Blog: Paul and Brett’s Alpha October 2021

Paul Major, Brett Darke – Portfolio Manager

The monthly BBH factsheet and commentary is always thought provoking and elicits a wide range of responses and views, here at the Trust we thought it would be a good idea to make the portfolio management teams commentary available in form of  rolling 12 month blog, as always any comments and observations are welcome.

October 2021

A most contentious confabulation

Regular readers are doubtless aware that our fascination for all things healthcare sits alongside an unbridled joy for the etymological richness of the English language. We relish taking advantage of the many and varied terms that one can draw upon in written prose, if for no other reason than to make our narratives slightly less turgid. As the pandemic has doubtless reminded us all; life is simply too short not to try to inject some levity along the way.

Some words are unusual in having more than one meaning that are not obviously linked. Confabulate is just such a word – it can refer both to the initiation of a conversation (latin: com – together and fabulari – talk) and the fabrication of an imagined experiential record to compensate for a lost memory (a psychiatry term based around fabula, which is latin for a folktale). This apposite word was very much at the forefront of our minds during October.

The broader debate amongst healthcare investors reflects the mindset of a jilted suitor; we are all trying to figure out why the eponymous ‘generalist investor’ has seemingly fallen out of love with healthcare, when it is so obviously attractive (vanity is a terrible curse).

As we have noted several times before, the pro-cyclical, pro-growth wider macro dynamic of “re-opening” is not an obviously favourable backdrop for defensive sectors and it is only now that global GDP velocity is reaching its limits (as evidenced by labour and supply chain constraints) that the sector may now come back into favour on its growth merits, since growth is less volatile and not economically or inflation sensitive in the same way as truly discretionary activities are – there are not many discretionary healthcare customers; we tend to use these services out of need or fear. With this in mind, it is impressive that the sector has fared as well as it has versus the broader market.
Indeed, when we look back over 2021, it is a beautiful irony that the healthcare sector made itself less attractive as an overall investment in the short-term by delivering the products (i.e. vaccines, tests and treatments) that have enabled society and thus investors to look beyond the pandemic.

Nonetheless, the investor must recognise that healthcare is not an amorphous blob, but a complex ecosystem of distinct sub-sectors and the relative performance of these to one another is a more vexatious and controversial topic. Obvious macro factors aside, nature abhors a vacuum and many financial professionals would find themselves unemployed if the role of retrofitting apparent facts to market performance were not so wildly popular (these missives would be a lot briefer as well!).

With regard to the healthcare sector, the pre-eminent question has been around why the valuation ascribed to innovative biotech/pharma companies or their products has declined over the past 6-8 months. Three factors stand out for healthcare in general and for the smaller, more focused therapeutics companies in particular:

Drug Pricing

In the US, the Democrats continue to try to append drug pricing measures to the budget reconciliation process. This has been cited by generalist investors for a reluctance to increase drug-related exposures. Although this is nothing new, and there are more reasons to believe that no egregious legislation is even possible within this Administration’s tenure than ever, investors have grown weary of this Damoclean disquietude and want something to happen, just to clear the overhang.

Even the publication of the proposed “Build Back Better” reconciliation bill in the last week of October without any of the feared ‘direct negotiation’ clauses was not enough to prompt a return to trend for the sector, with the Bloomberg US Pharmaceutical Index ending October 6% off the lows seen mid-month, but still >4% below the highs of August and back at levels seen in late July.

Perhaps Biden was being pragmatic: three centrist but very different Democratic senators opposed the sort of policies being discussed in the House (Bob Menendez of New Jersey, where most drug companies US operations are based – don’t bite the hand that feeds; coal-loving climate change sceptic Joe Manchin of West Virginia and Kyrsten Sinema of Arizona, prominent member of the Blue Dog Caucus who believe in the apparently contentious idea of cross party collaboration to actually get things done in Washington and who rightly think the House proposals would not fly with Republicans). Why include a clause in a bill that would risk your own slim majority to get it passed?

Pragmatism was never obviously a trait of the irrepressible blowhard Bernie Sanders, who controls the Senate Budget Committee. He said he would continue to work with house Democrats to fight to include some language on this topic into the final bill that goes to a vote in both houses and, as we go to press, a revised proposal has come forward.

This is much reduced in scope and probably represents a best case scenario for the industry. It was seemingly enough to win over Menendez and Sinema, who have said they would support the revised proposal. Critically, the bill focused on drugs that have lost exclusivity (9-12 years after launch) and also includes a carve out for small Biotech companies and those financially dependent on a single product revenue stream.

