Working through volatility and evolving political pressures
Evan McCulloch, CFA, Senior Vice President, Director of Equity Research, Portfolio Manager at Franklin Equity Group.
“We are encouraged by companies that have focused their efforts on new drug discovery platforms, novel compounds and areas of significant unmet medical need, and we have been selectively investing in areas such as orphan drugs, biologics and drug-device combination products. We are also seeing the benefits of heightened activity in terms of development and the new-product pipeline, and we think the FDA has been sufficiently accommodative.”
Looking ahead to a potentially long innovation cycle for biotechnology
We believe the fundamentals in the biotechnology and pharmaceutical industries appear strong heading into 2017. There has been a major wave of innovation occurring across these groups, and we are interested in the significant advancements in oncology, orphan diseases and neurological diseases, just to name a few areas. We are encouraged by companies that have focused their efforts on new drug discovery platforms, novel compounds and areas of significant unmet medical need. We are also seeing the benefits of heightened activity in terms of development and the new-product pipeline, and we think the US Food and Drug Administration (FDA) has been sufficiently accommodative. If anything, there is increased pressure on the FDA to approve drugs faster, not slower. An urgent need for treatments exists for challenging diseases such as cancer, Alzheimer’s, Parkinson’s and hepatitis B, to name a few. We have been particularly interested in the area of immuno-oncology, which attempts to recruit a patient’s own immune system to fight cancer. We have already seen incredible results and the commercialization of multiple drugs in this area. Gene therapy and gene editing are other areas of innovation that excite us. Several technologies are being developed to directly correct or replace sequences of patients’ genes that cause disease downstream. This approach could potentially cure diseases that would otherwise be fatal or chronically disabling.
Working through volatility and evolving political pressures
As we witnessed throughout 2016, biotechnology and pharmaceutical stocks are generally prone to sharp pullbacks and rallies, and we believe such volatility is likely to continue in 2017. In particular, we are closely monitoring the government and media scrutiny of drug pricing that has driven some of the recent unpredictability. Additionally, health care systems are in the early days of migrating from volume-based systems to value-based ones, a scenario that creates opportunities and challenges for both providers and suppliers. Over this past year, negative headlines and pricing pressure in commoditized drug classes exacerbated the perceived risk to pricing power and margins. However, since the conclusion of the US presidential election in early November there has been a lot of attention on the potential repeal or replacement of the Affordable Care Act and less pressure from the drug-pricing controversy that dominated investor sentiment in 2016, although these topics are apt to remain uncertain until they are more fully addressed by the incoming Republican administration in 2017.
As longer-term investors, we have opportunistically used selloffs to make selective stock purchases in companies that develop and sell innovative drugs designed to treat diseases of high unmet need. We view investing in companies with differentiated products and platforms and innovative research and development (R&D) as the best defense against real or perceived pricing pressures in the consumer marketplace. We believe secular trends such as aging populations in many developed economies and increased health care consumption by emerging economies should benefit innovative biotechnology firms in the long run. We also expect politicians to ultimately acknowledge that price controls would dis-incentivize R&D investment in the biotechnology and pharmaceutical industries and create undesirable outcomes for society when there is still a preponderance of diseases that can be better addressed by novel treatments. Regardless of any pending political action on the matter, we think the parties involved realize they should preserve these industries’ prospects going forward, in part because the United States leads the world in biotech innovation. Moreover, it is important to recognize that current proposals are not actual legislation, and there is no mechanism by which any politician or government entity can directly set the price of drugs in the United States. The country has a free market system, and, for better or worse, manufacturers can set and raise prices as they wish. The bottom line is that we do not expect legislation in 2017 that will have a significantly negative impact on biotechnology or drug companies, though we consider it possible that minor interventionist administrative actions may be pushed through somehow, perhaps in regard to the drug reimbursement mechanism in Medicare or other programs.
We see a likelihood for accelerated merger-and-acquisition (M&A) consolidation that enables better strategic focus, scale and efficiencies to keep pace with technological and policy evolution. Multiple large drug companies have been hunting more actively for growth through acquisitions of small biotechnology firms. Drug development is challenging and fraught with risk. Thus the larger companies often seek to boost their product pipelines and augment their growth through M&A, and lately many of them have been openly talking about their desire to do so.
