We recently had the opportunity to speak with Paul Yook, founder of BioShares, about the main differences between biotechnology and specialty pharma, the transformation of the biotechnology sector as well as the opportunities in the industry going into 2016.
ETF Database (ETFdb): Please tell us about yourself and about the trajectory that lead you to being a cofounder of LifeSci Index Partners and BioShares Funds.
Paul Yook (P.Y.): I have been investing in biotechnology stocks personally and professionally for nearly 20 years, and first started in the field as a biotechnology investment banker in the mid-1990s. The first ETF was launched in 1993 and I was first introduced to biotechnology ETFs in 2001. In the early 2000s, I used these funds (at the time (BBH ) and (IBB )) mostly for short-term exposure on a trading basis.
Over time I became more interested in these ETFs for longer-term investment purposes as I felt that the market for biotechnology stocks was becoming more efficient, with fewer advantages for active biotech managers, which include actively managed mutual funds and hedge funds. However, I found several characteristics of the existing funds suboptimal for my own investment purposes, including their relative large-cap nature and mix of nonbiotechnology sectors.
In other words, these existing older ETFs are not just biotech plays since there’s a lot of nonbiotech in them (specialty pharma has significant exposure). Whereas for my portfolio, I don’t want that exposure. I mainly want exposure to the biotech industry with equities that are not all mega-cap.
ETFdb: What was the biotech industry like back in the 1980s and 1990s?
P.Y.: The first public companies were formed around 1980. These include Amgen, Genentech, Biogen and Syntex. Some of these are still around, some have been acquired. These companies were straightforward in what they did. Companies like Amgen and Genentech created synthetic versions of well-known human enzymes or proteins, like insulin or human growth hormone. These were relatively simple solutions where they produced proteins or enzymes, which was basically a lot of biological manufacturing. New technologies developed over time, with the biggest changes being the sequencing of the human genome and the advent of humanized monoclonal antibody technology; there was an explosion of antibody drugs coming out of the biotech industry.
P.Y.: In the ‘90s and early 2000s, there were relatively few publicly traded biotechnology companies with approved FDA drugs, and the vast majority were in the clinical stages of drug testing. As a result, biotechnology was largely considered to be a research-sector with unprofitable companies, and this was for the most part true. However, the sector has evolved and transformed dramatically as there are now numerous success stories and more than 40 publicly traded biotechnology companies that are actively selling FDA-approved drugs. These later-stage product companies are so fundamentally different from the clinical trials-stage companies that it only made sense to us to divide them into separate funds. You see from a financial point of view that volatility is dramatically reduced at the products stage, the shareholder base is quite different, and investors focus on very different metrics, such as weekly prescription volumes, quarterly conference calls, and sales and marketing acumen.
ETFdb: What is the difference between biotechnology and specialty pharma?
P.Y.: When we first filed the prospectus for our BioShares funds in August 2014, Main Street investors did not focus on the first descriptive page of our methodology, which defined the holdings of our funds to include only “pure” biotechnology companies and excluded sectors such as specialty pharmaceuticals. This distinction has become a major focus in the financial markets as Turing, Valeant, Horizon and Mallinckrodt have come under the microscope for their unique business practices.
While we like many aspects of the specialty pharmaceutical business model and admire a handful of the companies, it astounds us at how different specialty pharma companies are from biotech companies.
The primary distinction is that biotech companies are research-driven. Many times the CEOs of leading biotech companies are Ph.D.s, M.D.s, or both, and are the scientific founders and leaders of the company. These companies spend hundreds of millions of dollars, in some cases over a billion dollars, in the R&D stage of their history before turning profits. Even the large and most successful biotechnology companies such as Biogen still spent more than 20% of sales on R&D expenses. Specialty pharma companies in contrast spend perhaps 5% of sales on R&D, and Valeant spends even less, with its CEO stating (and I paraphrase) that R&D is in his view not productive thus Valeant prefers M&A.
The end result is that biotechnology companies recruit cutting-edge scientists from the ground level up, and they maintain a culture of science and patients first. A danger in the specialty pharma model is to put profits first. Not surprisingly the end result is that biotechnology companies tend to lead the overall drug industry in breakthrough drug launches and financial returns.
ETFdb: Why do you think the market is not differentiating between these two industries?
P.Y.: The specialty pharma sector was a relatively small sector with only a handful of companies. Only in the past few years have companies proliferated, taking advantages of tax inversion strategies, M&A opportunities and unique FDA pathways such as “DESI” and “505(b)(2)” strategies. As a result, a handful of relatively unknown companies emerged as new Wall Street stars and moved into financial prominence. As most biotech ETFs are created by standard industry classification systems that do not really distinguish between and among biotechnology, specialty pharmaceutical, diagnostic and sometimes even medical device companies, many funds have become mish-mashes of health care subsectors.
ETFdb: What benefit do you offer investors by having two distinct funds that separate clinical trials companies and products companies?
P.Y.: Because clinical trial-stage companies and product-stage companies are quite different in financial metrics and trading statistics, the two resulting funds, BBC and BBP, have generated quite different results and are the least cross-correlated among all of the biotechnology ETFs. In addition, we believe that BBP, with its lower risk and volatility, could appeal to investors who otherwise might consider biotechnology to be too risky and speculative.
ETFdb: Could you tell us more about the holdings in the funds?