Even this moderate proposal may need to be watered down to get through. We continue to believe the passage of meaningful legislation on this topic is impossible at this point, just as it was for the previous Trump administration. We will monitor this situation, but the Build Back Better Bill is the only obvious vehicle (i.e. Trojan horse) for such legislation to move past the floor. We can but hope that its eventual passage in one form or another does provide some relief.

The FDA and new drug approvals

Some have argued that the rudderless US Food and Drug Administration (FDA) has become less predictable over the past year, during which it has lacked a confirmed nominee to head up the agency (Biden has struggled to get Senate confirmations for key positions across Government since his inauguration – we still do not have a US Ambassador to the UK for example), leading investors to discount more heavily any potentially material approval decision.

This uncertainty will weigh more on early stage companies than more mature large companies with many already approved products. This is definitely a topic worthy of further consideration: is there substance to it, or is it a confabulation, where a small number of unconnected data points are being weaved into a worrisome narrative?

Anti-Trust rules and the consequences for M&A

Unlike the FDA, the US Federal Trade Commission (FTC) has secured a permanent Commissioner; Lina Kahn. However, she is viewed as something of a maverick and this has prompted some to wonder if the FTC is now also harder to predict, leading companies to fret that M&A will be more time consuming and distracting to management.

Kahn’s appointment in June 2021 followed an announcement by her predecessor, Acting Commissioner Rebecca Kelly Slaughter, in March of 2021 that the FTC, in collaboration with its European, UK and Canadian counterparts, would update the approach to pharmaceutical mergers moving forward. Whilst no details of what this new approach would encompass were given, the BristolCelgene and AbbVie-Allergan deals were cited by Slaughter as ones where the scope of the work done by competition authorities might not have been adequate.

In the months since, we have seen some oddities – Illumina closing its GRAIL acquisition ahead of FTC sign-off and some deals seeing revisions to the socalled Premerger Notification and Report system (e.g. Merck-Acceleron) adding to an already febrile atmosphere in respect of deals.

The latter is not so unusual and certainly not a prelude to a deal collapsing or being blocked (e.g. Roche-Spark went through such a revision process six months before the deal was eventually blessed by the FTC in 2019), but any such newsflow is unhelpful to broader sentiment.

Consequentially, investors appear to be discounting potential future deal volumes. An ‘M&A option’ premium has long propped up investor sentiment to small/mid-cap healthcare companies and some suggest this has been diminished by recent FTC actions.

Frustratingly, this is another topic where further analysis to quantify the additional risks, to the extent there are any, is all but impossible. These deals often take months to complete their review processes before any remedies are requested or a deal is blocked. It is only with hindsight and the passage of time when a number of transactions have completed one way or the other that we will be able to determine if the ‘rules of engagement’ have changed.

Until then, this perception will remain as a nebulous risk to the attractiveness of innovative healthcare and one can choose to cite events as evidence in one direction or the other to confabulate a narrative (we leave readers to choose which meaning they wish to ascribe to the word in this paragraph).

If we were to take a position on the topic, it would be similar to our stance on drug pricing. It is all well and good to talk about changing things, but the risk that all of this results in a legislative change that meaningfully alters the landscape for healthcare seems slim to us (and we never presume M&A as an exit route in our investment theses anyway).

Save for a few egregious examples of price gouging that were really limited to some generics companies that took the “buy and promote” business model to extremes (Valeant being the most well-known example in its 2008-2016 “heyday”), where is the evidence that consumers have been harmed in the current situation? Few small companies have the financial capacity to bring drugs to market on their own and acquisition is really just the apotheosis of the licensing discussion.

We cannot recall an example of a company being acquired to stop a product being launched (which is the criticism levelled at the Tech industry), and this is unsurprising since this market is defined by limited periods of exclusivity/patent protection and continuous innovation. You really cannot afford not to launch something if it has the potential to be a good product.

The broken cannon

Let us return then to topic of the FDA. History is littered with politicians of meagre accomplishment. Some are lazy, others self-serving, but many are simply victims of the lassitude of the civil servants beneath. Grand visions are well and good, but if those tasked with implementation are unwilling or unable to make those ideas material, then nothing gets done. The General Patton quote seems more than apt: civil servants can be like a broken cannon - they won't work and you can't fire them.

