Eventide investors who tune into our portfolio and macroeconomic updates will frequently hear us say, “The fundamentals have not changed.”
What do we mean by this?
When we say “fundamentals,” we are referring to the underlying characteristics of a company that we believe will ultimately drive superior long-term performance. So, given this definition, while the stock price for a given company may vary significantly in a short period of time, it doesn’t always fully reflect the true fundamental value that we see.
What else drives biotech investment prices?
In our Framework for Biotech Investing, we outline three forces that impact biotech valuations:
- Market and macroeconomic forces — headwinds or tailwinds that impact the perception of nearly every company in the entire biotech industry
- Thematic forces — changes in confidence in a specific area of biotech, such as oncology or Alzheimer’s disease
- Company-specific forces — catalysts or setbacks, such as clinical trial results or mergers and acquisitions, which impact the perception of a company’s ability to accomplish their goals, namely to treat or cure a disease
Note that regardless of what is happening at the company, theme, industry, or even market-wide level, stock prices hinge on the perceptions of those buying and selling the stock.
In the short-term, investor perceptions can be strongly affected by emotions, but, in the long-term, we believe that the real-world factors driving company, theme, industry and market performance will ultimately be reflected in stock prices.
Therefore, if we as investors can be driven more consistently by fundamentals in moments when others are driven by fear, we will have opportunities to invest in well-positioned companies when their stock prices are below their real-world, intrinsic value.
We are currently in the largest absolute return drawdown for the biotech industry since 2006. When comparing biotech’s performance to the S&P 500 or the broader healthcare sector, the relative performance is even worse. The current drawdown has also lasted over twice as long as previous downturns.
So, long-term investors should ask: What is driving this volatility—fundamentals or fear?
What is Driving the Current Volatility in Biotech?
Let’s review current events using the above framework.
At the company level, prices often change based on catalysts that happen mostly independently of the market: clinical trial results, FDA approvals, and mergers and acquisitions.
So far this year only about a third of the catalysts have had positive effects on stock prices, about a third have had negative effects (such as disappointing clinical trial results), and a third have been neutral or delayed due to things like the impact of COVID-19 making it difficult to run clinical trials. While a negative trial at one company should not predict the success of an uncorrelated trial at another, sentiment towards biotech has nonetheless become more negative, and fear towards the entire industry has increased.
Meanwhile, uncertainty is besetting the entire stock market. Inflation, rising interest rates, global supply chain, and domestic labor issues are each contributing to a pessimistic outlook from investors. In times of uncertainty, investors flee to assets they deem “safe,” and many investors use broad categories and characteristics to determine which assets to sell and which assets to buy.
As investors adjust their portfolios in times of fear, they are likely to sell out of entire areas of the market that are deemed more volatile or risky. Biotech, being a historically volatile industry, is one of those categories, and so biotech stock prices may drop quickly based on fears in the stock market as a whole.
In our view, it appears that the primary source of the current volatility in the biotech industry is largely due to macroeconomic pressures on assets that are perceived as less safe, potentially driven by emotions of fear and uncertainty.
This leads us to the next question long-term investors should ask: Will biotech fundamentals bring stock prices back up in the future?
Reviewing Industry Fundamentals
One of the most basic drivers of company performance is supply and demand. A company that is well-positioned and competent to supply a product or service that has sufficient demand is poised for success.
For example, when a biotech company shares an exciting clinical trial result, investors gain confidence in that company’s potential to make money by providing a therapy to people who need it. In line with this increased investor confidence, the company’s stock price—independent of the broader market—should move up. Likewise, a positive result in, say, Alzheimer’s research may be seen as a scientific advancement that increases confidence in all companies with Alzheimer’s treatments.
This principle can also be applied to the biotech industry as a whole. While we are currently experiencing negative macroeconomic and market forces on the entire industry, we should ask ourselves: Have we lost conviction on the demand for the industry and the ability of companies to meet this demand over the course of the next 3, 5, or 10 years?
As one of our portfolio managers, Dr. Joy Ghosh, recently said, “The market is suggesting that we either no longer have illness [no more demand] or companies have completely forgotten how to develop therapies to address these illnesses [no more supply].”
The long-term trendline for biotech is positive, indicating that there is sober confidence in the perpetual prevalence of the industry. Recently, however, the biotech industry as a whole (as represented by the SPDR S&P Biotech ETF,1 also known as XBI) has started trading well below this trendline (as shown with the red line in the figure below), indicating that the market could be fearfully selling out of a well-positioned industry.
In fact, biotech companies are currently trading at their lowest valuations in 20 years. One reasonable metric to gauge a company’s valuation is to take its enterprise value—the value of its outstanding shares and net debt—and divide it by the amount of cash the company has on its balance sheet. For the biotech industry, enterprise value has historically been just under 4x the cash that a company has on its books. Recently, stock prices have dropped so much that enterprise value were recently only 2.2x the amount of cash companies have on their books. For some companies, enterprise value has actually dropped below their cash value.2
So, why is this happening?
When the economic outlook is uncertain and investors are keenly focused on interest rates and a company’s perceived ability to generate cash in a short amount of time, it’s difficult to confidently allocate to biotech companies without specialized knowledge of the space. Discounting earnings can be simple math, but the act of estimating sales and earnings is unique in this space. For example, the median annual spend on (R&D) for the biotech industry is over 37%—much higher than the broader index and other industries or sectors (Fig. 3).
Without informed insight of the viability, addressable target market, or competitive advantage of these drugs, devices, and therapies, estimating the growth that may (or may not) come as a result of these R&D efforts can prove very difficult. Therefore, investors without that specialized knowledge may simply sell out of the biotech space and plan to jump back in when their confidence returns.
Learning from the Past
Biotech has experienced periods of underperformance in the past and will almost certainly do so again in the future, but, at Eventide, our view is that companies meeting people’s previously unmet healthcare needs will outperform over the long-term. In our estimation, history supports this view.
In the periods following drawdowns, biotech typically rebounds (see Appendix). Sticking with the space, or even adding to allocations during periods of drawdown, would lead to considerably better performance outcomes on an absolute and relative basis than if one were to wait until the index returned to its most recent highs.
At Eventide, however, we don’t encourage investors to time the market. Rather, we believe that high growth, more volatile areas such as biotech should be approached with a long-term perspective. For instance, consider the rolling quarterly returns of the XBI Index below. Does it appear uniform where one could reasonably judge what the index could do next, or does it appear more random and sporadic?
Now observe the rolling 3-year returns calculated on a quarterly basis. Three years can hardly be considered “long-term,” but one can already note the difference. The risk/reward proposition of biotech is much more compelling, historically speaking, when the time horizon is measured in years as opposed to months or even quarters.
It is our conviction, then, that the fundamentals of the industry are a far better indicator of long-term performance than the short-term volatility caused by broad investor uncertainty. We have always been drawn to biotech both for its potential to change lives and for the potential for investment performance over the long-term. We have spent years building out the expertise of our team in order to make sober judgments and take advantage of times when emotions in the market create opportunities to invest at prices below intrinsic value.
We believe that there will continue to be substantial demand for the therapies being developed in the biotech industry, more specifically in themes that are experiencing breakthrough progress and in the companies that we deem competent to deliver these important therapies.
These fundamentals give us the confidence to continue with our long-term strategy.