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What's happened to biotech?

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With the share prices of biotech companies collapsing the past 11 months, investors are wondering where it all went wrong.

The numbers make grizzly reading. The S&P Biotech Select Industry Index, one of the premiere gauges of the biotech industry, is down 45% since February last year.

The shares of biotech companies – smaller biotechs especially – are famously volatile. This is the fourth time the index has fallen more than 33.3% since November 2015, but a 45% price drop is a big deal, even in biotech. Investors are naturally worried about what’s happening.

Small biotechs are mostly unprofitable

So what has caused biotech to fall? The short answer is inflation and interest rates—together with the fact that most biotech companies lose money.

Most biotech companies – and small biotechs especially – are unprofitable. Investors usually do not mind this. As the fates of biotech companies can change very quickly if they discover a blockbuster drug. BioNTech, the designer of the “Pfizer” coronavirus vaccine, went from losing US$180 million in 2019 to making $7.29 billion profit in 2021, data from Morningstar indicates.

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Source: Morningstar. Data as of 27 January 2021.

Loss-making companies get harder hit when inflation rises.

When inflation rises, almost every asset – property, shares, bonds – suffers. (Commodities and precious metals like gold appear to be a major exception, thriving on high inflation.) We are seeing this in real time right now, with the ASX 200 and property prices in capital cities falling this year, on record inflation.

Performance Of Different Asset Classes In A Variety Of Price Inflation Regimes

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Source: Wellington Asset Management, Incrementum AG

Inflation does this because it makes money – cash flows, profits – less valuable. By extension, it makes assets that produce money less valuable too. (Hence precious metals like gold, which have no cash flows, are an exception).

While inflation is a problem for all assets, it is an even bigger problem for unprofitable small biotechs. Why? Because their cash flows – profits – are often still years away. Meaning that high inflation has more time to eat them. On this score, we should note that the decline of small biotech the past 12 months very closely follows the decline of special purpose acquisition companies (SPACs), which have become the primary launch vehicle for unprofitable technology companies in recent times.

Unprofitable Tech: Biotech And SPACs Fall Together

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Source: Bloomberg. Data as of 27 January 2022.

Cause for optimism: valuations, private markets, demographics

Amidst the ruins, there are still causes for optimism. The biggest of which is that biotech remains a structural growth story.

Populations are aging in the world’s richest countries. One famous statistic: in Japan, more adult nappies are sold each year than children’s nappies. As populations get older, healthcare will continue to be well-supported as caring for the elderly forms the bulk of expenditure.

Another source of support is growing obesity rates, especially in English-speaking country. The causes of this are well-known: more processed food and more sedentary lifestyles. As more people become overweight, the need for healthcare increases, due to the health issues associated with weight gain.

In this context, healthcare spending has come to capture an ever-larger share of global GDP. According to Federal Reserve research, over a 20-year period where normal consumer prices rose just 2.2%, medical care grew at an average annual rate of 3.6% - roughly 70% faster than other spending categories.

Biotech is very well-positioned to capture this growing spending. And on this score, it is interesting to note that private markets – venture capital and private equity, often described as the “smart money” – sharply increased its investment in biotech in 2021, despite the selloff in the public markets. According to data from PitchBook, the Morningstar subsidiary, biotech deal value exploded in 2021 increasing over 40% year on year.