Biotech Bears: Jumping A Lower Bar Or A Higher One?

Posted March 17th, 2022 in Capital markets, FDA, R&D Productivity

Biotech sentiment is super bearish today, as the sector has been crushed over the last year. There’s blood in the water, especially for small and mid-cap players, and everyone’s looking for what caused the carnage.

There are many factors at work in the markets today, but one big factor over the last year or so has been the progressive drumbeat of negative catalysts, sending both individual stocks and sector sentiment cratering.

As the chart shows below, according to data from Morgan Stanley, the percentage of positive news events for SMID-cap biotech has gone from 60% in early 2020 down to below 30% in the first two months of 2022. But it’s not just small caps, it’s across the sector: on the Biotech Clubhouse last weekend, Jefferies’ Michael Yee said of 45 major clinical readouts from large and small players, only 20% were positive. In addition to challenging data, the FDA has also been on a tear with regards to clinical holds, both full and partial. According to Jefferies data, 2021 was already much higher than the multi-year average (>50 vs mid-30s), and 2022 is off to an incredibly tough start with 13 holds in less than 8 weeks.

Everyone has felt the pain, so there’s no need to hammer on the stock market impact of these new releases. It’s been bad, as we all know.

But a more interesting topic is trying to understand the “why”.

Why are we facing more negative trial data readouts and regulatory challenges today versus only a few years ago?

Here are a few thoughts on different explanations.

The Bar Got Lower.  During the venture capital financing explosion in biotech over the past decade, with fund flows up over 5-fold, companies were able to access tons of funding and advance broadly innovative pipelines. The cost of capital was dramatically reduced, as valuations went up. The virtuous cycle of 2013-2021, with only a few market hiccups, led to huge capital flows, larger rounds, hundreds of newly public SMID-cap companies, and bigger dreams. Along with this capital abundance, did the bar drop for what was a fundable concept?  Did discipline go down?  As I’ve written in the past, huge increases in capital abundance, like we’ve seen, almost certainly mean that aggregate discipline across the sector has dropped and the “average health of the herd” goes down.

The increase in the negative event rate may in part reflect this loosening investment discipline: higher risk, lower quality investments should have a higher failure rate, and should take several years to play through given R&D timelines. I’d rather not name names, but we can all think of some of the crazy ideas around risky science (preclinical dream stories), or unsupported clinical gambles (going to Phase 3 in the face of weak Phase 2 data), that have been funded in the past few years.

A counterpoint to this thesis is that the negative news hasn’t been isolated to newly public VC-backed biotechs, a large cap names have also seen disappointing or underwhelming data releases: Gilead’s Trodelvy was met with a collective “meh”, Sanofi’s SERD miss, and Biogen’s ALS oligo, as examples.

The Bar Got Higher. We live in a competitive sector, where every new drug not only competes against other new potential drugs for attention, but also with every prior approved drug for relevance. This is a riff off of the Eroom’s Law challenge of being “Better Than The Beatles” or around the idea that the “Low Hanging Fruit” has been picked.  New drugs have to beat prior standards, and novel approaches are often harder. Kodiak’s recent unfortunate blow-up is a great example of this: Eylea is a tough drug to beat. In hypercompetitive spaces within biotech, like cell and gene therapy and immuno-oncology, clinical and preclinical product comparisons, no matter how valid or invalid, can wreak havoc with how investors react to news.

Further, the regulatory bar may be getting higher.  It’s not clear to me that the uptick in clinical holds noted by Yee and others is due to higher stringency at the FDA, or lower quality from sponsors, but it’s definitely a situation where the bar is higher than most of biopharma’s expectations. Only time will tell how this “cautious regulator” plays through this time around (another Eroom’s Law villain), especially under Dr Califf’s leadership.

Importantly, in emerging spaces like new cell and gene modalities, the height of the bar wasn’t actually well appreciated, given the novelty of the space.  Only a few gene therapies have made it to Phase 3, even fewer to market. Clinical safety issues, as well as durability concerns, are only things learned by doing the work and collecting the data over time. The number of negative news events, including trial data, safety issues, CMC troubles, and regulatory concerns, all highlight what every new modality has to face in order to prove its merit as a therapeutic class. Recall the many monoclonal antibody blow-ups of the 1990s as an example, like the Centoxin debacle of 1992 or Campath-1H’s big failure in rheumatoid arthritis a few years later. Out of these challenges, the antibody field is now a major and mainstream modality – which wasn’t clear in the early 1990s.

The Game Changed. Forget about where the bar is, or was, because in many cases the Street just decided the game has changed. In February 2021, market expectations in biotech had moved to unrealistic heights and “perfection” was priced into many stocks. As gravity set in throughout 2021, the game changed: even “good” data or “positive” new releases were received with negative stock reactions, due to an increasingly bearish backdrop and the undershooting of those lofty expectations. There are countless examples today where objectively positive data is met with downward stock pressure: the data don’t matter, because the game has changed for many public investors swimming in red, and well off their high water marks. News releases are opportunities to escape your nearly illiquid positions amidst high volume, even if the price doesn’t change.

Stepping back, the billion-dollar question is of course how will this play out going forward.

If you think the uptick in negative news is either more of a statistical anomaly or just a reset expectations issue, rather than a truly scientific or clinical quality issue, than you might believe “reversion to the mean” should bring things back into positive-negative balance. An unwinding of the “changing of the game” investor psychology so to speak.  Given how bleak the sentiment is now, I suspect this will be at least in part true. Like pendulums that swing too far, the market will likely revert back to appreciating objectively good data with reasonable expectations, and rewarding the advancement of medicines to patients.

If you believe the negative catalyst downdraft has been primarily from the “Bar Got Lower” thesis, then you might be excited to see tighter purse strings from the market. A renewed stringency caused by less capital and more discipline could bring a higher quality product to the public markets over time.  I’m sure there’s some of this at work today, and more discipline will help. But this one will take time to purge the less fit members of the herd, especially since the typical biotech balance sheet remain rich relative to past bear markets. And given the negative data from larger cap stories, I’m not convinced this thesis explains all the bearish data flow out there today.

For the “Bar Got Higher” crowd, the only sustainable way forward is to be smarter – to win by outcompeting other approaches and investing in better science and medicine.  This would entail making new bets in less crowded spaces, as well as proving differentiation with smarter clinical trial designs in congested areas. And doing so will need to get over the bar set by both the market and FDA’s reviewers.

There’s still significant cash on the sidelines to fund new and emerging private biotechs, and the pace of funding has continued apace, with little sign of abating dramatically. Further, with the markets off 50% in a year, it’s a buyer’s market if you have a discerning nose for differentiated technologies and medicines in the public equity universe.

Longer term, I’m confident we’ll get back to a higher rate of positive news – plenty of unmet medical needs exist, and many of these can only be addressed through the kinds of innovation the biotech sector aspires to deliver.

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