Small Cap Biotech: When Will the 2021 Bear Market End?
Negative sentiment in the biotech industry has driven the SPDR S&P Biotech ETF (XBI) down more than 30% from February highs.
Pandemic-related issues in 2021 have caused significant delays in the pipelines of preclinical and clinical-stage companies.
Inflation is making it more expensive to be a pre-revenue drug development company, leading to more frequent financings and dilution.
Many pipelines, although delayed, hold significant value-generating potential as evident by recent advances in therapeutic platforms.
Due to the drop in market valuations, many small cap biotechs are significantly discounted and trading near or below cash.
Last weekend I revisited a small cap biotech portfolio that I had compiled on January 4th, 2021 based on the screening criteria below. The results were shocking. As of December 27th, 15 out of 20 small cap biotechs in the aforementioned portfolio were within 10% of their 52 week lows. Furthermore, over half of these companies had lost 80% or more of their market value from their 2021 highs in February. These weren't poorly positioned companies-- they all recorded higher revenue year-over-year, a surrogate marker and third-party confirmation of the value of their pipelines. So what is going on here?
At the end of a tough year in 2021, I'm asking myself: At this point, are small cap biotechnology stocks undervalued or are they simply "un-investable"?
Applied Filters for Stocks Screener on January 4th, 2021 - Source: Yahoo Finance
Between 1 and 15 (USD/Share)
Greater than 80,000
1 Yr. % Change in Total Revenue
Greater than 30%
Greater than 10,000,000 (USD)
The Case for a Fire Sale
My portfolio represents a tiny fraction of a sector that has been in a downturn since February 2021. As a result, I will refer to the SPDR S&P Biotech ETF (XBI), which holds a collection of 194 or so mainly biopharma biotechnology stocks. In December, this fund was down over 30% since its February 8th highs. Top XBI holdings include gene editing plays like Intellia Therapeutics Inc (NTLA) and Editas Medicine Inc (EDIT) which had significant swings over the past year. Even for a highly volatile fund like XBI, a 30%+ drop has only happened twice in the last ten years: once in early 2016 and once in late 2018, resulting in negative returns for two out of the last ten years (see chart below). The negative sentiment today is the result of a perfect storm of factors, as explained below. Unfortunately for fans of biotech investing, this trend may carry-on in 2022 until major catalysts like M&As and other deal activity jumpstarts the industry again.
Preclinical and Clinical Woes
The amount of funding injected into the pharmaceutical industry for COVID-related vaccines and treatments has had the unintended consequence of supercharging competition throughout the preclinical and clinical development pathway. Preclinical biotechs are competing for lab supplies, animal models, and human resources with an influx of infectious disease programs. This has especially impacted the availability of non-human primates for GLP tox studies, which now can take 16 months or longer to receive results--a linchpin for IND clearance to initiate human trials, leading to significant delays.
Clinical-stage companies are not off much better than their preclinical counterparts, albeit mitigated for those with revenue-generating products on the market. According to the Fred Hutchingson Cancer Center, the number of clinical studies initiated in the United States from February to May 2020 was only 57% of what would have been expected had the pandemic not occurred (1). This reduction in patient enrollment leads to delays down the pipeline, effectively reducing biotech productivity as measured by successful data readouts and M&A activity. For biotechnology companies with long-development timelines and limited patent coverage, this can seriously affect market valuations.
Longer preclinical and clinical development timelines due to Covid-19 are now coupled with increasing investment requirements to get to value-generating milestones and eventually, product sales, out-licenses or exits. Inflation is a double whammy for growth stocks, including biotechnology, and historically leads to lower returns for the sector (see below). For one thing, high cash balances have a higher carrying cost. Increasing expenses and delays from supply chain disruptions and human resources shortages reduce runways requiring additional financings and subsequent dilution. The silver lining is that eventually future lump sum payouts will reflect the lower value of money, especially after marketing-stage pharmaceutical companies-- those that have produce revenue streams-- start to drive M&A activity to take advantage of discounted pipelines. Once inflation levels out, this should create a floor on the financial modeling side regarding discount rates.
Many of the factors outlined above aren't going to fix themselves overnight. The slide in XBI has been dramatic, especially this Holiday season. The question is: has it fallen far enough or will there be a market correction in 2022? Let's review the case for a Holiday sale...
