After 5 years of a raging bull market, more than 140 IPOs and tens of billions in proceeds, there is a debate on whether the violent selloff in biotech stocks is a hiccup or the beginning of a real correction. I have no idea where the sector is heading in the coming weeks but it seems like the overall sobering experience coupled with this month’s selloff changed Wall Street’s perception around biotech. Investors are finally realizing drug development is fraught with uncertainty and that biotech is an attractive but not infallible segment, which is why I expect the correction to continue in 2016.
Biotech valuations are still rich and factor-in limited risk (e.g. clinical failures, longer timelines, biosimilars, drug pricing etc.). Even after a 15-21% fall, biotech is a huge outperformer with an average 5-year performance of 170% for major indices. This is dramatically better than the 67% delivered by NASDAQ over the same period. Such outperformance is justifiable to some extent by real progress, sometimes true breakthroughs (HCV, immuno-oncology, gene therapy etc.) but there is still a discrepancy between real commercial value and valuations.
This valuation gap isn’t new, however, for the first time it is accompanied by a fundamental change in sentiment around biotech as a sector. To me, this is an important warning sign because of all sectors, biotech probably has the highest dependency on sentiment rather than hard numbers.
The wave of biotech IPOs in 2013-2015 is probably the best example for how infallible biotech was in the eyes of investors, especially generalists. Biotechs have a dream factor very few other sectors do and this enabled companies to raise huge amounts of money in IPO proceeds at high valuations, sometimes with limited or no clinical data.
Initially, biotech IPOs were perceived as a huge success story, cementing biotech’s position as Wall Street’s favorite sector. But in the second half of 2015 the picture started to change as rosy projections hit reality. Despite some phenomenal exits like Receptos and ZS Pharma, most biotech IPOs now have negative returns and even stars like Agios (AGIO), Bluebird (BLUE) and Sage (SAGE) gave back most of their gains. 2015 was still a record year in terms of number of IPOs and overall proceeds but the performance of class of 2015 has been dismal (try to come up with one winner…).
Traumatic experience with DMD stocks
Last month I wrote about how hematology stocks were punished after failing to meet unrealistic expectations. The same is true for DMD stocks Biomarin (BMRN), Sarepta (SRPT) and PTC Therapeutics (PTCT) but in this case the exaggerated expectations relied on shaky fundamentals to begin with. It is hard to believe that at some point in 2015, investors assigned more than $5B to these programs despite various issues and uncertainties which were known at the time.
The desperate need for new DMD drugs coupled with a permissive regulatory environment enabled DMD companies to “sell” their drugs as breakthrough treatments for a devastating disease with a high likelihood of approval. In retrospect, all three drugs had very weak clinical packages but this didn’t bother investors who relied more on wishful thinking and incomplete, vague disclosures rather than clinical evidence.
Biomarin’s drisapersen, which came by way of the 2014 purchase of Prosensa, was the first to fall. Biomarin acquired Prosensa after drisapersen’s P3 failure, which was blamed on trial design issues. Biomarin convinced investors that there was enough evidence in the failed P3 (based on subset analyses) and smaller P2 studies to get the drug approved based on the “totality of the data”. Another term people often used to describe the drug was “approvable” as opposed to “effective” or “proven”. The support Biomarin got was almost religious as investors relied on the company’s successful track record (“they know what they’re doing”) in the field of rare diseases while ignoring obvious questions (see one example from Adam Feuerstein).
FDA’s review of the drisapersen package was brutal. As part of an advisory panel last November, FDA reviewers easily tore apart every claim and data mining presented by Biomarin, who probably relied too much on anecdotal testimonials of patients and their families. The panel voted overwhelmingly against the drug and last week a formal complete response letter followed.
Sarepta is about to receive a similar treatment from the FDA based on briefing documents released last week (see Feuerstein’s review). The company’s DMD drug (eteplirsen) is a direct competitor to Biomarin’s drisapersen but in contrast to Biomarin, Sarepta would like the FDA to approve eteplirsen primarily based on a 12-patient randomized trial that demonstrated a clinical benefit. Until last week, eteplirsen was perceived as better positioned because functional improvement (6-minute walk test, 6MWD) was accompanied by increased dystrophin levels in muscles (this was not observed with drisapersen) and fewer side effects. But FDA’s analysis revealed many issues making the data set inconclusive on top of being very limited. It turns out that after 3 years of treatment, dystrophin levels reached only 0.9% of normal values and the functional benefit is tricky at best. Eteplirsen’s FDA panel is taking place this Friday.
PTC submitted ataluren (Translarna) for FDA approval earlier this month. Ataluren, intended for a different subset of DMD patients (caused by nonsense mutations), also failed to demonstrate a clinical benefit in a large P3. Nevertheless, the company would like to approve the drug in a subset of patients with baseline 6MWD of 300-400 meters where a statistically significant effect was observed. This subset represents less than half of the patients in the study and PTC claims this subset analysis was prospectively defined with the FDA. (Let’s see how the FDA describes it)
Ataluren’s P3 was designed based on subset analyses of a prior failed P2. PTC looked for patients in which ataluren demonstrated clinical benefit and applied these criteria in P3. After seeing the P3 data, the company now asks the FDA to rely on a new subset analysis. This casts serious doubt on the entire study and it remains to be seen whether this analysis stands up to scrutiny.
Biotechs still offers tremendous value proposition
It is important to make the distinction between biotech companies and their stocks. Most high profile biotechs are decent companies with a solid scientific foundation and as a group they continue to make progress regardless of stock performance. As was the case with other technological leaps, I am sure biotech will eventually deliver, it will simply take more time and actual reward may be significant but more modest than initial expectations. Fundamentally, things have never been better for the drug development industry which now has both the development tools and financial resources to advance the field.
With that in mind, I plan to keep my short positions (BIS) which consists ~20% of the portfolio. I still intend to be selective and have positions in companies with solid clinical data and depressed valuations as they are likely acquisition targets. Names I like include companies with clear clinical PoC in P2s like Esperion (ESPR) and Trevena (TRVN) as well as companies with positive P3 data with a relatively high likelihood of regulatory approval such as Exelixis (EXEL) and Amicus (FOLD).
Portfolio holdings – Jan 18, 2016