Macro has its hand on the tiller (again)

Oct 13, 2023

In May 2022 the biotechnology market was experiencing one if its greatest corrections since the index’s inception, having dropped 40% in 5 months.  Back then we were observing that the fundamentals of the Market had not changed, yet prices were depressed due to concerns regarding soaring inflation and rising interest rates. The title of our quarterly in mid-2022 was “History Rhyming”.

Fast forward to late September 2023, with the US Fed is signalling that it will hold interest rates higher for longer, causing a broad selloff in stocks, and we could have used the same title for this current quarterly.  With macroeconomics once more grabbing hold of the proverbial tiller, we get the distinct impression that history is rhyming once again.

The Unwinding of Easy Money

The latest bout of market jitters is arguably an extension of the unwinding of very accommodative monetary policy that was in place from the GFC in 2008/9 until the start of calendar year 2022. Since then, the US Federal Funds rate has been raised from near zero to 5.5%. In late September 2023 the US Fed opting to keep rates on hold at 5.5%.

If there was no change to interest rates, then what is all the fuss about?

The biggest change in September was the revision of the “dot plot” which is updated quarterly. This “dot plot” graphic indicates where each Fed official sees interest rates rising — or falling — in the future, currently through to 2026. Officials signalled in those updated projections that they see one more rate hike this year. They also now see just half a percentage point worth of cuts in 2024 on the expectation that inflation and economic growth will gradually slow. Those estimates signal policymakers are prepared to keep rates higher for longer. This contrasts with last quarter where officials expected to cut rates by a full percentage point.

OK, so what does this have to do with Biotechnology?

Quite apart from the rhetorical question around the Fed’s actual track record over the long term in getting these sorts of things right, when you really understand the Biotech sector, how much of the above really matters when valuing assets?

Good question. Fundamentally, nothing.

Biotechnology is a sector largely made up of drug development companies with little or no cash flow now, but with significant profits and cashflow prospects in the future. Higher interest, or their expectation, can, for these sorts of assets and using standard valuation techniques slavishly, theoretically, significantly reduce asset valuations overnight.

Using Discounted Cash Flow (DCF) modelling, which is standard in the Stockbroking and Investment Banking world, has the unfortunate effect of often rendering 5 year and longer dated cash flows as having very little “value” for quality drugs which may have significant cash flow generating capabilities for decades.

It can be a significant flaw in the use of this valuation technique for assets of this nature, which we have observed over many years and yet the Market continues to use it as “the norm”

Takeover activity invariably increases at such times as Big Pharma, knowing the real long-term value of such assets picks up bargains. Indeed, May 2022 coincided with Big Pharma starting to increase their pace of M&A. Shrewd investors do the same.

It is our view that the current ‘risk-off’ mentality that has investors indiscriminately selling sectors such as tech and biotech is overdone, with the Biotech Index, in USD, now testing levels seen back in May 2022 – the depths of the most recent correction, as can be seen from the blue line in the chart below.

HBB Performance vs Biotech Index

Normalised HB Biotechnology performance compared to the S&P biotechnology select industry index, in USD and AUD, since the start of monetary tightening in January 2022. Returns before fees.

A similar, short episode (based upon short term interest rate expectations at the time) also occurred in March 2023, as can be seen in the chart above. Here at HB Biotechnology, we have consistently taken advantage of these opportunities, both in April / May 2022 and March 2023, to accumulate high quality, well capitalised biotechnology companies. Each time, we have been rewarded, as evidenced above, by significantly outperforming the index as markets ‘normalise’.

All our experience, and history, suggests that we should expect the current conditions to produce the same result for those holding high quality assets in the sector.