Commentary: A good pair of genes — investing implications of biotech's innovative pipeline

Every industry sector goes through innovation cycles and unlike the innovation we are witnessing within the technology sector, in which product cycles are short and widespread adoption comes at a rapid pace, health-care innovation emerges at a slower pace and usually over decades. Today's pharmaceutical sector is delivering the fruits of almost 20 years of drug discovery since the sequencing of the human genome in 2000, in the form of novel treatments that are changing standards of care by leaps and bounds. These innovations will soon become the staples of many health-care portfolios. The institutional community should be aware of this inflection, and the ways in which key trends of innovation and evolving regulations are working together to present alpha-generating opportunities.

Even just a few years ago, the possibility of novel treatments to cure or radically enhance the outcomes for major diseases, including various types of cancers and devastating and rare diseases such as hemophilia and cystic fibrosis, seemed remote. Yet today, as innovative research is turning a corner, we see a renaissance of innovation in which ideas once perceived as science fiction have become reality. One such technology is gene therapy, a procedure in which defective DNA that is responsible for triggering a particular illness is replaced with a corrected version of DNA, usually with just a single injection. There are scores of public and private companies using gene therapy in major clinical trials and across a variety of diseases. The first such therapy — Spark Therapeutics' Luxturna — was approved late last year. Innovation advances are clearly creating value at the company level. As this industry disruption is occurring, investors can benefit from being exposed to these firms.

As new products move from clinical testing to regulatory approval and commercial use, innovative drug developers are likely to enjoy robust revenue streams that make them attractive targets for consolidation. Large-cap companies understand that buying innovation can help address problems ranging from lukewarm organic revenue growth, poor revenue streams from a limited roster of products, losses from drug pipeline failures and diminished pricing power.

The big pharmaceutical companies have not prioritized innovation and now find themselves under-invested in innovative new technologies. Much of the innovation now comes from the laboratories of small and mid-cap companies as well as from university labs beyond the reach of big pharma. Eventually, these new therapies will be approved, and the small and mid-cap companies that developed them will threaten and disrupt static large caps that have failed to keep up. To remain relevant and competitive, large-cap firms are increasingly forced to acquire smaller disruptors. This consolidation wave commenced in earnest last year and now counts several transactions: Gilead's purchase of Kite, Celgene's acquisition of Juno, Sanofi's buyout of both Bioverativ and Ablynx and Novartis' purchase of AveXis, among others.

Regulatory reforms are catalyzing a wave of positive industry changes and this should lead to greater attention from institutional investors as they seek newfound exposures. Prior to the official passage of tax reform last December, M&A levels were tepid as the industry awaited clarity from Washington on cash repatriation and future corporate tax rates. Upon passage of tax reform in December, the biopharmaceutical sector saw eight M&A transactions within six weeks.

Investment returns are likely to improve with a regulatory and policy agenda that increases the speed at which new drugs are approved and delivered to the market. Under Dr. Scott Gottlieb's leadership, the Food and Drug Administration has made an observable shift in its approach to new product approvals to a more accommodative stance from a previously more conservative posture. Mr. Gottlieb's tenure only began in May 2017, but last year alone the FDA approved 46 new drugs, the highest number since 1996. The FDA has adopted a deregulatory posture that is pro-patient, pro-technology and one that ultimately strikes a more balanced posture between patients and the biopharmaceutical industry. As the FDA slowly decreases the regulatory requirements needed to obtain drug approval, the institutions that invest in these health-care companies may see returns on capital going up.

The past two decades of deep clinical research are now starting to bear fruit in the number and quality of highly innovative drugs that are being delivered to patients who need them. Institutional investors should be exposed to these innovations because the value that such medicines can create for patients, health-care systems and, ultimately, shareholders in these companies is likely to be substantial. The industry's tailwinds comprised of innovation, robust market activity and favorable regulations should not be ignored.

Ori Hershkovitz is co-founder and chief investment officer, Nexthera Capital LP, New York. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.