The small and mid-cap biotechs poised for a big breakout

One of the old pearls of wisdom applied to investing is to invest in what you know. If you want to play in the small end of biotechnology, understanding the science or having an expert interpret is essential. After all, this is often the riskier end of the healthcare sector where a failed trial could mean the end of a company and your investment.

This is why you’ll typically find fund managers in the biotech space have medical backgrounds, like HB Biotechnology’s Charlie Williams, who holds a PhD in Biomedical Engineering.

In the first interview of our biotech mini-series, Williams shares why he sees the biggest opportunities in the small and mid-cap space, how to evaluate these companies to minimise your risks and the signs we are about to see a biotech boom. He also reveals three stocks with big potential he is monitoring.

What is the outlook for global healthcare and biotechnology?

After a three-year biotech bear market, it looks like we may be in for a change in fortune. You have to go back to 2000, in the aftermath of the dot-com crash (aka ‘the genomics bubble’ for biotech investors), to encounter a biotech bear market that has persisted for this long. This time around the biotech bear market was driven by indigestion from the spate of IPOs in 2021, then high inflation and monetary tightening that has persisted since the beginning of 2022.

While conventional equity markets such as the ASX200 and S&P500 have recently been reaching all-time highs, biotech is barely above pre-covid levels, as measured by the XBI, and we believe well poised to break out the bear market now that interest rates globally appear to have plateaued – and may be on the way down again.

With the focus shifting away from macroeconomic data and “Fed talk”, markets are returning to valuing biotech companies on fundamentals which, on the whole, we believe are still at compelling prices right now.

Are we heading into a biotech boom? What signals are you seeing?

There is no doubt that we are living through a golden age of biotech innovation with more new therapeutic modalities to treat disease than ever before. 20 years ago, we only had 2 therapeutic modalities: small molecules (chemicals) or antibodies. We now have approved gene editing therapies, RNAi therapeutics, radio-therapeutics, peptide therapeutics and cell therapies such as CAR-T, with other, newer modalities such as protein degraders and molecular glues rapidly advancing through the clinic.

Yet, while we are experiencing some of the greatest scientific innovation, prices have been driven lower over the past couple of years, not due to any change in the fundamental prospects in biotech innovation, but rather analysts revising up the discount rate used to value biotech companies (which pushes prices down). 

It is no surprise that large pharma has taken advantage of these lower prices to go on an acquisition spree, with 2023 being the second-highest year for overall acquisition value and this trend continuing into 2024.

What are the key sub-industries when we talk about biotechnology that investors should be aware of?

Oncology has long been a huge sector for global investment in biotech, making up around 50% of the investment opportunities in listed biotech markets and we continue to find good opportunities here. 

However, with many blockbuster Immunology and Inflammation (I&I) drugs coming off-patent in the next few years, such as Humira and Stellara, we have seen significant interest in this sub-sector of the biotech market – especially oral drugs that have a novel mechanism of action. As evidence, we’d point to notable deals in the I&I space such as Prometheus acquired by Merck (NYSE: MRK) for $10.8 billion, DiCE and Morphic acquired by Eli Lilly (NYSE: LLY) for $2.4 billion and $3.2 billion respectively, and Vertex (NASDAQ: VRTX) acquiring Alpine Immune Sciences for $4.9 billion, among others.

While we have tended to be wary of neurology investment opportunities in the past due to ‘black box’ (unknown or poorly understood) mechanisms of action and/or highly subjective clinical trial endpoints that can lead to outsized placebo responses, we see a rise in ‘precision neurology’, akin to what has occurred in oncology over the past decade or so. Increasingly we are seeing neurology drug development programs being led by genetically defined targets and patient enrichment using increasingly validated biomarkers that we hope will ultimately lead to an increased likelihood of success for clinical-stage drugs.

Which areas of the market do you see the biggest opportunity in?

We focus on global small to mid-cap biotech companies, which we define as having less than US$5 billion market cap upon our initial investment. With soaring inflation and rising interest rates, this cash-burning sector has been one of the hardest hit over the past 3 years. 

