The US biotech sector is unusual in that the number of public companies continues to grow, with between 40 and 80 IPOs per year¹ over the past four years: there were 856 biotech stocks on the Nasdaq alone in December 2021, and 27 on the NYSE.² The overall US equity market, including large cap pharma, has seen the number of public companies drop over the past 20 years, as private companies have remained private for longer, leading to a growing number of “unicorns” (private companies valued at over $1 billion). In contrast biotech has been a buoyant IPO market where relatively immature companies with no revenues let alone profits, and sometimes without clinical data, can raise capital. Most IPOs have been at preclinical, phase 1 or phase 2 stage with a minority having reached phase 3, FDA review or already marketing. Rhepa has never invested pre-IPO and has also avoided buying new firms soon after flotation, but the growing universe of companies provides a rich canvas for building the portfolio. 

Performance has been garnered from firms of all sizes. Large caps (over USD 25 billion) averaging 40% of the book have contributed 38% of returns; mid-caps (between USD 5 and 25 billion) have made 38% of returns while small and micro caps (below USD 5 billion) have generated 25% of returns, over the past ten years. Of course, some firms that started as micro caps ended up as mega caps. Rhepa’s portfolio position sizes range from below 0.5% for “candidates”, which are usually pre-profit and sometimes pre-revenue, to 0.5-1% for fractional positions, 1-3% for core positions and 3-10% for “high conviction” positions. A handful of names have moved all the way from conviction to candidate: “Norwegian cancer specialist Algeta in the early years of the fund and more recently Apellis Pharmaceuticals, Mirati Therapeutics and Myokardia are good examples. And we have averaged four takeover bids per year, taking the total number of bids to around 50,” recalls Henrik Rhenman. 

The approach is active both in terms of market exposure and trading individual names. Net exposure has ranged between 37% and 153%, though the normal range would be 70-150%. Gross exposure has been as low as 52% and as high as 221%. Leverage can be used for extended periods or also more tactically to take advantage of market setbacks. Occasionally, the Value at Risk (VaR (95%)) limit of 3% over 20 days could require exposure reductions. At the name level, though Rhepa is taking a multi-year view on investments, the average holding period is just shy of five months, because the manager actively trades around the volatility in single stocks which can overshoot both to the upside and downside. The rule of thumb on single name risk is to cap probable maximum losses at 1%. 

Rhepa’s staff, board and scientific advisory board own a majority of the management company and collectively have around EUR 25 million invested in the fund. The investment team has steadily grown. Henrik Rhenman now co-manages the strategy with Susanna Urdmark, who joined in 2017 and featured in The Hedge Fund Journal’s 2021 50 Leading Women in Hedge Funds report published in association with EY. Urdmark brings experience from both the industry itself and the sell side. She was previously CFO of a generic drug company, Bluefish Pharmaceuticals, where she helped to raise capital, expand into European and emerging markets, and managed a team of ten in finance. Prior to that she managed the Handelsbanken Asset Management Global Healthcare Fund. She was formerly a sell side equity analyst covering Nordic pharma and biotech companies for Handelsbanken Capital Markets. There are also two analysts specialised partly in healthcare services, medical technology and healthcare information technology.  

The in-house team are complemented by an external board and a scientific advisory board (“SAB”), which is drawn mainly from Sweden’s Karolinska Institute. The SAB members, many of whom are professors, include eminent practising and semi-retired academics, research scientists, doctors, and surgeons, who specialise in areas such as oncology and nuclear medicine; metabolism and endocrinology; autoimmune and nervous system; neuroimmunological research; gastroenterology; and neurotransmission. The SAB members help to assess innovation, reviewing internal presentations of 120 or so companies per year. Over a multi-year period, Rhepa invests in around 30% of companies presenting. “Novocure and Horizon Therapeutics are two good examples of controversial names in the market where the scientific advisory board was of great help and support to take a stand early on. They have been substantial performance contributors,” says Rhenman. There is no hard and fast rule on what stage or sort of clinical trial data is required to invest or provide proof of concept. “Even if a company has not yet released phase 2 data, we may draw conclusions about the scientific risk from other firms in similar areas,” Urdmark points out. “We might review private companies in a particular research area to deepen our understanding of the dynamics and competitive environment,” she adds.

Identifying growth companies, products, and services

Drug industry growth projected to average around 7% per year has not matched the growth of the largest US equity market sector, technology, but it has been relatively steady – and is faster in selected emerging markets, such as China. Rhepa has accessed emerging market growth mainly through global companies listed in developed markets but has also had some names listed in Hong Kong and mainland China (though not India so far). “Emerging and frontier markets that use lower cost locally produced generic drugs are of less interest,” says Urdmark.

It has been important to identify innovation to tap into the above-GDP growth profile, as Rhepa has observed that some mature pharmaceutical companies regularly on the precipice of patent cliffs have behaved more like volatile bonds than growth equities. 

Important portfolio themes in early 2022 include diseases – cancer, Alzheimer’s and obesity – as well as treatment types – gene therapy, gene editing, CAR-T, RNA and bispecific antibodies – that might be applied to multiple conditions.

“Alzheimer’s is a potentially huge market where Biogen is first to have obtained approval for a new treatment. Obesity could also be considered as a disease in its own right, and which contributes to many others. New techniques and modalities are developing fast,” says Urdmark. “Gene editing to change DNA and change a patient’s cells has proof of concept, but no market yet. We do not yet know which diseases can be treated and may become less deadly diseases that can be treated prophylactically,” says Rhenman.

