IBB - XBI: A Vehicle For The Transformative Benefits Of Artificial Intelligence Within Biotechnology

2023-07-01 04:59:34 ET

Summary

• Artificial Intelligence stands to revolutionize drug discovery and manufacturing in the biotech industry, promising faster, cost-effective processes, which could greatly benefit biotech investors.
• The SPDR S&P Biotech ETF, an equal-weighted fund with broad industry exposure, presents an attractive investment vehicle to leverage these AI-driven changes.
• Despite recent downturns in the biotech sector and XBI's specific exposure to smaller, speculative biotech firms, long-term trends and AI advancements suggest a strong rebound.
• Anticipated improvement in the time and cost of drug discovery due to AI, coupled with easing capital market conditions, will drive small-cap biotech outperformance, an area XBI is heavily exposed.
• Long-Term Equity Anticipation Securities (LEAPS) on XBI tracking the ETF's price movement offer a capital-efficient way for investors to potentially significantly enhance return on invested capital.

Thesis

Artificial Intelligence enabled drug discovery is poised to disrupt the biotechnology industry to the benefit of shareholders. The SPDR S&P Biotech ETF ( XBI ) offers investors who are looking to gain exposure to the industry a diversified and simple approach to benefiting from this trend. With the biotech industry as a whole having been affected by headwinds since the Covid-19 related tailwinds subsided, and the XBI ETF still being down 48% from the peak, we make out that the long-term industry tailwinds provide investors a chance to accumulate shares before the market reprices the industry.

The AI Opportunity in Biotechnology

In assessing the burgeoning domain of AI-enhanced drug discovery, we see an array of profound advantages. We observe that the utilization of AI in this sector brings forth groundbreaking improvements across all stages of drug discovery, fostering a paradigm shift in the traditional industry processes that were both time-consuming and expensive.

Revolutionizing Drug Discovery

Let's begin with the up-front stages of drug discovery - target identification and molecular simulations. AI algorithms, trained on vast datasets spanning clinical trials, patents, and other research data, are swiftly recognizing and predicting disease mechanisms, spotlighting novel target proteins and genes. Through machine learning algorithms such as Google’s ( GOOGL ) DeepMind AlphaFold, the 3D structures of these targets can also be anticipated, hastening drug design and development. Research & development for a new drug could take as much as 12-18 years, costing between $1-3 billion on average. One of the main reasons that this process is so time consuming and resource intensive is that vast amounts of data are funneled through often times manual processes, subject to a lot of trial and error, until eventually thousands of compounds make it to pre-clinical trials and then just a handful of viable candidates to commercialization. As such, we find there to be a monumental opportunity in applying the benefits of what AI is currently best at, finding patterns hidden deep within large datasets, to this process.

Moving further down the line, AI is redefining molecular simulations and candidate testing. Conventionally, these phases would involve costly and time-consuming physical tests. However, with AI, high-resolution molecular simulations can be executed in silico, leading to substantial cost and time savings. Also, the prediction of essential properties like toxicity, bioactivity, and physicochemical characteristics of molecules are now handled with finesse by these AI systems. Traditionally, drug discovery involves sifting through extensive libraries of candidate molecules. Now, we're witnessing a paradigm shift with AI systems capable of originating completely novel, promising drug molecules. Once promising lead compounds are recognized, AI is further employed to rank these molecules, helping to streamline candidate selection. We distinguish that the inclusion of this technology will create remarkable value within the entire drug discovery value chain.

Production Efficiencies

We believe that AI's ability to propose synthetic pathways for the production of drug compounds is a game-changer. It's not only about theoretical drug design anymore; AI can recommend alterations to molecules to simplify their manufacturing process. From an investment perspective, the implementation of AI in drug manufacturing brings several promising benefits. The ability of AI algorithms to scour the breadth of chemical synthesis knowledge efficiently and ascertain the optimal synthetic pathways is a remarkable asset in drug production. This advancement directly addresses one of the significant challenges in the pharmaceutical industry: identifying cost-effective and efficient synthesis processes.