However, there are signs that this market is now starting to be valued on fundamentals, as opposed to reacting to macroeconomic data and poised to break out of a three-year biotech bear market. 

 Additionally, should interest rates be cut in the near to midterm, the small to mid-cap biotech market should be one of the biggest beneficiaries of lower interest rates.

How do you manage the risks involved in investing in small and mid-cap companies in this space?

As a bottom-up stock picker, we have always invested in companies with compelling risk/reward ratios regardless of the market conditions.

One of the key criteria we screen for when searching for small to mid-cap biotech companies is capital adequacy. 

We will not invest in any biotech with less than 12 months' cash runway and typically prefer longer. 

 By way of example, our current portfolio of small to mid-cap biotech companies has a weighted average cash runway of 1.9 years and is ~50% cash-backed when taking into account the cash held by portfolio companies.

This strict adherence to risk management rules is one of the factors that has allowed us to outperform our index, the S&P Biotechnology Index, by 15.2% p.a. since launching as HB Biotechnology.

Weight loss drugs like Ozempic have been a big media focus. Do you expect this to continue and are you investing in this theme?

You’d had to have been living under a rock not to have heard of the GLP-1 obesity drugs Ozempic, Wegovy (Novo Nordisk) and Zepbound (Eli Lilly) which have driven the prices of those large-cap pharmaceutical companies to all-time highs. Being injectable drugs, there’s a big focus on cost and access to these weight loss drugs. 

Both Novo Nordisk and Eli Lilly have invested heavily in additional manufacturing capability in an attempt to satisfy demand.

Concurrently, there is a race to develop a similarly effective oral GLP-1 that would be easier and cheaper to produce as well as more convenient for patients. Both Novo and Lilly are developing their own candidates internally, however, there are other smaller companies in this race such as Structure Therapeutics (NASDAQ: GPCR) and Viking Therapeutics (NASDAQ: VKTX), the latter of which has shown strong weight loss with an acceptable tolerability profile in early clinical development.

What three stocks are you watching and why?

Domestically, one of the biggest data readouts in the next 12 months will be Opthea (ASX: OPT).

We rarely have large Phase 3 trials conducted by Australian companies and Opthea have two readings out in 2025. Their phase 2 data in wet age-related macular degeneration (wet AMD) was compelling and, should these be replicated in Phase 3, this will be a significant stock-moving event. 

While the stock has traded down with funding overhand in recent times, with their last capital raise completed in June 2024 and enrolment completed, Opthea appears to have sufficient cash to make it through the first of their two Phase 3 trials, expected in early 2025.

Aroa Biosurgery (ASX: ARX) is another stock that has traded down in recent times, in their case due to earnings downgrades in FY24.

However, their inventory issues and downgrades appear to be behind them and are likely on track for a maiden profit this financial year. Additionally, despite its strong revenue growth profile, Aroa remains below industry peers on an EV/Revenue basis.

Internationally, Verona Pharma (NASDAQ: VRNA) received FDA approval for its drug, Ohtuvayre (ensifentrine), in June as a treatment for Chronic Obstructive Pulmonary Disease (COPD) and represents the first novel mechanism of action to be approved in this indication in decades. Our checks with US-based doctors suggest there is significant pent-up demand for a novel therapy such as ensifentrine to treat the over one million patients who remain symptomatic on maximal therapy (i.e. triple therapy).

Can you share an interesting or strange thing you’ve learnt or experienced across your time investing in healthcare and biotechnology companies?

While reading a broker report this past year, I came across a piece of analysis that suggested that if you had a strategy of blindly buying biotech companies the day they released negative trial results, regardless of their indication or trial phase, you would have been handsomely ahead of market returns 12 months afterwards. 

We’re not about to adopt this algorithmic ‘busted biotech’ strategy, but it was an interesting analysis that suggests that selling is typically over-done the day of a negative data release, something we have observed anecdotally, and it can pay to take a look at under-loved assets/companies.