Personalised treatment could be a game changer for cancer and other conditions. “Understanding the disease for each person, such as their cancer tumour profile, allows for therapy tailored to them, and personalized medicine could also move beyond oncology,” says Urdmark. 

Currently Rhepa estimates that around 25% of the pipeline of its biotech and pharma holdings are in orphan drugs, targeted at relatively small markets for rare diseases, but the logical conclusion of more precise and effective customized drugs is that blockbuster drugs would no longer exist.

“Ultimately, all drugs might become orphan drugs. It is not an exaggeration to expect tens of thousands of treatments. They would be more precise but also more difficult to compare on cost,” foresees Rhenman.

Rhepa has had some exposure to vaccine makers, before and after Covid, including AstraZeneca, Pfizer and Dynavax, which makes a vaccine for hepatitis B and is taking part in developing one for Covid, but does not view vaccines as a game changer for healthcare: “Vaccines will probably not prevent the most prevalent conditions such as cancer and Alzheimer’s,” says Urdmark.

Beyond pharma and biotech, the most highly valued sub-sector, medical technology, has seen phenomenal innovation. “Robotic surgery firms such as Intuitive Surgical with their Da Vinci technology are doing an astonishing job in a remarkably broad range of surgical procedures. There will be a procedure for every part of the body, to repair and heal hard and soft tissues. The potential market is very large as everyone has the same body parts globally,” says Rhenman.

In healthcare services, remote, virtual treatment is clearly a growth area exploited by firms such as Teladoc Health. “Telephone or video calls are more efficient methods of treatment. The emergency room and hospitals in general are a very expensive way to treat many conditions such as a sore throat. Existing companies, such as United Healthcare, and new ones should bring in new solutions for primary care in the US market,” says Urdmark. Another notable trend is value-based care, which changes the model from payment for inputs to payment for the output of patient health. “Rather than being reimbursed on a transactional level, the health system should take more responsibility for patient health, and treat patients as effectively and efficiently as possible,” she adds.

Rhepa’s new sub-sector, healthcare IT, could show some convergence both with healthcare services and technology. “Healthcare technology and services could be combined where technology enables services. More broadly, healthcare IT firms can be classified either in the healthcare or technology space – Google has been investing into innovative healthcare solutions. Consolidation is already happening with two take outs from the fund’s holdings seen so far,” says Urdmark.

A “Cinderella” sector in 2021

For the fund, the 2021 investment year was mainly shaped by two factors. First was the strong economic recovery following the slowdown caused by the pandemic, which mainly benefited sectors other than healthcare. The second factor was the weak performance of small- and medium-sized companies, which in many cases showed negative share price development. The long-term earnings growth profile of healthcare has seemed relatively less attractive compared with not only megacap technology but also the violent recovery seen in more cyclical sectors, and recent earnings numbers have also sometimes disappointed as Covid has diverted resources in several ways. It has slowed drug market growth, postponed many elective treatments, and delayed regulatory milestones for new drugs since the extraordinarily fast vaccine approvals consumed a great deal of regulatory time. If a combination of vaccines, booster shots, higher uptake thereof and/or new antiviral therapeutics can keep severe illness, due to Covid variants such as Delta, Omicron (and the inevitable future ones) at manageable levels, these pandemic-related headwinds could recede over the next year or two, and let investors refocus attention on the medium to long term growth profile, where Rhenman remains confident: “The pipeline of innovation is strong: multiple ailments remain uncured and new technology can be applied to medicine that is increasingly targeted and tailored towards both rare conditions and an individual’s personal health profile”.

US drug pricing reform

In early 2022, Rhenman is on balance constructive around drug pricing: “In some parts of the drugs industry pricing power has been declining. Against this, clarity on US drug pricing reform could remove what has been a persistent source of investor anxiety and intermittent panics for multiple years. Drug pricing reform is a complex area where factors such as discounting, reimbursement, inflation and annual increases all need to be weighed up, but we see potential for higher initial net pricing balancing out discounts for segments such as Medicare”.

Valuations, interest rates and cyclical fashions

Rhenman judges, “Aggregate valuations of the biotech sector are low and attractive compared to historical levels, especially considering the low interest rate environment”. However, if tapering of asset purchases, and persistent post-transitory inflation, lead to US interest rates rising significantly faster than the current modest forecast, valuations might still be threatened. 

Headline averages for the entire healthcare sector however belie variations between sub-sectors. “The average is inflated by medical technology around 30 times PE while large cap pharma may average only 14-15. This valuation dispersion is interesting for us,” says Urdmark. “On an individual level, risk-reward varies to a great extent depending on the market expectations for a particular product, project, or technology, which we take into consideration through adjusting the size of a specific holding. The average weighted P/E ratio for the fund’s holdings is 19.5 (12 months forward looking), excluding companies with negative P/E ratios as well as companies with P/E ratios >50 as this would otherwise distort the data. Most of the very high P/E companies have recently turned profitable or have other attributes that make normal comparisons difficult.” 

Valuation multiples could contract, possibly due to an interest rate shock, but the icing on the growth story cake, if and when interest rates stabilize, could be a broad-based valuation expansion. The healthcare sector is valued at a slight discount to equity markets but has sometimes historically risen to a premium. This scenario might occur when and if slowing economic growth leads investors to rotate away from cyclicals and towards more secular growth sectors again.