FDx Advisors Blog

Is the business of biotech advancing to the next level?

September 2, 2015 Written by Beau Noeske

The continuous run in biotech can provoke thoughts of a potential bubble, especially when a majority of the firms in the sector don’t earn a profit. The NASDAQ Biotechnology Index for the past ten years increased over 300%. Since 2010, the number of IPOs in the sector has significantly increased and accounts for a large portion of the total IPOs in the United States. New IPOs are launched before the lead product has been through pre-clinical trials, which could up the ante on potential failure. It is not uncommon to see the initial share price grow by 100% before there is any evidence of product success. Also, it is not unusual to see a decline by 50% or more in stock price because of one of the many clinical pre-trial hurdles failed. Because of the nature of the biotech sector, a company’s progress can lead to binary results in the stock price. A lot of our asset managers tend to be underweight in biotechnology due to the firms generally not meeting revenue requirements or because of the binary outcomes.

Does that mean biotechnology is in a bubble? Since the biotechnology sector does not have a cyclical or seasonal relationship as technology or commodities, such as energy would experience, bubbles for this sector are harder to determine. The aging population continuously increases, and the need for better medicine is always in demand. In the 1980’s and 1990’s pharmaceutical companies invested a significant level of research and development towards production of new medical drugs. But, the level investment did little to improve industry profits or increase the level of new product breakthroughs. So, big pharmaceutical partnerships with smaller biotech companies were formed to allow industry participants to focus on their strengths. The smaller biotech companies were better suited for research, while the pharmaceutical companies could focus on marketing. Since the shift in focus, profitable biotech companies have been few and far between. Eventually, biotech firms shifted away from riskier business models of developing medicine from start to finish to acquiring licensing on third party projects for refinement. The reduction in risk has also meant a potential for a lag in significant medical improvements.

The biotech sector faces challenges due to uncertainty, integration, and knowledge transfer limitations. The uncertainty is unlike any other sector. For example, a manufacturer of cars and computers will have a solid understanding the product will be viable before research and development take place. Product development in biotechnology goes through multiple trial periods with possibility of failure at any stage of the process. Because of the trial and error process, funding can reach into the billions. A report from the National Venture Capital Association states investments in biotech firms tend to be a fraction of the typical cost for medical drug development. Because of the investment shortfall, public equity or partnerships with large pharmaceutical companies are expected to cover the cost of development. Public equity deals are difficult because valuations are generally based on earnings and the majority of the biotech firms are only in the research and development phase. Firms can really only be valued on their R&D projects. But, there is no clear requirement on how to report R&D, so biotech firms have a considerable amount of discretion to report the data. Because of reporting limitations, valuations on R&D are difficult. Partnership deals with big pharmaceutical companies carry risk for overpaying or backing out of a partnership at an inopportune time due to expertise constraints or limitations. The challenge to integrate specialized functions is becoming much more difficult. Biotech firms typically arrange licensing agreements between each other to facilitate information transfer between specialists in molecular biology, genetics, cell biology, protein chemistry, etc. Challenges arise due to the difficulty to patent knowledge and who has the right to the discovery. Because of the patent issues there can be potential lawsuits and withholding of material information from one another. For any significant level of success, the partnership needs to be in place over a considerable amount of time due to the complexity of the development process.

The potential in the biotechnology sector is challenging to say the least. Because of the industry’s structure and development process, methods to invest in the market can be highly risky. The inability for an investor to appropriately value an opportunity and the structural challenges to move development forward at an efficient pace would give any investor pause. Because of the risk associated with biotech, the managers on our platform tend to have a low exposure to the sector or invest with large biotech companies.   Some of the managers view the larger firms to have a more diverse lineup of medical products to decrease the binary outcome risk. Statements we hear from our managers are the opportunities are immense, but without earnings history and binary outcomes it can be a risky proposition.

Tags: , ,