Biotech: Boom Or Bubble?

Currently, there are many exciting products in the pharmaceutical and biotech space producing clinical data that show meaningful change for patients. Last year, we saw drug launches representing major advancements in the treatment of multiple sclerosis, hepatitis C and leukemia.

We saw important clinical data come out on compounds for prostate cancer, pancreatic cancer, pulmonary fibrosis and other blood cancers, which may provide the next wave of potential product launches this year and next. Those products represent meaningful advancements over the older treatments that are currently available.

What’s happening in the industry’s earlier-stage pipeline is also quite exciting, particularly in regard to a number of drug discovery technologies that are opening up avenues of treatment for diseases that were previously not addressable with more traditional drug approaches. These include RNA interference and gene therapy, which more directly address the genetic defects associated with those diseases and correct them. We have a close eye on these technologies and the compounds coming out of them that are in early development.

In the treatment of hepatitis C, the launch of a new drug last year represented an important advancement over the previous standard of care, which involved about a year of injections, caused flu-like side effects and could cure only about half the patients of this disease.

The new treatment does away with those toxic injections. It’s an oral drug that’s combined with other oral drugs, and it’s taken only for 12 weeks. And in future generations of that regimen, it could be shortened further. So we’re seeing an opportunity to possibly shorten the regimen, but also to potentially double cure rates.

Valuations and Growth Prospects

We don’t believe we are seeing a biotech bubble right now, for a number of reasons.

We look at valuations over the long-term. In terms of the large-cap stocks, the price-earnings (P/E) multiples have expanded to currently about 20 times from about 10 times at their trough roughly two and a half years ago.

The current levels are in line with the historical average for those stocks over the last 10 to 15 years, but that’s also in line with growth rates. The largest companies are now experiencing major new product cycles, and that’s caused acceleration in their growth rates. Our models are supportive of the multiples of where they’re trading right now.

The bottom line in terms of why the biotech rally has occurred is improving fundamentals. There’s been a renaissance in research and development productivity.

We’ve seen a number of new products generate positive clinical data, as well as a number of mid-stage and early-stage pipeline products that look very promising. We think there is now a good regulatory environment for drug companies in terms of gaining drug approvals.

Additionally, many of the recent drug launches have demonstrated that when you launch a good drug into the market, it will sell. We’ve seen that with a number of drugs, including those targeting multiple sclerosis and prostate cancer.

On the small-cap side, which has not participated in the rally as much as the large-caps, we’re still seeing a lot of value. They tend to be riskier companies, as they typically have most of their value housed in one or two developmental-stage programs.

Nonetheless, some of these earlier-stage drug discovery technologies that have players in the small-cap space are quite compelling to us.

RNA interference (“RNAi”) is a way of turning genes “on” and “off”: turning genes “on” to produce a protein that is otherwise lacking, or turning a gene “off” to halt production of a disease-causing protein. This technology is opening up a range of diseases that were previously not treatable to new-drug approaches.

A lot of these are what we’d call “orphan diseases” with small patient populations—typically less than 200,000 people. But because the market still supports premium pricing for treating diseases of small numbers, we are finding there are still reasonable commercial opportunities.

US Affordable Care Act Impact

In the near term, the impact of the Affordable Care Act is likely to result in the expansion of health care coverage, which could provide a very small boost to overall drug utilisation.

When we look at the number of patients who are likely to gain insurance and are likely to start taking pharmaceutical drugs, and divide it by the number of years it’s likely to take to implement that, we would estimate it’s about a 1% boost to the overall drug market each year. It’s a pretty small impact.

What’s more important to us are the long-term implications. As the Medicaid program expands and as health care costs continue to rise, there is likely to be an increased need to amplify efforts on cost containment.

As we make investment decisions, we have to be cognizant of the fact that there is likely to be continued pressure on drug prices and drug utilisation.

We believe the drugs least likely to see reimbursement pressure are the ones free of competition. So we have a mantra: “First in class, best in class, only in class.” And then, the drugs should address a significant unmet medical need and have a demonstrated clinical value. Those are drugs that we believe will survive any reimbursement environment, no matter how intense the pressures become.

Beyond the issues in the US market, which is fairly well penetrated today, in our view, Europe is rising in importance for the biotechnology sector. Companies are having the opportunity to build a marketing infrastructure in Europe and launch their own drugs rather than partnering with one of the larger pharmaceutical companies, which is what they were doing in the last decade.

The next move, we think, will be into the emerging markets, although they are a challenge. There’s still not as much spent per-capita on health care in emerging markets as there is in developed markets, and health care systems need to be developed in many cases. But we are always looking for companies globally to invest in.

Evan McCulloch is vice president portfolio manager/research analyst at Franklin Equity Group.