Biotech Growth Trust: A Compelling Entry Point for Long-Term Investors?

It has been a difficult period for investors in small cap biotech stocks, which have suffered a huge write down in the last year or so as these long duration assets have been adversely affected by the sharp increase in discount rates. If you look at the fundamentals however it seems as though the sell-off has gone too far.

One way to value unprofitable biotech companies is to compare their market caps to the net cash on their balance sheets. Using this measure, the valuations are well below previous crisis levels such as the dot com bubble and the global financial crisis, with 25% of these stocks trading at less than their net cash.

The managers of the £415m Biotech Growth Trust (LON: BIOG) say that they have never seen such a dramatic disconnect between industry fundamentals and performance, or such a compelling entry point for long-term investors. This is backed up by the broker Investec, who believe that biotech has the potential to deliver some of the highest returns over the next decade and describe it as ‘a classic contrarian opportunity’.

Bad Timing

In 2019, the trust made a structural shift to emphasise emerging biotech companies, which are responsible for two-thirds of the drug industry’s research and development pipeline. In the following 18 months it delivered exceptional returns, but this ended at the start of 2021 and the subsequent losses have wiped out all of the outperformance since the manager was appointed in 2005.

BIOG is managed by OrbiMed, one of the largest dedicated healthcare investment firms in the world, with the portfolio rebalancing designed to allow the firm to ‘exercise its advantage of superior research and judgement in small cap stocks’. Obviously things haven’t exactly gone to plan, but there is no denying the long-term potential from the current low starting level.

Investec believe that the secular growth drivers of the sector such as innovation and demographics are deeply entrenched. They also point out that after the historically large drawdown, valuations are close to 20-year lows.

Bright Future

The manager continues to believe that small cap biotech stocks have the most upside potential and says that the current environment is conductive to accelerated M&A activity. Large pharmaceutical companies like Merck, Bristol-Myers Squibb and Abbvie are all facing key patent expirations in the period 2025-30 and need to replace the pipeline of new drugs.

One point to bear in mind however is the meaningful exposure to Chinese unlisted biotech businesses that currently stands at 7.9% of the portfolio, with a further two percent in their listed peers. OrbiMed has reduced their investment in this area, although they believe in the long-term prospects and the Chinese government’s unwavering commitment to promote innovation in the sector.

Biotech Growth has taken a real battering with the shares down around 34% in the last two years and they now trade at about a five percent discount to NAV. If you like the prospective returns, but are uncomfortable with the high volatility, you might prefer its stablemate, Worldwide Healthcare (LON: WWH) that provides a broader exposure to the biotech and healthcare sector.