The Case for a Holiday Sale
It is that time of the year, especially when indexes like the NASDAQ were up a startling 46% at the beginning of the Holiday Season (11/1/21). While many investors are waiting to take their long-term capital gains in 2022, there are plenty of short-term capital gains to offset from the rise of the NASDAQ, especially certain tech stocks. Since its local peak on 11/3/21, XBI has fallen 14.1% to 12/29/21, adding insult to injury. Before investors continue to jump ship, they should note that Wash Sale rules limit investment into the same or similar company after 30 days if losses are to be tax deductible in 2021. This means that investors may start to crawl back into these companies in early January. Looking back, tax-loss harvesting might have been a major contributor to the last annual drop of XBI in 2018, when the fund marched up 26.8% in the three weeks following a Christmas eve low of $64.38.
It is true that 2021 had major drug disappointments, but for the most part, therapeutic pipelines remained intact, albeit significantly delayed. Not only that, maturing technology is leading to breakthroughs in the cell, gene, and CAR-T therapy space, as well as up and coming DNA/RNA and oncolytic virus therapies. According to the industry organization PhRMA, novel life-changing treatments for blood cancers, autoimmune, neurological, and infectious diseases using these approaches are up for FDA review in 2022. In fact, almost 80% of Phase I programs would be first-in-class therapies if approved today (2). The risk associated with this level of innovation is bound to result in many failures, but the overall pipeline represented by XBI is robust and diverse, and technological advancement is a sign of a healthy sector poised to grow over the next 3-5 years.
In addition to advances in therapeutic approaches, drug developers are becoming more adept at leveraging biological data to recruit and measure treatment response. Predictive markers and surrogate endpoints are used more frequently in clinical trials for long-term diseases like Alzheimer's and Wet Age-Related Macular Degeneration to establish efficacy at earlier time points, saving time and money. Genetic markers also allow clinical-stage companies to target specific patient populations and achieve regulatory benefits like Orphan Drug Designation. A big win this year was Amgen's Sororasib (Lumakras), which was granted accelerated approval as the first KRAS-blocking drug in May to treat KRAS G12C-mutated Non-Small Cell Lung Cancer (NSCLC).
Another curious result of the perfect storm of anti-biotech sentiment is that many preclinical and clinical companies are now trading near or below cash. Out of the 20 companies in the stock screener, 12 companies (60%) have price-to-book and price-to-cash ratios less than 2 (see below). For comparison, this is below XBI's average price-to-book of 3.9 as of 12/29/21 and well below the historical Biotechnology (Drug) sector of around 7. Note that the price-to-book and price-to-cash calculations below were based on Price/Share as of 12.30.21 and balance sheets as of 9.30.21, derived from SEC filings. As a result, without considering additional financings, cash balances are lower by actual net cash flow in Q4.
Two biotech companies to note within my pre-screened portfolio are Ovid Therapeutics Inc. (OVID) and Homology Medicines, Inc. (FIXX), both trading at price-to-cash premiums of only 10%. While the cash burn of these companies is high-- their lead products are in Phase III and Phase II clinical trials respectively, they have been able to manage quarterly burn to between $10 million and $30 million per quarter, in Ovid's case by partnering with Takeda. Over $200 million in cash at the end of Q3 affords a 16 to 24-month runway for these companies, sufficient for hitting clinical milestones with back-up cash left over. Buying into these companies and other biotechs within the XBI ETF means obtaining a piece of discounted pipelines and sufficient runway to weather any storm 2022 may bring.
What happens next?
The last time small cap biotechnology stocks suffered this much was in Q4 2018, when XBI dropped 23.3% over two months to bottom out on Christmas Eve before rallying 26.8% the following three weeks, and adding another 13.8% in gains three months thereafter.
The magnitude and duration of delays that continue to build up for troubled biotechs--with programs becoming more expensive to develop and commercialize-- is a driving factor for biotech pipeline valuations in 2022. Some interesting things might start to happen. On one hand, many preclinical biotechs may see higher levels of attrition in their pipelines and a focus on later-stage assets. On the other hand, some biotechs, especially clinical-stage, will see attractive M&A opportunities as trials read out and large cap pharmaceutical companies take advantage of the beaten down sector to reinvest their cash heavy balance sheets into innovative technology. For investors that want exposure to the industry, XBI and its holdings over an avenue to invest in a sector that is poised for significant growth.
Ticker Symbols Mentioned:
SPDR S&P Biotech ETF (XBI)
Intellia Therapeutics Inc (NTLA)
Editas Medicine Inc (EDIT)
Ovid Therapeutics Inc. (OVID)
Homology Medicines, Inc. (FIXX)
I have a beneficial long position in the shares and derivatives of companies comprising the XBI ETF. Likewise, I have no business relationship with any company whose stock is mentioned in this article.
Photo Source: Dimhou/Pixabay