GNMSF - Biopharmaceutical Stocks: The Rally Has Just Begun

2023-12-14 12:25:24 ET

Summary

• Biopharmaceutical sector valuations have become more attractive after a significant decline in 2021.
• Larger drug companies are making acquisitions and partnerships with small-cap stocks at generous premiums.
• Money managers are under-invested in the sector and may be pressured to add holdings before year-end, potentially fueling a significant upward move.

I wrote an article this past May , with the SPDR S&P Biotech ETF ( XBI ) at $85, suggesting that valuations in the biopharmaceutical sector were beginning to look attractive. Subsequently, in mid-October, I stated that the bottom was in, and I have reemphasized this on several occasions since. The 30-month decline was totally justified. 2021 was the greed portion of "fear and greed" at its utmost - there were no returns from fixed income investments, the risk on strategy was prevalent and the supply of IPOs was significant. Most of the companies that went public were in very early stages, i.e., pre-clinical or Phase 1, and valuations approximated $750 million. This was in stark contrast to the recent past, when companies were at least in Phase 2 clinical study and the valuations were around $250 million. The implication was that the current companies would not have a commercial product before 2027 and would therefore have to raise additional funds. There was little margin for error - any negative news would adversely impact the stock, and as the investment outlook soured, raising money became very dilutive. The correction was so severe that the enterprise valuations in many cases became negative.

The bottoming process in the sector has been standard. There was little interest in buying and the mood was somber. Stocks, for the most part, did not react to favorable news at medical conferences. Subsequently, the intelligent buyers, namely larger capitalization drug companies, began to forge partnerships and to make acquisitions at generous premiums, recognizing both the absolute valuation of the small cap stocks and the large discount to valuations accorded larger companies. This has been followed by renewed interest, although I note that even with a 23% rally, the XBI trades at less than one half of its 2021 peak and is at levels comparable to 2019.

One underappreciated fact is that money managers have been under-invested in this sector coming into December. If the strength in the stocks persists, they will be pressured to add to holdings before year end in order to show adequate representation. This could fuel a significant move upward leading into the week of San Francisco healthcare conferences in January.

The fundamentals of the healthcare industry also remain strong. I forecast US healthcare expenditures to grow at an average annual rate of 6% through 2030, at which time they will account for $7.3 trillion in spending, or 25% of GDP. This will be fueled by the aging of the population, which results from the baby boom generation and recent advances in medicine that have extended longevity. As older people consume much greater healthcare dollars , this trend will contribute to utilization.

In terms of attractive investment areas, I continue to maintain that the GLP-1 drug class will become the largest in history, benefitting not only drug manufacturers like Eli Lilly ( LLY ) and Novo Nordisk ( NVO ), but also distributors, including McKesson ( MCK ), and vial and injector manufacturers such as Stevanato Group ( STVN ). The immuno-oncology revolution has just begun, with first generation therapies, e.g. the PD-1s, being augmented with drugs that act synergistically on other pathways . Bispecific antibodies and antibody drug conjugates are advancing in application, and this should benefit Regeneron ( REGN ), Eli Lilly, Amgen ( AMGN ), Genmab A/S( GMAB ), AstraZeneca ( AZN ) and Gilead Sciences ( GILD ). I note that ImmunoGen ( IMGN ) is being acquired by AbbVie ( ABBV ) for $20 billion.

With the recent rise in the XBI ETF, investors may begin to wonder if they "missed the rally". I strongly maintain that it is just starting, and that, in the short term, gains will be incrementally driven by portfolio adjustments. However, the larger picture of the biopharmaceutical research renaissance remains intact, and age demographics will support strong demand for new therapies.

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