Introducing Next Generation Medicine basket

Introducing Next Generation Medicine basket by Michael McKenna
Today we are introducing a new Saxo theme called NextGen Medicine and covers the frontier of new medical treatments.

Beginning last year, we discussed many different themes starting with the green transformation which we defined as one of the most important ones in the coming decade. However, the green transformation theme as become extremely expensive, something we look at in the soon to be published Q1 Outlook. Throughout 2020 we also discussed bubble stocks, e-commerce and ‘misery industries’. Starting this year, we introduced our Commodity Sector basket as we believe reflation will be the most important theme over the next 12-18 months.

Explanation of theme and the selected biotechnology companies

Today we are launching our next theme called NextGen Medicine containing companies which are working on the next generation of medical diagnostics and treatment, such as analysis of DNA and RNA, immunology, and within cell and gene therapy. The use cases are spanning widely – ranging from treating rare genetic disorders or skin diseases to fighting cancer and viruses with a new and improved line of defense.

We have selected 30 companies for this theme with a global selection universe of biotechnology companies but filtered on the percentage of institutional ownership. Our hypothesis is that high percentage of institutional ownership is a validation as this category of investors has more access to knowledge about these frontier treatments and can thus more informed decisions. This filter has unfortunately removed many Asian biotechnology companies. We have also filtered on cash and equivalents relative to free cash flow, and if the latter is negative we can calculate what we call a burn rate, which is essentially how many years of funding the company has left under current operations. We have removed biotechnology companies with relatively stressed funding situation. Finally, we have sorted on market capitalization in USD and also tried to balance the list across various treatment technologies and geographies although the US is heavily concentrated in this theme because the country has a deeper financial market for absorbing these types of risks.

Name Domicile Mkt cap in USD mn R&D in % 12M Rev in USD mn Burn rate Insti %
Illumina Inc US 54,947 1.2 3,239 NM 106.4
Moderna Inc US 51,304 1.4 247 NM 58.6
Seagen Inc US 33,492 2.4 1,864 NM 90.3
Genmab A/S DK 29,132 1.5 1,656 NM 56.5
Exact Sciences Corp US 24,632 0.6 1,321 3.5 89.8
BioNTech SE DE 24,623 1.0 122 2.2 NA
Grifols SA ES 17,751 1.8 6,039 NM 51.1
CRISPR Therapeutics AG CH 14,774 1.6 77 5.7 79.1
Argenx SE NL 13,217 2.0 54 6.2 53.1
Mirati Therapeutics Inc US 10,918 2.6 12 1.7 103.1
Fate Therapeutics Inc US 10,385 0.9 18 4.5 102.6
Natera Inc US 10,258 0.8 362 3.2 115.3
Invitae Corp US 9,293 2.4 245 1.6 86.9
Ultragenyx Pharmaceutical Inc US 9,096 4.0 215 4.3 116.7
Twist Bioscience Corp US 8,817 0.5 90 1.9 107.3
Denali Therapeutics Inc US 8,758 2.4 24 2.8 89.6
Arrowhead Pharmaceuticals Inc US 8,297 1.6 88 2.9 74.1
Iovance Biotherapeutics Inc US 7,490 2.7 0 1.4 117.2
Pacific Biosciences of California Inc US 6,869 0.9 80 NM 89.4
Galapagos NV BE 6,669 8.9 574 10.8 54.7
Beam Therapeutics Inc US 6,552 1.4 0 0.9 71.5
Swedish Orphan Biovitrum AB SE 5,867 2.6 1,649 NM 115.9
Sage Therapeutics Inc US 5,326 5.7 7 2.2 116.4
Abcam PLC GB 5,292 0.9 328 NM 130.5
Intellia Therapeutics Inc US 5,266 2.7 62 6.4 99.5
Editas Medicine Inc US 4,773 2.8 92 4.3 92.0
PTC Therapeutics Inc US 4,673 9.4 358 4.4 116.5
Allogene Therapeutics Inc US 4,544 4.2 0 2.4 115.2
CareDx Inc US 4,342 1.0 169 NM 109.2
MorphoSys AG DE 3,693 3.6 339 NM 76.2

Table explanations: R&D in % is the 12-month R&D expense in % of market cap, Burn rate is the number of years the company can sustain current negative free cash flow (NM means not measurable and is used for those with positive free cash flow), Insti % is the institutional ownership of the floating shares (those that are tradeable, so if all shares are not publicly available then the ratio can be above 100%) in %.

The long-term drivers of this theme are the maturing of promising technologies within cell and gene therapy, monoclonal-antibody therapy, and small-molecule therapy, which will attract the necessary funding to complete all trial stages of the treatment development. Ageing populations in the developed world will drive demand for treatments of many diseases ranging from cancer to brain disorders. These new treatments also have the possibility of having fewer side effects compared to the old pharmaceutical drugs. Gene editing holds the possibility to make antibody therapies to work better and in general many of these companies likely represent the future of medical treatment and thus they will most likely become acquisition targets of major pharmaceutical companies.

Performance, selection bias, and survivorship bias

The biotechnology industry was for many years viewed as a pure lottery ticket. Great ideas but many were too expensive to pursue relative to the risk capital available and many disappointing trial data made it unattractive to investors. In the period 2004-2010 the biotechnology industry lived a boring life (see chart) with little outperformance or investor attention. But starting in 2011 and 2012 a new class of biotechnology companies entered public markets with better results and increasingly more interesting technology. More mature biotechnology companies such as Gilead Sciences saw enormous growth rates in its hepatitis C treatment. This started a positive feedback loop of strong returns in public markets creating more risk appetite in the venture capital market and the industry enjoyed a spectacular bull market in the years 2011-2015. In the following years from 2016-2019, the industry entered a new ice-age period driven by slowing growth by the mature biotechnology companies and many bad FDA reviews in clinical trials. But the Covid-19 pandemic brought renewed attention to biotechnology but more importantly the smaller more advanced and next generation biotechnology companies using mRNA, gene editing technology, and antibody drug conjugates. The companies that we feature in our inspirational list, but there are so many more interesting companies that we could not add, so we encourage investors to research wider in the hunt for good long-term potential winners.

Our NextGen Medicine basket has done well up 897% since December 2015 compared to 78% for the MSCI World. Past performance is no guarantee of future performance, and in this basket since we sort on market cap and the segment has experienced a strong bull market, we explicitly select recent winners. This naturally creates a selection and survivorship bias in the basket. Investors should therefore focus less on the long-term returns of the basket and more about the overall theme and what will drive it in the future.

The NextGen Medicine basket has an interesting outlook, but the high growth expectations come with valuations. The basket has a price-to-sales ratio of 22.4 and non-measurable price-to-earnings ratio as most of the companies are not profitable. The price-to-book ratio is 9 making it one of the most expensive segments in the entire equity market. The future does not come cheap these days.

Biotechnology is a very high risk

The risks associated with the theme are the high valuations which is dominating the biotechnology industry in the beginning of 2021. High valuations correlate with high expectations which can be difficult to meet and on average high valuations have historically meant lower future returns. Furthermore, companies in the research phase have high event risk around trials for approval of their products, which leads to potentially large single day drops in individual biotechnology positions. Other biotechnology companies are also trying to solve the same diseases and the ones that gets an approval for a treatment first often gain the momentum and most of the market value. A short-term risk for some of these biotechnology companies is manufacturing delays due to Covid-19. Historically, the biotechnology industry has gone through long periods of low or flat returns, so investors getting exposure to biotechnology stocks should have a long-term horizon.

Topics: Equities Technology Health Care