Biotech Investing Is for Risk Takers Only

"With stocks starting to price in interest-rate cuts next year, the biotech sector has emerged as a winner for investors seeking riskier bets with more distant payoffs.

But investing in biotech is tricky because this industry is a sector of haves and have-nots. While every industry has its winners and losers, the gap in biotech is bigger due to the binary nature of drug development. Many companies spend years testing one medical approach or platform. In the end, either the idea works or it doesn't, and that could be the difference between tripling your investment or losing it all.

Because of that dichotomy, being able to weed out the losers (or actively bet against them) is especially important for fund managers. Index funds generally serve investors well in other sectors but the argument for active management is stronger in a category with such a wide dispersion of outcomes. An analysis by asset-management firm Janus Henderson demonstrates that the disparity of average annual returns by sector over the past decade was highest among healthcare by far, with biotech leading the way.

For example, the gap in returns between the top five and bottom five in biotech was more than four times that of the software industry, with the top five biotechs returning 287% versus a loss of 78% for the bottom five. In the software industry, by contrast, the top gainers returned 140% versus a 46% loss for the bottom five.

The race to develop an effective Covid-19 vaccine helps illustrate the winner-take-all nature of the industry. In 2020 and early 2021, Moderna and Novavax, two vaccine developers, took off, adding billions of dollars to their respective market capitalizations. But investors who bought into those stocks at, say, the start of 2020, had very different results from each company three years later. While Moderna has come tumbling down from its 2021 peak, it has still more than quadrupled in value since early 2020, thanks to the commercial success of its mRNA vaccine. Novavax, whose vaccine hasn't made nearly as much headway, gave back nearly all of its astronomical pandemic gains.

The difficulty in picking winners stems from the "90/90" rule, explain Janus Henderson portfolio managers Andy Acker and Daniel Lyons. 

According to their estimates, 90% of drugs that enter human clinical trials fail to achieve approval, and for the 10% of drugs that do get approval, consensus sales estimates tend to be wrong 90% of the time.

In a sector with so many losers and a few top performers, Acker argues that it pays to have a team of people who can more accurately assess the clinical and commercial risks of drug development. "In biotech, you don't have to be perfect, but if you're right more often than consensus, that can add value consistently over time," he says. "In this industry, if you're right 60% of the time, you're going to have a good career. And if you're right 70% of the time, you're a rock star."

These are, of course, self-serving reasons for him and other fund managers to advocate for their approach. Though actively managed funds have been popular lately, years of research show them underperforming broad indexes over longtime horizons. But Janus Henderson's Global Life Sciences Fund, which invests in everything from pharma to biotech, has outperformed the MSCI World Health Care Index over the past decade, with annualized returns of 11.1% versus 8.7%, respectively.

Investors who prefer to forgo active-management fees have different exchange-traded funds to pick from. For small-cap biotechs, many investors typically opt for the equal-weighted SPDR S&P Biotech ETF with the ticker symbol XBI. As of December, the ETF comprised 125 stocks, of which about half are at or near an early commercial stage, while the rest are at the clinical stage, according to Jefferies analysts. While the S&P Biotech ETF is up 21% over the past month, it is still down by nearly half from its 2021 peak. For more mature companies, investors could opt for the iShares Biotechnology, or IBB. Because it contains larger companies, the IBB is more exposed to earnings performance while the XBI moves on more binary clinical catalysts, Jefferies notes.

There isn't a single way to invest in biotech. But if you do wade into such risky waters, it is important to bear in mind that for every winner there are plenty of losers as well." [1]

1. Biotech Investing Is for Risk Takers Only. Wainer, David.  Wall Street Journal, Eastern edition; New York, N.Y.. 27 Dec 2023: B.10.