Sticking to your Guns

Jul 7, 2023

Looking back at FY23, one of the things that most stands out is that the level of outperformance achieved has reinforced the importance of Sticking to your Guns: Adherence to investment protocols.

While considering what to focus on for this financial year end review, I came across an article from RA capital’s Managing Director, Peter Kolchinsky, which is part of a series on how RA capital, a specialist US-based biotech investor, thinks about portfolio construction. Comfortingly, many of the key takeaways from this series ofarticles reflect how we approach portfolio construction here at HB Biotechnology.

Accordingly, in this review I thought I would focus on two of these principles that are core components of our portfolio construction and risk management rules – we believe an important factor in how we have consistently outperformed the broader biotech market.

However, before we focus in on these components, since it is the end of the Australian Financial Year, it warrants a quick review of performance for the past 12 months:

Figure 1: FY23 Investment Performance before fees. Biotech Index is S&P Biotech Industry Select (TR) in AUD

For completeness, our long-term performance can be found here.

This level of out-performance for our clients in FY23 was pleasing, especially considering the 6 months prior to FY23 (January to June 2022) was one of the most painful and dramatic downturns in the Biotech market’s history, triggered by the start of the most aggressive rate hiking cycle since the 1970s. The biotech index dropped more than 40% in just 5 months, as seen in the chart below. We have come to refer to this period as the Biotech market’s equivalent of the GFC.

Figure 2: Relative performance of HB Biotechnology vs the S&P Biotech Index (TR, in AUD) from 31 Dec 2021 to 30 Jun 2023. All figures are on a pre-fee basis.

All HB Biotechnology clients have recovered the losses from this period and are in front, net of all fees. This is in no small part due to Sticking to our Guns: Strictly adhering to our investment protocols and risk management rules.

Now, a brief overview of two very important components of our investment protocols:

Capital Adequacy of Investee Companies

While we have written about the importance of capital adequacy before, the emphasis given to years of cash flow and burn rate in Peter Kolchinsky’s article, as well as our own investment protocols, warrants a quick recap. Balance sheets always assume greater importance in significant market downturns.

While we have minimum criteria for our portfolio companies of at least 12 months cash runway, with anything below this considered to be in the “danger zone”, ideally we seek opportunities with 2 years cash runway when adding a company to our portfolio.

The downturn we recently experienced is a perfect illustration of why this cash criteria is so important: Markets typically overshoot, both on the up and down sides. The last thing you want to be doing as a cash-burning biotech company funding meaningful research and clinical trials is be forced to raise capital at depressed prices.

 

Throughout the recent downturn, the weighted average cash runway of our portfolio companies has always been greater than 2years and, as at 30 June 2023, our portfolio is 51% cash backed (when considering cash held on portfolio company balance sheets) with a weighted average cash runway of 2.8 years.

 

Capital adequacy of our portfolio companies is tested formally at least monthly, providing an important input to our risk / reward ranking criteria, portfolio inclusions and weightings.  Adhering to these protocols is a very important element of how we managed to not just survive the recent downturn, but significantly outperform.

Expert validation of the underlying company and science

In Peter Kolchinsky’s article, he refers to a “Core” group of biotech companies that have at least one specialist biotech investor on their register.  The inference here is that those companies that have attracted investment from industry specialists are more likely to have superior science and management, and therefore superior prospects of generating a return.

For a generalist investor, this is not a bad way of identifying which companies may have superior prospects – and which ones to avoid.  While checking whether other biotech specialist investors are on the register is one element of our due diligence process, we take this concept of expert validation much further.

A core component of our investment process, and mandated by our risk management rules, is to interview multiple Key Opinion Leaders (“KOLs”: Physicians, hospital executives, health system directors, researchers, etc) as part of our due diligence process.  While our investment team and advisory panel may collectively have PhDs and years of industry knowledge, we cannot hope to have the level of insight of professionals who may have been researching for their entire professional lives, for example, a particular cell signalling pathway implicated in cancer cell survival.  Similarly, it is critically important to understand the likely prescribing practices of physicians in the most relevant commercial markets, and where a potential new therapeutic may sit relative to current, or near future, standard of care.

 

At HB Biotechnology we have established a considerable network of KOLs, advisors, industry experts, researchers and clinicians that are critical to our investment process.  Checking to see if an industry specialist fund is on the register is a reasonable first step to validating the science, however this is no substitute for conducting your own due diligence and KOL interviews.

 

So, what’s in store for FY24?

Back in late May 2022 we had questioned whether the market had reached a Turning Point, with evidence of M&A activity starting to pick up in the sector – typically a good sign for improving sentiment.  With the benefit of 20-20 hindsight, it appeared that May 2022 was indeed the bottom.

Fast forward to the end of the 2023 Australian Financial Year and we are confident that global biotech is on a stable footing.  M&A activity continues to grow, fuelled by the combination of attractive asset prices and large pharmaceutical companies with abundant cash reserves seeking to bolster their product pipelines and guard against Loss of Exclusivity – a dynamic we’ve written about previously here.

While we haven’t seen much in the way of IPO activity to date, there have been plenty of well-supported secondary offerings – another positive sign for improved sentiment in the sector.

Whether interest rates stay higher for longer, or we head into a recession (in which case we would expect rates to ease), we see global biotechnology as a bet each way and, with its characteristic of very low correlation to conventional markets, worthy of consideration in a diversified portfolio.

 

Looking specifically at the HB Biotechnology portfolio, while the first half of calendar 2023 was relatively quiet from a price-moving catalyst point of view, many of our portfolio companies are reaching important clinical or commercial milestones in 2H calendar 2023 and accordingly we expect a far more ‘lively’ half ahead.

 

In continuing to provide investors exposure to high quality global biotechnology through a portfolio of actively managed, listed investments, we continue to find compelling investment opportunities in this market.  We believe this dynamic will continue into the coming year.