Investing In The Pharmaceutical Sector Amid Surging Inflation

Summary

• Growth investors often keep a close eye on the pharmaceutical/biotech sector because of the high risk-high reward nature of investing in young companies developing novel drugs.
• When economic growth stalls and recession fears surface, investors of every discipline turn to the pharmaceutical sector because of the recession-proof nature of this industry.
• After outperforming the S&P 500 last year, the pharmaceutical sector looks poised to deliver another strong performance in 2023.
• To achieve investment success in the healthcare sector, an investor needs to have deep knowledge about companies, their products, the pipeline of drugs, technological developments, and the status of regulatory approvals.
• For the less sophisticated investor, the best bet is to gain exposure to this sector through collective investment schemes such as mutual funds and exchange-traded funds.
• Looking for a portfolio of ideas like this one? Members of Leads From Gurus get exclusive access to our subscriber-only portfolios. Learn More »

gorodenkoff

The pharmaceutical/biotech sector has always been a favorite among growth investors because of the high-risk/high-reward nature associated with small-cap biotech companies developing novel drugs to fight diseases once thought to be incurable. Investing in the healthcare sector, however, is not just for growth investors. When economic growth stalls and recession fears surface, investors turn to this sector because of the recession-proof nature of this industry. Today, with inflation surging to multi-year highs, geopolitical tensions disrupting the global supply chain, and interest rate hikes dampening investor sentiment, many investors are looking for refuge in the healthcare sector. The objective of this analysis is to discuss the outlook for this business sector and to introduce a few ways investors can gain exposure to this sector without investing in the stocks of pharmaceutical companies directly. In addition to three leading ETFs, I will also introduce a fund that has recently performed well by issuing structured products, and the best-performing healthcare investors in the PE space.

The Outlook For The Pharmaceutical Sector

In 2023, it is anticipated that innovation will drive growth in the pharmaceutical/biotech sector. Advancements in important therapeutic areas and positive clinical study results may act as key drivers for the market. The major contributors to the biotech space are digital health and Artificial Intelligence (AI). Although it is still early days for AI in the biotech sector, its significance is growing due to the ability to analyze large amounts of data to identify new drug candidates and optimize drug development.

In addition, there has been an increase in investment in the development of treatments for rare diseases, oncology, Alzheimer's disease, and immune disorders. An estimated 7,000 rare diseases are still underserved, which leaves ample wiggle room for both large and small biotech companies to experiment with.

Today, the pharmaceutical R&D pipeline is focused on next-generation cell therapies, gene therapies, and targeted cell therapies, many of which are aimed at treating orphan diseases. According to Pharmaphorum, orphan drugs account for 40% of new medicines in development, and Evaluate predicts that by 2026, orphan drugs will account for a fifth of all prescription drug sales and nearly a third of the value of the global drug pipeline. Some big pharma companies are developing pipelines with successful clinical trials that benefit the sector.

Healthcare spending in the United States is expected to grow at a 6% annual rate through 2030, propelling the industry to a $7.5 trillion valuation, or 25% of the country's GDP.

Using the S&P Biotech index (XBI) and the Nasdaq Biotechnology Index (NBI) as proxies for the performance of biotech stocks, one can conclude that biotech stocks have shown relative stability in the market compared to other industries in the past year. The defensive nature of this sector has a lot to do with this outperformance in the last 12 months. The Covid-19 pandemic has also played a part in luring investors to the biotech space as people, in general, have become more aware of biotech/pharmaceutical giants because of the global vaccination drive.

Exhibit 1: Performance comparison

Data by YCharts

At the beginning of 2022, many investors did not expect the biotechnology/pharmaceutical sector to outperform the broad market last year with health experts projecting an end to the pandemic. The outperformance came on the back of an increase in demand for safe-haven assets due to a sharp rise in the odds of a recession. With the S&P 500 implying a 73% probability of a recession in 2023 and Bloomberg monthly surveys placing the odds of a recession this year at a staggering 70%, it seems reasonable to conclude that recession-proof stocks will stay in high demand this year as well.

Exhibit 2: Market-implied odds of a recession

Bloomberg

The pharmaceutical sector, amid technological advancements and increasing odds of a recession, seems well-positioned to outperform the market in 2023.

Ways To Gain Exposure To The Pharmaceutical Sector

Individual investors can gain exposure to this sector through various methods, such as buying the stocks of biotech companies or investing in funds. Investing in individual stocks carries inherent risks and investors should equip themselves with deep knowledge about companies, their products, the pipeline of drugs, technological developments, and the status of regulatory approvals to make informed bets. When done correctly, investing in the stocks of pharmaceutical companies can help investors enjoy healthy long-term returns. For the less sophisticated investor, the best bet is to gain exposure to this sector through collective investment schemes such as mutual funds and exchange-traded funds. Below are three top-tier ETFs and one market-beating mutual fund that will help investors diversify into the pharmaceutical sector at a reasonable cost.