AI allows the industry to streamline the process of drug manufacturing and eliminate wastage or redundancies. The result is a more effective, quicker, and ultimately more profitable production line. For instance, the AI-driven identification of optimal synthesis paves the way for significant cost savings, boosting the return on investment and ultimately offering a compelling benefit to shareholders. Simply said, this has huge implications on the bottom line of biotech companies.

Still At Its Infancy

As we can see, 64% of drugs are located within the discovery stage of the drug development process:

We anticipate that over the coming decade, biotech companies will see a great improvement in the time and cost of bringing drugs to market, launching many discovery candidates out of the discovery stage of development and into clinical trials at a faster pace than ever before. Our view is that a tidal wave of AI-enabled innovation will bring substantial improvements to the top and bottom lines of many biotech companies. In addition, we expect this market opportunity will likely bring a host of new startups looking to bring their molecules to market as the barrier to entry will be substantially lower than during previous times in history.

The disruption of AI in the biotech industry will not happen overnight, and we remark that this process will see incremental progress over the coming years, decade and even decades to come. This presents an opportunity for investors to gain exposure to an industry that will benefit from the involvement of AI over time.

The Case For XBI

There are a few notable ETFs to decide from when looking at the pure biotech ETF selection. Let’s start by looking at the total assets under management:

Out of the top 5 largest biotech ETFs, ranked by total assets under management, we can see that the iShares Biotechnology ETF ( IBB ) and XBI have by far the largest amounts of assets under management. This can play a role when looking at the liquidity in both the stock and options markets. The ARK Genomic Revolution ETF ( ARKG ) is an actively managed ETF and the Direxion Daily S&P Biotech 3X Shares ETF ( LABU ) is a leveraged ETF, which investors must carefully consider. In picking the best ETF to go with, we are only interested in passive ETFs. This leaves us with the IBB, XBI and First Trust Biotechnology ETF (FBT).

Let’s now look at the expense ratio:

Of the three ETFs that we will consider in this article, XBI is the cheapest with a 0.35% annual expense ratio. This is already a large bonus, as expense ratios can have a significant impact over long-term returns. Before we decide, we must still look at the differences between the three:

iShares Nasdaq Biotechnology ETF:

IBB tracks the ICE Biotechnology Index, which is a modified float-adjusted market capitalization-weighted equity index. As a result, it leans more towards larger, more established biotech firms.

SPDR S&P Biotech ETF:

XBI is an equal-weighted ETF that follows the S&P Biotechnology Select Industry Index. This index comprises companies in the biotech industry that are a part of the S&P Total Market Index. Because it's equal-weighted, the fund's holdings range from large pharmaceutical corporations to smaller, speculative biotech companies, providing diversified exposure to the industry.

First Trust NYSE Arca Biotechnology Index Fund:

FBT tracks the NYSE Arca Biotechnology Index, which is a modified equal dollar weighted index. This index comprises companies involved in the use of biological processes to develop products or provide services, including companies in biotech, pharmaceuticals, research services, and agricultural chemicals. Like XBI, this fund provides exposure to companies of various sizes, but its equal weighting can cause it to lean towards smaller companies than IBB.

We stand to believe that the equal weighted nature of the XBI, which has in recent times been beaten down more than the two others, due to the larger exposure to small cap, speculative biotech companies, also has the greatest chance of showing the strongest comeback when the market reprices the industry and the current macro conditions wane. In addition, as we mentioned earlier, anticipating that a host of new startups will be looking to bring their molecules to market as the barrier to entry will be substantially lower than during previous times in history, bodes well with the equal weighted, higher small cap exposure nature of the XBI ETF.

