Investors often see pharma and biotech stocks as reliable havens at times of volatility. But while the Covid pandemic has brought some uncertainty, there are many better reasons to consider a small cap biotech ETF than as a traditional safety blanket.
2020 was termed “the greatest ever year for the biopharma industry.”1 The global pharmaceutical market was valued at about US$1.25 trillion at the end of 2019, well up on its US$390 billion 2001 evaluation.2 Research and Development, a key indicator of vitality, rose from $129 billion in 2010 to $179 billion by 2018.3 IQVIA has reported a 3 percent compound annual growth rate (CAGR) since 2014.4
Let’s look at what is driving growth in biotech and pharma right now, and then see how the junior side captures all of this and more.
1. On the macro-level, very low interest rates and strong government support for small and mid-sized companies has injected considerable capital into the markets. PwC has identified such high investor demand, strong financial capacity and limited assets as potential conditions for market deals.5
2. Within the biotech / pharma sphere, FDA approvals and pre-approvals were already on the rise before the pandemic, and the vaccine drive only increased awareness of the need to expedite regulation of innovative medicines.
3. The US leads strongly in global biotech. U.S. retains a dominant position in research, development and commercialization, propelled by market forces, government policy and not a little competition with China (both medical and military)6. The US produced almost half of all biotech patents filed from 1999 to 2013.
This graph shows steady historical growth in US biotech investment from 2001 to 2016. Beyond the graph, in 2020, over $26 bn was raised in venture capital for biotech (the prior high was $19 bn in 2018).
source https://medium.com/swlh/why-biotech-investments-are-thriving-26b02cb78d65. Published March 19, 2019.
4. Growth in this sector does not depend on a post-vaccine spending boom, on employment figures or other traditional business metrics. R&D is at the center of value-determination, while the impact of short term economic dips is smoothed by the insurance system that covers medical costs. Data and innovation are therefore better indicators of future growth that they might be in other sectors. Consider the example of Inovio. It spent $95m on R&D in 2019, when its revenues totaled $4m. Yet by mid-2020 the company’s market cap was $4.3bn – its DNA vaccine technology development was paying off, as Inovio was positioned among the leaders in Covid-19 vaccine research.
We have established that biotech and pharma have strong growth indicators for at least the near future. What makes the junior side of this sector so exciting and at the same time renders the ETF as the most sensible vehicle for the retail investor to gain exposure?
1. Patent Cliff: Many large firms are about to face a patent cliff, whereby their exclusive rights over a popular drug will end. This will cause a serious dent in their revenue stream due to the increased competition, which means they will be looking around for other possible sources of income.
2. Large cap, large stash: The ten largest biotech and pharmaceutical companies in the S&P 500 had an average cash stockpile of $10.7 billion as of mid-June, 2020.7 These companies have considerable accumulated funds, setting the stage for extensive merger and acquisition activity, with its upward effect on small cap valuations.
3. Market buoyancy and SPACs: In the low interest rate environment, investors are searching for yield. One way they seem to be finding it is through Special Purpose Acquisition Companies (SPACs) which form with no operations other than the promise of merging with an ambitious, potential-laden business within two years. A new SPAC is created on average every five days since the start of 2021, which means there are billions of dollars amassed and looking for M&A potential.8 Junior biotechs are a logical address for some of this SPAC energy.
4. Performance: The record shows junior biotech stocks beating their senior counterparts over the last six months. (The gross expense ratio for IBBJ is 0.45%. For more performance details see https://www.defianceetfs.com/ibbj)
Notwithstanding this aggregate growth, you still can’t be sure where the next breakthrough or super drug will come from. Investing in one particular junior biotech company contains significant risk. Defiance’s Nasdaq Junior Biotechnology ETF (IBBJ) tracks the Nasdaq Junior Biotechnology Index, offering exposure to small-cap “junior” companies, under $5 billion of market capitalization. The rules-based, weighted index provides access to this dynamic sector, without over exposure to any one company or deal. It is rebalanced every quarter to ensure that the maximum weight of any one security does not exceed 8%.
Small caps know they must innovate to survive. In 2020 the Junior Biotech Index captured companies that spent nearly $20bn on R&D, equivalent to 63% of their revenue. Some of these companies did not yet have any revenue, and of those companies who did some level of sales, 73 (the equivalent of 40% of the index) reported R&D expenses higher than their revenues.9
Research and innovation remain high, in an industry where this is the source of growth and development. Whether to treat cancer or find a vaccine for Covid-19, governments also continue to prioritize biotech and pharma, whose centrality to the wider economy has only been highlighted by the global corona pandemic. Defiance’s IBBJ offers balanced exposure to this thriving sector, while mitigating the risks of investing in a single company.
