Small-Cap Biopharma: Down, But Not Out

Biopharma Tackles Unmet Medical Needs

Most of us have benefited personally from the work of innovative biotechnology and pharmaceutical (biopharma) companies. Notable recent examples include COVID-19 vaccines and treatments.

Historically, breakthroughs such as these have benefited biotech investors as well. Though the industry has hit a rough patch lately from a stock performance perspective, we think the long-term outlook for biotech companies is favorable.

Biopharma Has Taken It on the Chin

The small-cap biopharma industry got a boost as investors favored companies working to develop vaccines and treatments for COVID-19, as well as those working on other potential medical breakthroughs. They rose nearly 53% by the end of 2020 compared to a 19% rise for small companies generally, as measured by the Russell 2000^® Index. Since the beginning of 2021, however, small-cap biotech companies have declined 57% while the Russell 2000 declined 12%.¹ See Figure 1.

What Factors are Affecting Biopharma?

In our view, the factors contributing to biopharma’s drop include:

Adverse Clinical Trial Events and FDA Decisions

Disappointing clinical trial results and a harsher regulatory environment have led to unpleasant surprises for drugmakers. While the U.S. Food and Drug Administration (FDA) may keep a firmer approach to industry oversight, history shows the regulatory pendulum can swing to a more moderate approach.

Expectations for Higher Interest Rates

Rising interest rates, which make more speculative investments less attractive, have weighed heavily on the lofty valuations of this largely unprofitable group of companies. In January 2022, the Federal Reserve signaled a more aggressive withdrawal of its economic policy support and implemented two increases in the federal funds rate as of May.

Accelerated Outflows

In a dramatic reversal of 2020’s significant inflows, outflows from the ARK Genomic Revolution ETF and other health care-themed funds have pressured small-cap biopharma stocks.

Oversaturation

The voracious appetite for biopharma investments led to a record number of initial public offerings in 2020 and 2021, many of which were early stage. The number of publicly traded small-cap biopharma companies swelled to 350 at the end of 2020, creating a glut of potential investments just as investor interest waned.

Despite These Headwinds, We Have a Positive Long-Term Outlook for Small-Cap Biopharma

Even though the biopharma pullback has been substantial and protracted, we remain optimistic about the industry for reasons that include the following:

Significant Rebounds Have Historically Followed Strong Pullbacks

Since peaking in February 2021, biopharma stocks in the Russell 2000^® Growth Index slogged to a decline of -64% as of April 30, 2022. This performance compares to an average biopharma drawdown of ‑32% over 126 days. See Figure 2. Our analysis further reveals 11 declines of 17% or greater since the 2008-2009 financial crisis.²

After bottoming, the average historical rebound after six months has been 32% and 58% after 12 months. See Figure 3. The sector has historically outperformed the Russell 2000^® Growth Index by 17% on average during the subsequent 12 months.³

Figure 2 | Biopharma Pullbacks Can Be Deep and Prolonged

Figure 3 | Historical Biopharma Rebounds Have Been Sizable

Robust Pipeline of New Drugs

The number of disease-fighting biologics and small-molecule drugs in development is at an all-time high. Furthermore, small biopharma companies are at the forefront of evolving technologies like cell therapy, gene editing and protein degraders, leading to the next generation of blockbuster drugs.

Potential Acquisitions on the Horizon

Mergers and acquisitions of small-cap biopharma companies may be poised to accelerate. Big Pharma is flush with COVID-19 vaccine cash that could be deployed in many ways, including paying down debt, raising dividends, buying back shares or buying smaller firms. This may make small-cap biopharma firms attractive acquisition targets.

Pfizer’s high-premium acquisitions of Arena Pharmaceuticals and Biohaven Pharmaceutical for $6.7 billion and $11.6 billion in December 2021 and May 2022 may be signs of this development. The high valuations can raise acquisition precedents and attract investors to the industry. In addition, much of the acquisition capital often is recycled back into new or existing small-cap biopharma companies.

Advances in Science Support the Biopharma Industry

Innovation is accelerating, and scientific advancements lead to new ways to treat diseases. We believe the current, historic drawdown for small-cap biopharma companies may reverse course as the environment for these companies improves.