We are longstanding investors in the pharmaceutical sector, but think investors should be more critical in evaluating the chance of drug pipeline failure and risks to capital.
For context, our enthusiasm for pharma stems from the sector’s unique Macro-Thematic backdrop and the associated tailwinds to earnings, dividends and valuations.
At the turn of the millennia, the industry came under concerted political pressure to waive intellectual property rights and allow poorer countries access to generic copies of key drugs. This attack on the inviolability of patents undermined pharma’s emphasis on pipeline innovation and muddied the investment case. There were two consequences: pharmas were forced to recalibrate models, paring research & development (R&D) and operating as distributors of consumer health goods; and a material de-rating in share valuations ensued.
Things began to change in the midst of the ‘Great Financial Crisis’. The gathering threat of communicable disease (HN1, Avian Flu, Ebola etc.) illustrated the fragility of global health. This affirmed the importance of pharma R&D and encouraged more conciliatory political attitudes. Expedited approval processes in novel, or promising drugs became commonplace and pharmas were encouraged to participate in strategic health initiatives.
Political conciliation gave succor to the industry and encouraged a return to R&D-driven innovation. Change came too late to bridge the ‘patent cliff’ – a period of concentrated drug patent expiries and falling revenues –but soon enough to ensure that 2014/2015 was the most fruitful period for pipeline productivity since 1996/1997 (source: FDA, New Chemical Entity approvals, January 2017). Understandably, pharmas with innovative pipeline prospects have re-rated.
One notable area of promise has been Immuno-Oncology, or I/O. At the risk of oversimplifying an impressive field of research, I/O entails developing drugs which enable the immune system to unmask, identify and attack cancer cells. I/O is a meaningful advance in treating cancer and has excited much investor interest.
The field has been led by four large-caps: Bristol-Myers Squibb, Merck Inc, Roche and AstraZeneca. For some time, Bristol Myers was held to have an unassailable lead; its Opdivo drug gaining FDA approval for treating Melanoma in December 2014 and acceptance for several other cancers in rapid succession. As one would imagine, the market rewarded Bristol Myers with a premium rating which peaked at 38x prospective earnings in mid-2014.
This was to the Fund’s advantage. Given our thematic case for the return of pharma innovation, we had been early to anticipate the potential of I/O. At peak, 4% of the Liontrust Macro Equity Income Fund was invested in Bristol Myers.
However, we felt queasy at the valuation attributed to Bristol Myers. The company was priced at a steep premium to peers, with little room given to the possible limits of I/O and the risk of future disappointments. We read the hallmarks of what George Soros terms ‘reflexivity’: a narrative had taken hold in investors’ minds, whitewashing uncertainty and risk and driving valuations higher. The holding was cut and profits were taken.
Happily, the decision was vindicated. Bristol Myers has since suffered a sizable de-rating and now trades on only 18x prospective earnings, as subsequent clinical trials have questioned the drug’s use in arresting more common cancers.
Today, we think AstraZeneca finds itself in a similar position. We own AstraZeneca and like its record of emerging market growth and recent successes in “new” oncology; evidence of a return to pipeline productivity. As per Bristol Myers, however, the problem is the risk for AstraZeneca entailed in the forthcoming release of clinical data from its MYSTIC I/O trial. Expected mid-year, MYSTIC’s readout may involve subtleties in respect of efficacy vs competitor drugs, but the impact on AstraZeneca’s share price will be explicitly binary. Disappointing results augurs share price weakness. We can’t tolerate such risk and have used post-Brexit bid speculation as an opportunity to cut exposure from a substantial overweight (c.5% weight in Liontrust Macro Equity Income) to a present, relative underweight (2.2% as at 31 January 2017).
To be clear, this isn’t just about I/O. Pipeline risk and binary share price outcomes are a defining feature of pharma investing. And herein lies the rub. As pharma investors, none us can claim a privileged insight into the success of any drug prospect. We can only make informed guesses, using the weight of available evidence. This brings to mind JM Keynes’ distinction of risk and uncertainty: risk being subject to mathematical scrutiny and is ultimately quantifiable; and uncertainty sitting inscrutably beyond mathematical analysis. Under such circumstances, controlling holding size becomes a key defence against capital loss.
If anything, such uncertainty demands a reappraisal of Andrew Witty’s reign at GlaxoSmithKline; the emphasis on long duration Vaccine and Consumer Health assets giving a reassuring visibility that is often lacked by more exciting peers.
NB - As at 12 February 2017, the Liontrust Macro Equity Income Fund had 16.7% exposure to pharmaceuticals