VanEck Biotech ETF (BBH)

VanEck Biotech ETF aims to track the performance of the MVIS US-Listed Biotech 25 Index. The fund typically invests in companies that are involved in the development of biotechnology products or technologies, as well as companies that are engaged in the research, development, manufacture, and distribution of biotechnology products.

BBH seeks to invest in the top 25 most liquid biotech companies, which may include medium-capitalization companies and foreign companies listed on US stock exchanges. The fund is rebalanced quarterly and is classified as passively managed. The fund has a 0.35% expense ratio and typically invests at least 80% of its total assets in securities from the fund's benchmark index.

Exhibit 3: Fund performance as of December 31, 2022

VanEck

Invesco Dynamic Biotechnology & Genome ETF (PBE)

Invesco Dynamic Biotechnology & Genome ETF is an exchange-traded fund that aims to track the performance of the Dynamic Biotechnology & Genome Intellidex Index. The fund typically invests in companies involved in biotechnology and genome-related industries such as pharmaceuticals, medical devices, and research and testing. The ETF is managed by Invesco and is listed on the NYSE Arca exchange.

The fund seeks to introduce investors to companies engaged primarily in the research, development, manufacture, marketing, and distribution of innovative products and services in the Biotechnology and Genome-related industries. The fund is a passively managed fund that is rebalanced quarterly. The fund has a 0.57% expense ratio and invests at least 90% of its total assets in securities that comprise the underlying index, which is made up of common stocks of 30 biotechnology and genome companies in the United States.

Exhibit 4: Performance metrics as of December 31, 2022

Invesco

First Trust NYSE Arca Biotechnology Index Fund (FBT)

First Trust NYSE Arca Biotechnology Index Fund is an exchange-traded fund that aims to track the performance of the NYSE Arca Biotechnology Index. The fund typically invests in companies that are primarily engaged in the development, manufacture, and marketing of biotechnology products and therapies. The ETF is managed by First Trust Advisors L.P.

The fund aims to introduce investors to a diverse portfolio of 30 biotechnology companies. The fund has an expense ratio of 0.55% and normally invests at least 90% of its net assets (including investment borrowings) in the common stocks and depositary receipts that comprise the index, which measures the performance of a cross-section of biotechnology companies with small, medium, and large-cap companies that are primarily involved in the use of biological processes to develop products or provide services.

Exhibit 5: Performance metrics as of December 30, 2022

First Trust

Ruthenium Global Pharma Fund

Ruthenium Fund, founded in 2015 in Luxembourg, operates three dedicated sub-funds: Global Pharma, Unconstrained Bond, and Absolute Return. Ruthenium's Global Pharma fund makes long-term investments in the pharmaceutical and biotechnology sectors. Dr. Dmitry Reykhart, an expert in the pharmaceutical industry with a background in regulation and academic and practical experience, is the chairman of Ruthenium Global Pharma Fund and the creator of its strategy. The strategy has been credited with contributing to the exceptional performance of the fund compared to others in the industry. This fund aims to generate market-beating returns by creating equity-linked structured products.

Since its inception, Ruthenium Global Pharma Fund has produced consistently positive results, ranking among the top ten performing funds in the Barclay Hedge Health Care/Biotech index. According to the Barclay Hedge platform, which monitors the activity of over 7,000 investment funds, Ruthenium Global Pharma Fund outperformed global indices and benchmarks in the Health Care/Biotech sector in September 2022 with a yield of 5.2%. The steady growth in the value of this fund's investment units continued throughout 2022. According to the report, Gilead Sciences' impressive return was a driver of the fund value last year. Gilead Sciences has a significant weight in the fund and reported 79% growth in its relatively new oncology segment and a 28% increase in sales of Biktarvi, an innovative HIV drug, at the end of the third quarter. The fund operates with a 1 and 20 fee structure.

Exhibit 6: Fund results

Ruthenium

Private equity investments

Investors with a focus on private equity investments in the healthcare sector might want to consider TPG Capital Healthcare, owned by TPG Inc. (TPG) which is one of the largest alternative asset managers in the world. TPG Capital Healthcare was the winner of the Healthcare Private Equity Firm of the year award at the PEI Awards 2021, which demonstrates the company's strong track record in committing to lucrative new deals and exiting investments at a profit. The company's active portfolio includes investments in Allogene, Immucor, Monogram Health, and Confluent Medical.

Conclusion

With stocks poised to remain volatile this year because of macroeconomic uncertainty, investors need to diversify their portfolios to have any chance of beating the market in 2023. The pharmaceutical sector, because of its recession-proof characteristics and disruptive nature, is one of the best bets for investors today.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.