According to interest rate traders , the Fed target rate reaching 400-425 bps on 18 December 2024 is the highest probability of outcomes. That’s a 100 bps drop from the current target rate. This will ease the pain somewhat on smaller, more speculative biotech companies that are more dependent on capital markets. We see the improving capital market conditions to drive outperformance of small cap biotech names.

Lucrative Options Opportunity

We are strong advocates of using options to enhance investment returns. Investors should of course fully understand the benefits and risks before undertaking any activity within the options markets. We see a strong opportunity in buying LEAP options ((LEAPS)) on the XBI ETF. With the current share price of $83.58, investors can profit from the recently crumbling and now low IV by buying the 19th December 2025 $40 strike calls for a current mid-price of $47.00. This strike price is the lowest in the options chain for this expiration date and currently offers a delta of 0.963, meaning the underlying share price movement of XBI is almost entirely tracked by the LEAP option. With the price per share of $47 to buy the LEAP option, investors would only pay ~ 56% of the value per share, while tracking 96.3% of the price movement of the underlying XBI shares. Furthermore, of the $47 per share paid for the LEAPS, the intrinsic value is $43.58 (83.58-40), leaving just $3.42 as extrinsic premium to pay. This is the equivalent of paying just ~ 4.1% extra per share, for the opportunity of paying 56% of the value per share now and providing the other $40 per share of capital on the 19th December 2025, to be able to purchase the underlying shares. We believe this strategy provides a very capital efficient way of gaining exposure to the underlying share price movement of the stock, potentially substantially increasing the return on invested capital ((ROIC)) in the process.

Risks

We must underline that while the XBI ETF offers exposure to a dynamic industry, it is not without its share of risks. The biotechnology sector is known for its high volatility, a consequence of its nature as a high-risk, high-reward industry:

• One major concern lies in the heavy reliance on research and development ((R&D)). We see companies investing large sums in R&D, hoping to develop successful treatments. However, not every research venture translates into a viable product, often resulting in financial losses. This process can also span many years, adding a significant time risk. In our view, while these industry risks will always remain, our investment thesis being that AI will disrupt the biotech industry in a positive light, will lighten these risks somewhat in the long-term.

• Another risk we identify is regulatory in nature. Securing FDA approval for a new drug is a complex, uncertain process, and failure to gain approval can impact the stocks of these companies negatively.

• It's important to note that XBI, being an equal-weight ETF, has significant exposure to smaller, more volatile firms. While these can provide high growth potential, they are also more prone to substantial swings and may rely heavily on a single product.

• Lastly, we observe that the sector is susceptible to changes in the macroeconomic environment, including alterations in healthcare policy and patent laws . Given these risks, we recommend that investors carefully assess their risk tolerance.

Conclusion

We foresee an imminent evolution in the biotechnology industry, largely driven by the integration of artificial intelligence in drug discovery and production. We believe this integration will lead to faster, more cost-effective processes, in turn, presenting a compelling opportunity for investors in this industry. The XBI ETF, with its broad and diversified exposure, stands out as an attractive investment vehicle to capitalize on these changes. We view the ETF's current lower performance, influenced largely by its small-cap exposure and macroeconomic conditions, as a temporary situation. It's a chance for investors to take a position before the industry undergoes a potential revaluation. We appreciate XBI's equal-weighted structure, which we believe provides a diversified exposure, from established giants to emerging innovators, and we find this attribute attractive.

Investors might also find a unique opportunity in leveraging Long-Term Equity Anticipation Securities ((LEAPS)) on XBI, given the low implied volatility. We believe this offers an efficient way to track XBI's price movement, significantly enhancing return on invested capital.

The influence of AI in biotech is still in its early stages, and while the progression may take years, even decades, we assert that this gradual shift offers investors an excellent opportunity to benefit from AI's long-term contribution to the sector. Taking into consideration both the underlying temporary headwinds, the long-term industry tailwinds and the potential for medium to long-term market revaluation, we are assigning a strong buy rating to the stock.

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