Investing involves risk. Principal loss is possible. The Fund is a recently organized investment company with no operating history. As an ETF, the fund may trade at a premium or discount to NAV. Shares of any ETF are bought and sold at market price (not NAV) and are not individually redeemed from the Fund. The Fund is not actively managed and would not sell a security due to current or projected under performance unless that security is removed from the Index or is required upon a reconstitution of the Index. A portfolio concentrated in a single industry or country, may be subject to a higher degree of risk. The Fund is considered to be non-diversified, so it may invest more of its assets in the securities of a single issuer or a smaller number of issuers.
The securities of small-capitalization companies may be more vulnerable to adverse issuer, market, political, or economic developments than securities of large- or mid-capitalization companies. The success of biotechnology companies is highly dependent on the development, procurement and/or marketing of drugs. The values of biotechnology companies are also dependent on the development, protection and exploitation of intellectual property rights and other proprietary information, and the profitability of biotechnology companies may be affected significantly by such things as the expiration of patents or the loss of, or the inability to enforce, intellectual property rights. The research and development and other costs associated with developing or procuring new drugs, products or technologies and the related intellectual property rights can be significant, and the results of such research and expenditures are unpredictable and may not necessarily lead to commercially successful products. Diversification does not assure a profit, nor does it protect against a loss in a declining market.
The Nasdaq Junior Biotechnology Index is designed to track the performance of a set of securities listed on The Nasdaq Stock Market® (Nasdaq®) that are classified as either biotechnology or pharmaceutical according to the Industry Classification Benchmark (ICB).
The NASDAQ Biotechnology Index contains securities of NASDAQ-listed companies classified according to the Industry Classification Benchmark as either Biotechnology or Pharmaceuticals which also meet other eligibility criteria. The NASDAQ Biotechnology Index is calculated under a modified capitalization-weighted methodology.
The S&P 500® is widely regarded as the best single gauge of large-cap U.S. equities. There is over USD 11.2 trillion indexed or benchmarked to the index, with indexed assets comprising approximately USD 4.6 trillion of this total. The index includes 500 leading companies and covers approximately 80% of available market capitalization.
1 “The Biotech Paradox Of 2020: A Year In Review,” Bruce Booth, January 4, 2021. https://www.forbes.com/sites/brucebooth/2021/01/04/the-biotech-paradox-of-2020-a-year-in-review/?sh=a5abee43b3ac
2 “Revenue of the worldwide pharmaceutical market from 200m1 to 2019,” Statista, https://www.statista.com/statistics/263102/pharmaceutical-market-worldwide-revenue-since-2001/
3 “Total global spending on pharmaceutical research and development from 2010 to 2024,” Statista, https://www.statista.com/statistics/309466/global-r-and-d-expenditure-for-pharmaceuticals/
4 “Why Consider Investing in Pharmaceutical Stocks?” Melissa Pistilli, Investing News Network, June 11, 2020 https://investingnews.com/daily/life-science-investing/pharmaceutical-investing/investing-in-pharmaceutical-stocks/
5 “Global M&A Industry Trends in Health Industries,” PwC, https://www.pwc.com/gx/en/services/deals/trends/health-industries.html
6 “In Biotech, the Industry of the Future, the U.S. Is Way Ahead of China,” Scott Moore, February 17, 2021. https://www.lawfareblog.com/biotech-industry-future-us-way-ahead-china
7 “An Upstart Biotechnology ETF Right for the Times, ”Todd Shriber, August 11, 2020. https://www.nasdaq.com/articles/an-upstart-biotechnology-etf-right-for-the-times-2020-08-11
8“Why Some Biotech Companies Are Turning to SPACs,” Luis Sanchez, Jul 28, 2020. https://www.fool.com/investing/2020/07/28/why-some-biotech-companies-are-turning-to-spacs.aspx
9As a reference point, weighted average R&D expense, as a percentage of total sales, was 10.5% for the Nasdaq-100, and 4.8% for the S&P 500 in 2019. https://www.nasdaq.com/articles/the-launch-of-nasdaq-junior-biotech-2020-09-03