Pandemic a shot in the arm for sector but investors need to do their homework.

All investors should have exposure to biotech stocks in their portfolio, especially for the foreseeable future as countries and governments worldwide grapple with the COVID-19 pandemic. The pandemic has propelled the biotech industry into the spotlight. The sector has been at the forefront of efforts to find a treatment for the virus. 

Headlines giving hope that a biotech company has a treatment or vaccine close to market have helped revive stock markets and sentiment, and led to those companies outperforming, generating significant returns in a relatively short period. 

COVID-19 has boosted the reputation of companies focused on developing treatments, vaccines or diagnostics for the Coronavirus and also given them near-term revenue opportunities and an accelerated path to market (for their product).

However, for the broader biotech sector, the pandemic has also provided challenges, necessitating a shift in focus for most companies either trying to keep their base businesses on track or making the most of COVID-19 tailwinds.

These challenges, and the industry’s ability to adapt quickly, highlight the sector’s resilience.

Solid fundamentals 

Although COVID-19 dominates investor and market attention, we note that companies are also being rewarded for progress in other disease areas. Fundamentals for the biotech sector remain strong, given an ageing population and obesity continuing to drive up the incidence of diseases and demand for therapies. 

The pandemic has not changed our belief that biotech companies that deliver solid, unequivocal data and commercial outcomes with potential to make a material difference to a patient’s course of disease will continue to be rewarded and deliver good returns to their investors.

Hence, in the short term, biotech companies offer investors the opportunity to generate value relatively quickly from companies with COVID-19 tailwinds or breakthrough treatments in other disease areas. 

In the medium to long term, due to the strong fundamentals, biotech companies offer resilience despite the threat of a recession caused by the pandemic.

Key risks

Biotech, however, is not an easy space for retail investors to navigate. Although mid- to large-cap biotech companies tend to be less volatile, investors should be mindful that in the small-cap and micro-cap biotech space there will be volatility. Most companies at the smaller end of the biotech sector will not as yet have earnings, revenue or even a product approved and in the market. 

Although clinical or regulatory success offers significant returns quickly, failure of a clinical trial or regulatory setback is likely to lead to significant losses in a relatively short time. Also, for early-stage companies running clinical trials, results can sometimes be hard to interpret and the underlying science is typically not easy for a layman to understand. 

Valuation of clinical-stage companies, where probability of success is used to risk-adjust future revenue dependent on the clinical stage of development, adds another layer of complexity for the typical investor.

Key considerations for investing in biotech stocks

Australian biotech experience

The global biotech sector, especially the United States market, is more mature, larger and sophisticated, with much higher company valuations. However, in recent years several ASX-listed biotech companies have rewarded investors and sentiment towards the sector has improved. CSL remains the largest, most successful Australian biotech. 

Until recently, most ASX-listed, small-cap biotech companies did not have the ambition or resources and capability to focus on undertaking Phase 3 trials, or take a product all the way to the market. Most either licensed out their technology after proof-of-concept trials or were acquired by a bigger player for significant premiums.

Licensing and merger and acquisitions (M&A) activity remain high in the sector and continue to attract investors. However, investors now have further growth opportunities as several companies are nearing maturity and are undertaking Phase 3 trials or product approvals and commercialisation. Consequently, several ASX-listed biotechs achieved market capitalisations of more than $1 billion – Mesoblast, Opthea, Polynovo and Avita Medical, to name a few.

In FY21, biotech companies with COVID-19 tailwinds or neutral impact from COVID-19 are likely to outperform. 

(Editor's note: Do not read the following ideas as stock recommendations. Do further research of your own or talk to a licensed financial adviser before acting on themes in this article).

Bell Potter Securities’ key biotech picks are Mesoblast (ASX: MSB), Genetic Signatures (ASX: GSS), Opthea (ASX: OPT), Immutep (ASX: IMM) and Oncosil (ASX: OSL), each of which is expected to deliver key clinical data or commercial outcomes (partnering and/or product approval and/or launch) in FY21. 

Mesoblast and Genetic Signatures also have significant COVID-19 tailwinds, in our view.