there any sort of times where you think, actually, these are times where maybe biotech will underperform the broader market?

LT: Yeah, I mean I think historically, quite rightly, it’s been viewed like that. It has changed markedly over the last five years. In terms of the number of stocks, the sector is still very much weighted towards those loss-making early-stage companies, you know, the ones that are typically more binary and no doubt this is where much of the disruptive innovation is to be found. And so, that part of the market’s kind of critical to the long-term growth. However, there is a very large profitable, more defensive part of the sector, which really has come into its own in the last, you know, six to eight months. And there’s a mid-cap part of the sector, which is a high growth, innovation driven kind of commercial assets or soon to be commercial assets, which is where our fund has typically kind of invested, which have compelling R&D pipelines and growth from, you know, commercial launches.

So, I think the sector now really does offer a mix of defensive top line growth and pipeline leverage, which, from a long-term perspective, is a area of focus. 

So yeah, I think, you know, when you’re thinking about the next 12 months from a macro perspective, if we’d looked back 12 to 18 months from now, the growth profile of biotech perhaps would not have looked as attractive versus some of the other areas of the market. But, you know, the confidence that we’ve got in that growth outlook now sets it apart from many other areas when there’s nervousness and concern about the growth outlook for many of the other areas. So, I think that actually it’s kind of come into its own in the last six months and looks really interesting on the next 12-month view

DM: Do you selectively do some of those sorts of loss-making, pioneering, innovative type of drug biotech companies? [LT: Yep] Or do you tend to focus on that large cap defensive part, or is in fact your fund a nice mixture of all?

LT: We’ve tried to keep it a mix of all of those. We have the larger cap part of the market from a more defensive perspective. As I said, the smaller cap, more binary part of the market is where much of that innovation happens. And so, I think it’s really important that investors get exposure to that early-stage innovation as well. But, in terms of where we’re more overweight, as I said, it’s the mid-cap part of the market, which I think offers commercial opportunity as well as R&D pipeline. 

In terms of the fund, it’s probably about 80% invested in companies that are profitable or have commercial assets that aren’t profitable yet but have that in their near-term horizon. So, I think the view that biotech funds are all very small-cap binary, it’s not necessarily any longer the case and certainly isn’t with the Framlington Biotech fund.

DM: And again, I know we’ve just sort of touched on it, but it  that larger-cap part that has a bit more defensive characteristics, because I’m guessing some of their products are mission crucial, you know, these are ‘have to have’ drugs as opposed to lifestyle drugs or whatever, you know?

LT: Yeah, absolutely. I mean the companies have – maybe matured is not the right word – but all of biopharma now understand that they need to build businesses in drugs that are safe and effective. In standalone businesses where another ‘me too’ undifferentiated product is no longer a business model that any of these are taking; they’re all looking for new medical opportunities, often for patients that have no other options, trying to produce the most effective drugs that they can. And when they follow that business model, honestly they’ve been successful. 

So, I mean, if you just even look at some of the larger cap companies in the sector, I mean, Gilead [Gilead Sciences, Inc.] has completely changed the outlook for HIV AIDS patients over the last 20 years+. They’ve done a similar thing for Hepatitis C patients. Vertex [Vertex Pharmaceuticals] in terms of developing the first drugs to treat the underlying symptoms of cystic fibrosis and the underlying disease. So, there’s numerous examples. And what that means now is that, when we’re thinking about the revenue outlook, we’re thinking about the financial outlook for these companies. They have proven to be truly defensive because these drugs are used by, needed by, patients and are being prescribed by doctors.

DM: And maybe then lastly, if we could just touch on M&A in the sector. As with lots of sectors, if you have a good idea and you prove it works, somebody bigger might come and acquire that intellectual property and then make all the profits. How has M&A been in the last sort of 12 months and how does that look maybe for the year or so ahead?

LT: Yeah, I mean, to your point, I think it’s inevitable in a sector that’s very innovation focused with lots and lots of small cap opportunities. You know, all of large cap pharma are looking to expand their R&D pipelines. Some of them are very explicit about it. Like, for example, Pfizer, giving longer-term guidance of how much of revenues will come from business development. Others are less explicit and you know, they’re just taking opportunities when they come. Last year, I think the fund had around five acquisitions of companies we owned which definitely supported the performance of the fund. And I think going forward, we should assume that M&A continues to be ever present in the sector. I mean, it’s impossible to run a fund for M&A specifically; you know, we own companies that we think are high quality, judged by numerous different ways. And it does mean that we are in companies that are often the ones that get bought. 

I do think though, it’s worth remembering that the longer-term upside from companies that remain independent and that can grow, launch their drugs, can also be meaningful and sometimes more meaningful than M&A. So, as I said, we just try and focus on the best access to the best quality companies. I mean there’s over 300 companies in the index, there’s more in terms of the global opportunity and the fund’s in around 50 to 55 companies.

DM: Great. Linden, thank you very much for your time this morning.

SW: The AXA Framlington Biotech fund looks to tap into what is now one of the fastest growing subsets of the healthcare sector. The portfolio can invest globally but tends to have a bias towards the US, where most biotechnology companies are based. This sector requires a specialist, focused team with skills, experience, and a network to keep up with the changes that are taking place and that is exactly what manager Linden Thomson and her team offer. To learn more about the AXA Framlington Biotech fund visit fundcalibre.com – and don’t forget to subscribe to the ‘Investing on the go’ podcast, available wherever you get your podcasts.

Please remember, we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at the time of listening, Elite Ratings are based on FundCalibre’s research methodology and are the opinion of FundCalibre’s research team only.