A great thing about living in New York City as an investor is that, sooner or later, almost everyone who is anyone in the financial markets passes through, and often I get to meet to talk over ideas.
The annual Jefferies Global Healthcare Conference every June is an example. This year it featured about 400 biotechnology companies. There was also a “view from the buy side” panel featuring three money managers with good records and a collective 60 years of experience.
Here’s their take on why this is a great time to invest in biotech, how to maneuver and what to avoid.
Reason 1: Biotech is unloved, which makes it a good place for contrarians to bargain-hunt
Biotech investing is trickier now that we’ve moved on from the go-go years of 2012-15, when the proverbial “blind man with a stick” could make money in the sector. Yet it’s a good time to buy biotech because it is pretty widely unloved. Net cash flows into the group so far this year are more or less flat.
Reason 2: Biotechnology is an island of innovation in a sluggish economy
A lot of people look at tech and Silicon Valley as the home turf of innovation and rapid-growth companies like Facebook FB, +1.48% Alphabet GOOGL, +1.73% and Tesla TSLA, -0.43% But biotech companies more than hold their own on innovation. Find the right one, and you can land a 10 or 20 bagger [a stock that rises 10- or 20-fold], says Philip Dreyfuss of Farallon Asset Management, a hedge fund with $40 billion under management. “It is a tremendously exciting time,” he says.
“Innovation is reaching exponential levels,” agrees Jay Rao, a medical doctor and money manager at Balyasny Asset Management. “Advances in biology and science are breathtaking, and they are creating tangible benefits for patients. That’s kind of incredible when you step back and look at the rest of the economy. There are lots of opportunities to do in-depth, fundamental analysis on product launch trends and clinical data events.”
Reason 3: M&A will bounce back
Supposedly, Donald Trump was going to change the tax code so that companies could bring cash back home. This was going to spur waves of buyouts by innovation-starved Big Pharma companies hungry for growth.
So far, however, this has been a dub. Deal flow in the sector is the lowest it’s been in five years. Alas, Trump is not finished yet. It’s too early to write off tax reform. But even without his help, Big Pharma has over $500 billion in cash to deploy to fill out thin pipelines. Those forces haven’t gone away. “M&A and consolidation are inevitable,” says Rao. “It is more a question of when, not if.”
Reason 4: There will be no draconian crackdown on drug prices in Washington, D.C.
One big fear that’s keeping investors out of biotech is the potential for a crackdown on drug prices by politicians.
But this is unlikely to happen in any serious way, according to the Jefferies panelists. As this becomes more apparent, investors will get more comfortable with the group and drive up biotech stocks, benefitting anyone who gets in now.
It’s difficult to imagine that Washington will impose any price controls with Tom Price as secretary of Health and Human Services, given his history of rejecting this kind of policy, said Rao, at Balyasny Asset Management. “The transmission mechanism doesn’t seem to be present to enforce anything that’s fundamentally threatening to the industry,” he said.
Instead, politicians being politicians, they are more likely to go for the low-hanging fruit. So they’ll crack down on the prices of products that are most visible to consumers — like the EpiPen — even if these products are relatively cheap compared with expensive specialized therapies.
Besides, the pharma industry is doing a good job of demonstrating to politicians that drug costs are only a relatively small portion of overall health-care costs. And that “expensive” drugs can actually save money by eliminating chronic diseases, and keeping people out of hospitals and at work.
Reason 5: Biotech is a safe haven from the steam roller of computer-based trading
One big fear in the market now is that artificial intelligence (AI) deployed by the statistics geniuses will make it difficult for old-school stock pickers, like me, to survive. So far, this has not played out. Major “quantitative” funds like Two Sigma Investments and Winton Futures Fund are significantly lagging behind the market this year.
That may be only temporary. We have to wait and see. But biotech will probably be immune from artificial intelligence, because stock-moving developments in this space are too quirky to model with computers.
“These are highly idiosyncratic, data-driven events,” said Dreyfuss of Farallon Asset Management, referring to drug studies and product launches that move biotech stocks. “It’s one thing to say ‘What is the relative multiple of consumer products companies?’ and arbitrage small differences. It is harder for computers to predict how a company will do the first time it reads out a trial.” For this reason, he thinks health care will be the last area of investing that gets “commoditized” by AI.
Pitfalls to avoid
Big Pharma companies like Sanofi SNY, +1.76% Pfizer PFE, +0.76% Bristol-Myers Squibb BMY, +1.40% AstraZeneca AZN, +0.29% GlaxoSmithKline GSK, -0.09% Roche RHHBY, +0.21% and Novartis NVS, +0.75% look intriguing as potential contrarian investment ideas. Their stocks have gone nowhere, or declined, during the past several years.
But the Jefferies panel suggested it may be better to take a pass. “Big Pharma will continue to be the most challenged part of the overall health-care sector,” said Harlan Sonderling, a health-care analyst at Columbia Threadneedle Investments. “Big Pharma is a tough place to make money.”
One reason is the lack of growth. Earnings estimates for the group are the same level now as they were in 2012, says Sonderling.
Another problem is that they tend to develop “me too” drugs that lack pricing power. Any blockbusters have a hard time moving the earnings needle because these companies are so big. “Large-caps are victims of their own success,” says Dreyfuss. The more successful they are, the harder it is to replicate that success.
They also tend to have bloated overhead. “They have big campuses that really should turn into housing projects or back into Air Force bases,” says Sonderling. Then there’s the overly complex accounting. “There are so many recurring non-recurring charges that the earnings quality becomes questionable,” he says.
It might also be better to avoid medical-device and managed-care companies. Health-care investors have flocked to these names to avoid biotech and pharma stocks that might get hit by drug-price controls. That trade could reverse itself as worries ease about a drug-pricing crackdown.
Like any sector, biotech has potential “black swan” events that could hurt you — out-of-the-blue developments that could tank biotech stocks.
Here are two big ones to ponder. What would happen if a major managed-care company like UnitedHealth Group UNH, +0.77% Anthem ANTM, +1.46% or Aetna AET, +0.76% merged with a big drug retailer like CVS Health CVS, +1.35% or Walgreens Boots WBA, +1.75% ? Or what if Amazon.com AMZN, +0.76% gets into prescription-drug sales? Either change could shift the balance of power in drug pricing away from drug producers.
At the time of publication, Michael Brush held INCY. Brush has suggested INCY, KITE, FB, GOOGL, AMZN in his stock newsletter, “Brush Up on Stocks.” Brush is a Manhattan-based financial writer who has covered business for the New York Times and The Economist group, and he attended Columbia Business School in the Knight-Bagehot program.