After coronavirus vaccines made biotech the best performer in 2020, the sector faced a major toll this year.
Small biotechs have underperformed this year
Source: S&P Global, ETF Securities. Data as of December 7, 2021.
Over the past year, the S&P 500 has returned 26%. Yet over the same period, the S&P Biotechnology Select Industry Index, which measures the US biotechnology sector on an equal-weighted basis, fell 16%.
The underperformance has left many wondering what’s going on.
Underperformance is due to politics
Politics was the main driver of biotech’s underperformance. Since Joe Biden won the presidential election, he has tried to make drugs more affordable. Although these changes should have only a modest impact on the fundamentals of biotechnology companies, they have nevertheless affected the market.
What are Biden’s changes? There are three:
As part of the $2 trillion infrastructure and climate bill that Biden pushed through Congress in November, the government will negotiate lower prices for older drugs purchased by Medicare. While these types of negotiations are common in other parts of the world, including Australia, the United States has been unusual in the freedom it has given pharmaceutical companies to set the prices they charge the government.
With the government negotiating some drug prices, revenues for biotech companies are expected to be lower. However, they are unlikely to be significantly lower. Analysts quoted by the Wall St Journal believe the bill will have a ‘very modest’ impact on the pharmaceutical industry, with an overall reduction in industry revenue of only 3% to 5%, equivalent to giving up less than a year of growth.
Another reason for the sale is restrictions on mergers and acquisitions that Biden is imposing in the healthcare sector. In a bid to increase competition, Biden is set to take a closer look at hospital and pharmaceutical mergers. In this regard, we have already seen a slowdown in M&A activity this year.
Number of M&A transactions quarterly
Source: Assess. Data as of August 1, 2021
Tighter monitoring of mergers and acquisitions is dampening the valuations of smaller biotech companies. Indeed, M&A activity – such as around patent cliffs – is one of the main drivers of their value. This is perhaps the easiest explanation for the underperformance of small-cap biotechs.
The end cause was the power vacuum at the top of the Food and Drug Administration, the industry’s top regulator. The FDA has burned eight commissioners since 2015. And from January to November 2021, there was no permanent commissioner (a new commissioner was only appointed in November, after several months without a commissioner). The vacuum at the top has led to delays in drug reviews and, in some cases, confused regulatory decisions.
Why we remain optimistic
Despite political headwinds, we remain optimistic about the outlook for biotech. Why are we optimistic? Three reasons:
Drawdowns above 30% are common
The sector is currently cheap
Similarity to the 2015-2016 crash
The first is a simple story. Among biotech investors, there has always been an understanding that “volatility is the price of admission”. Volatility can go both ways, up and down.
A look at the history of the index shows this. Looking at the 10-year history of the S&P Biotechnology Index, declines greater than 30% are common (chart below). In each previous case, the index has rallied and in some cases, major declines have been followed by periods of outperformance. However, past performance is not indicative of future returns.
Today’s Biotechnology Harvesting in a 10-Year Perspective
Source: S&P Global, ETF Securities. 10-year S&P Biotechnology Select Industry Index price returns as of December 7, 2021.
Another reason for our optimism is that the sector now looks cheap. The S&P Biotech Index is currently trading on a one-year forward price-to-earnings ratio of just 11.6 as of December 8, 2021. This is about half the forward PE of the S&P 500 Index, which is on a PE forward of 21.7 on the same date.
It’s worth noting that these low PE ratios don’t owe biotech companies to be cigar butts, with their best days behind them. Many of these cheap biotechnologies are at the forefront of modern medicine. Some invent the cure for cancer (literally). While others are developing mRNA technology, the miracles of which we have seen with covid-19 vaccines.
A final reason for our optimism is that today’s decline resembles the biotech crash of 2015-2016. After presidential candidates Hilary Clinton and Donald Trump criticized biotechnology “price gouging,” the index fell nearly 50%. Yet, in the five years that followed, the index gained 284.2%.
The S&P Biotech ETF (CURE) invests in the stocks that make up the benchmark S&P Biotechnology Select Industry Index closely in proportion to their weighting in the index and aims to provide investors with a return that (before fees and expenses) tracks the performance of its benchmark. .