As the biotech rally continues to fuel bubble trouble talk, Bellevue Asset Management explores where the industry stands today and where it is heading.

The biotechology sector's recent performance on the Nasdaq Biotech Index has garnered it some real attention from wealth managers. But this has also prompted investors to fear a new biotech bubble. The author of this article, Dr Daniel Koller, lead manager of BB Biotech at Bellevue Asset Management, explores the opportunities and challenges that shape the outlook of this rising sector. The views expressed here are those of the author, but WealthBriefing is pleased to share them. If readers wish to respond, they should email the editor at tom.burroughes@wealthbriefing.com

When the US Federal Reserve raised the issue of strained valuations in biotechnology companies, they were thinking of investor concerns. True, the biotech sector has performed well because it is successfully addressing areas of rising demand for healthcare products from ageing populations, and because of significant M&A activity. The Nasdaq Biotech Index beat the broader stock market's performance by more than 12 percentage points in the first quarter. Look at the trends at work and an investor can see there is plenty to suggest the outlook for the sector is still robust.

The market’s enthusiasm for new drugs has boosted the profits of biotech companies in recent years and this should continue through 2015, augmenting revenue growth and moving more firms into profitability. It also allows companies to invest more in their new product and R&D pipelines, enabling firms to make the move from one-product companies to diversified, profitable high-growth stocks.

There were 41 new medicines approved in 2014 – the second highest figure since 1996. This trend of product approvals should ensure strong momentum in the sector through 2015 and beyond, as investors can expect updates on pipeline products throughout the year.

Evidence of the longevity of this trend comes from the continuing inflows of capital into the sector, with the IPO window open and significant amounts of cash raised through secondary placements by smaller and mid-cap companies. Investors should welcome these funding transactions as many companies have been able to bolster their balance sheets.

With these strengthened balance sheets, companies can invest in drugs in their pipelines and retain ownership of these drug “candidates”.  The alternative was to team up with more deep-pocketed partners, but kiss goodbye to potential upside later on. Many attractive biotech companies now carry a lower refinancing risk than they did several years ago. In the case of pipeline successes, these companies are expected to enjoy much higher valuations by having retained all rights to the developed molecules. The valuations of established larger companies such as Celgene and Gilead reflect the different growth trajectories and risks of their businesses. Given this potential growth they remain attractively priced.

Investors should also remember that the combination of worldwide low interest rates and a healthy acquisition appetite in the healthcare industry means further M&A activity in coming years. Because smaller and mid-sized companies now have more balance sheet independence, we’d expect M&A activity to take some precedence over licensing transactions.

Investors haven’t forgotten the debate around drug pricing, namely that high drug prices could limit innovation and ultimately hinder long-term financial growth. While this will continue, targeted discounts and pricing studies should ensure that companies still generate fair returns for the risk and investment they have made. This will force companies to strive for product differentiation and is likely to benefit the dominant players for certain conditions as well as those companies that succeed in bringing innovative and differentiated products to the market.   

Governments and healthcare services know very well that innovative drugs with higher cure rates and fewer side effects ultimately save national healthcare systems money. These treatments should therefore continue to enjoy strong pricing power.

Antibiotics is a good example of a therapeutic area that has actually benefited systematically from regulatory incentives. The public and government are aware of the dangers of bacteria that are resistant to antibiotics and stand ready to support research into new treatments. The US FDA is now working proactively with drug companies to make the testing regime for new antibiotics swifter, and less costly than in the past, when testing specifications might have changed midway through the process, requiring a restart.

For pharmaceutical companies, these new drugs command a higher price than existing generic drugs; and as the problem of antibiotic resistance widens across populations, the demand for new drugs will expand. 

Despite biotech having been the best performing sector since the financial crisis, there are good reasons to expect further profit and revenue growth in 2015 and beyond. We believe the industry’s biggest innovators with a strong pipeline of products will be where some of the most interesting investment opportunities lie.