P.Y.: Our funds follow a set of rules created by LifeSci Partners, and our team comprises biotechnology investment professionals with decades of experience in the field. Today, BBP contains approximately 40 stocks, all with FDA-approved drugs, and an average market cap of approximately $17 billion. BBC contains approximately 90 stocks all in the clinical stages of research and with an average market cap of $1.5 billion. They span many disease categories, such as cancer, diabetes, neurological disorders, pain and antibiotics.
ETFdb: Who should invest in your funds? In other words, what kind of investor should hold these ETFs?
P.Y.: I believe that many investors are underinvested in biotechnology, or worse, have no exposure to this sector. Biotechnology has generated nearly all of the growth in the global drug industry since 2010 and has been one of the best sectors in the market over the same time period.
Our funds were designed and created for any investor, small or large, knowledgeable in biotechnology or just learning about the space, to gain exposure to the dynamic technological changes and financial results that come with investing in the sector.
ETFdb: What is your overview and outlook of the health care sector going into 2016, and what are the main challenges that lie ahead (e.g. some negative factors going forward are increased government regulation, potential pricing regulation and fiscal policy concerns)?
P.Y.: 2015 was another volatile year for biotech stocks. But with 85% of the year over, it looks to again be one of the top sectors in the market. I am very enthusiastic about opportunities for biotechnology investors in 2016 as individual stocks trade 25%+ below July highs as a result of a dramatic sell-off that lasted through the end of September. There are real concerns for the sector and I think the most important and fair concern regards pricing of drugs and price increases. However, I believe stock prices already reflect the vast majority of damage that could occur and I believe companies that develop and launch truly innovative and curative medicines will continue to reward their shareholders.
In addition, we have been seeing biotechnology and pharma M&A activity pickup meaningfully since a very quiet summer, and I expect activity to continue as acquirers must find current valuations to be highly attractive.
ETFdb: Relating to that, where do you see opportunities for the health care sector?
P.Y.: Within the broader health care investment space, we have seen tremendous gains for hospital stocks and health insurance companies, and I believe that the next few years will be more challenging as these businesses tend to have cyclical margins and we are at or near peaks. With the announcement that significant insurance companies are exiting the Obamacare plans due to unprofitability, the bonus of increased covered lives that the sector enjoyed over the past few years will be coming to an end.
ETFdb: As a side question, what is your view on Valeant?
P.Y.: Valeant has a portfolio of very exciting products and older products. Given how big the company is, they’re going to have a wide variety of products. I think there are a long of negative things that are said about it. But at the end of the day, they have a lot of really exciting products, most of which are acquired through M&A. They do not spend very much money on R&D; about 3.5% of sales, which is exceptionally low. Large-cap pharmaceutical companies like Merck, Lilly, Pfizer and Bristol-Myers will spend about 15% to 25%, and biotech companies spend even more than that. Valeant spends a tiny amount on R&D.
In pharma and biotech companies, the scientists and researchers lead the company; they have a research-based culture, whereas Valeant is a finance and a deals-driven corporate culture. That’s the perception, that they’re financial whizzes. They have a very low tax rate, they use debt to their advantage, and they have extremely high leverage on an EBITDA multiple basis. But they have some very good companies and they’ve been known to be a sales powerhouse. I think things got a little crazy there with the stock falling to the $70 level.
Specialty pharma is a unique business; it’s not a largely organic growth business where you’ve got great scientists who will keep generating new drugs. The company is reliant on so many external factors to keep their growth going, including finding exciting companies who want to join them and being able to finance them. Therefore, there’s just too many factors outside of Valeant’s control to keep enjoying the growth they’ve enjoyed.
ETFdb: Regarding the biotech subsector specifically, what opportunities do you see going forward?
P.Y.: A great deal is written in the media about the latest cancer breakthroughs, gene therapy and gene editing companies, and those are certainly exciting. However, I am equally excited about the increasing pace of clinical trial activity in various neurological syndromes. Not just Alzheimer’s but also amyloidosis, Parkinson’s, DMD and MS. There are also exciting programs in antibiotic research, skin disorders and alopecia (hair loss).
Neurology is one of the most exciting areas of current clinical research in biotechnology because we haven’t done much for it. The brain is the most complex organ in human biology; so little is known. Multiple sclerosis and Alzheimer’s, as examples, are very big drug markets for the biotech sector, but their drugs barely work. I think the current research that’s in this space is really exciting because it’s focusing on disease-modifying drugs. These are therapies that potentially will impact or modify the progression of the disease rather than treating the symptoms.
If you look at Alzheimer’s drugs today, they simply treat the symptoms. There’s an explosion of funding for these companies as well. As an example, there’s a recent company that was just formed, called Denali Therapeutics, that did their Series A round of funding (startup round) just six months ago and raised $217 million. Again, this was a startup that raised $217 million. This was exceptional even in the realm of biotech startups. But it’s because they said very little publicly and hired the top professionals of neurobiology research. They’re going to focus on these brain diseases, Alzheimer’s and Parkinson’s. There’s a real opportunity to create landmark breakthrough therapies over time. It’s going to take them a long time, it’s a startup, but I think this is an area we all want to closely follow.
The Bottom Line
The biotechnology industry started more than three decades ago, with new breakthrough technologies developed over time. Some of the biggest changes in biotechnology were the sequencing of the human genome and the advent of humanized monoclonal antibody technology. This industry has moved from a research-sector with unprofitable companies, to an industry with numerous success stories and more than 40 publicly traded companies that are actively selling FDA-approved drugs. Investors looking for specific exposure to the biotechnology industry can look at the BBC and BBP ETFs as an investment option. Further, over the past five years, the biotechnology sector has generated most of the growth in the global drug industry and has been one of the best-performing sectors in the market.