Biotech: Ignore the Noise

by iShares Insights Team of BlackRock, 8/25/17

Years of persistent price performance turned bio-pharma into a momentum-like trade. However, bio-pharma gains have been increasingly punctuated by political rhetoric, leading bio-pharma to decouple from momentum names.

We believe biotech's long-term historical drivers, demographics and mergers and acquisitions (M&A) activity to secure patent protected drugs, may outlast near-term political headwinds and should lead investors to consider bio-pharma from a longer-term perspective. Biotech valuations also currently appear attractive relative to the broader market and look less crowded than other growth sectors. Over the short term we see potential opportunities in select individual biotech and pharma names.

Biotech has historically been driven by long-term growth prospects. Investors have historically focused on two key long-term drivers: aging demographics and strong pricing power via patent protected drugs. The importance of these trends has not diminished, however the market's focus on these trends has diminished recently, focusing instead on political headlines.

Since September 2015, the bio-pharma industry has increasingly become a rhetorical target of politicians focused on drug pricing. Investors grew increasingly cautious as politicians from both sides adopted a tougher regulatory attitude towards drug pricing, leading bio-pharma gains to become increasingly punctuated by sharp, bearish reversals on political headlines. This led many bio-pharma names to decouple from the broader momentum names.

Biotech's correlation to momentum has broken down

Biotech's correlation to momentum has broken down

^{Source: Thomson Reuters, 7/21/2017. The time series shown is the 90-day rolling correlation between the MSCI USA Momentum Index and the Nasdaq Biotechnology Index. Correlation is a statistical measure that captures the degree of the historical relationship between the returns of a pair of investments or indexes. Correlation ranges between +1 and -1. A correlation of +1 indicates returns moved in tandem, -1 indicates returns moved in opposite directions, and 0 indicates no correlation.}

Don't overlook the secular trends

Just as investors pivoted out of bio-pharma names due to near-term regulatory risks, they rotated back in following President Trump's election with the expectation of deregulation. Those expectations may pay off, but investors appear to be missing the broader point; trading around political headlines has come at the expense of focusing on potentially favorable secular trends – aging population and M&A activity to secure new drug patents, which may offer significant pricing power. We believe those trends could remain over the long-term. The market's distraction with short-term matters may offer opportunities for long-term growth investors. The aging of patent protected drugs could lead to an increase in M&A as companies look to maintain their pricing power. Investors may want to ignore the near-term headwinds and refocus their attention to the long-term growth trends.

Under-owned, undervalued?

While bio-pharma's long-term growth drivers haven't changed, its investor base may have. The momentum breakdown in 2015 and lingering political headwinds led to industry wide outflows and cheapened valuations. Relative valuations – measured here as the ratio of the Nasdaq Biotechnology Index P/E to the Russell 1000 Growth Index P/E ratio – have cheapened over the past few years amid industry wide outflows and now sit below the 5 year average. However, valuations have stabilized as industry wide bio-pharma focused ETP inflows have begun to recover. Long-term growth investors may want to consider bio-pharma given current valuations, lack of crowding, and potential long-term growth prospects.

Conclusion

Investors may want to ignore the political noise and focus on bio-pharma's secular trends, including potentially favorable demographics and M&A activity as pharmaceutical companies look to expand their patent base in an effort to maintain pricing power. The bio-pharma industry dynamics can be complex and difficult to monitor. Understanding the Food and Drug Administration (FDA) approval process, drug pipeline, and impact on competitors requires specialized science or medical training. We believe this supports being selective in stock selection. But the complexity of single stock analysis has also driven interest into the ETF structure, where investors can gain exposure to the sector while avoiding the potential pitfalls of individual stock selection.

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