However, not all civil service organisations are temples to mediocrity. When one considers the dominance of the US-based healthcare companies in global innovations, there are many factors that one could point to (and that we have articulated previously). Indubitably, the private sector has been helped greatly by the accommodative and pro-innovation stance of the FDA.

This agency has undeniably led the world in finding ways to break down those barriers between novel devices and drugs and the patients who desperately need them. It has also brought transparency to its decision-making processes and clarity on timelines that especially helps small companies plan their activities and capital requirements.

Many of these regulatory innovations (for that is what they are) have been copied around the world, but some still remain the preserve of the FDA (principally in respect of flexibility of trial design, conditional approvals and surrogate endpoints). That the organisation will perform at a high level and continue to support such innovations became an axiomatic assumption, and with some justification: the following three charts are taken from the FDA’s annual report to Congress, as required under the Prescription Drug User Fee Act (PDUFA) that funds the agency.

Figure 4 shows the total number of drug applications for novel products submitted to the agency. This reflects the industry’s overall performance in terms of R&D productivity. What is notable from an FDA perspective is the growing proportion of the total that are committed to an accelerated review cycle, which has risen from 22% in 2011 to 47% in 2020:

One could counter that Figure 5 is self-serving as it only covers a sub-set of applications. What about those that did not get approved? Figure 6 illustrates the proportion of applications that were approved on their first cycle (i.e. not subject to delay, even though the reason for delay is most likely a deficiency on the part of the filing, not the agency failing to complete its work). Again, there is little here to suggest that the FDA fell apart during the pandemic:

Contrived conniptions

At this point, the cynical reader might wonder if your managers have simply made up this list of issues and there is no fretting about the FDA in reality. However, a cursory examination using everyone’s favourite web search engine will turn up many a news article on this topic. What is going on?

The first argument is that Congress’ failure to appoint a permanent Commissioner is demoralising staff. This may be true, but the failure to make such appointments is a government-wide phenomenon born of the partisan politics in Washington. The FDA is far from rudderless: the acting Commissioner, Dr Janet Woodcock, is an agency veteran of more than 30 years and a previous Commissioner herself.

There are limitations to not being a confirmed appointee, but these are unlikely to figure into day-to-day operations. If the FDA is indeed demoralised, it is not yet showing up in reduced approvals; there were 48 so-called novel drug approvals in 2019, 53 in 2020 and there have been 42 so far this year with two months to go.

That said, the last twelve months has probably been a very politically charged period for the agency with all the pressure around rapidly approving SARS-CoV2 vaccines and treatments. Some mistakes were made and there is also the Aduhelm controversy, which continues to be the subject of Congressional scrutiny. Perhaps the agency has never needed an advocate and defender more than it does today.

We do see some evidence that manufacturing site inspections have slowed; this is not surprising when many of these are abroad and the pandemic has played havoc with travel planning, especially in and out of China, which is a major source of raw pharmaceutical ingredients.

The idea that the FDA has got tougher in some way seems to hinge around accelerated approvals. Under this system, the drug company conducts a smaller study to evidence that the drug impacts the levels of a measurable compound in the body that is widely associated with a disease state.

This type of biomarker study is known as a surrogate endpoint and the approval granted under such circumstance is “conditional”. The filer will have pre-agreed to running a further trial with a hard endpoint (i.e. a measurable disease outcome such as heart attacks, or death). If the latter trial confirms the positive hypothesis, the conditional approval converts to a normal approval. If it does not, then…

The FDA withdrew two conditional approvals, both for specific tumour types for immuno-oncology drugs in early 2021 (Merck’s Keytruda and Astra’s Imfinzi); both drugs remain on the market for a number of other cancers. Whilst these withdrawals have been cited as cumulative evidence of a changing approach from the agency, it is merely sticking to previous agreements that date back several years.

If there is a question here, it should be why such a long period of time elapsed between the negative trial results for Imfinzi being reported and the indication being pulled (one year for Imfinzi, two months for Keytruda, so they ended up happening within weeks of each other despite the data being temporally distant).

Contemporaneousness is not evidence of correlation or causality and the answer to this question is that a committee is convened to discuss these conversions and withdrawals and the availability of other treatment options is a factor in the committee’s deliberations.

Whilst a trial may fail to hit the confirmatory endpoint, it may have some activity. Thus the FDA might be inclined to keep the indication on the label. However, if another drug comes along that shows better or more definitive efficacy in that same population then of course it makes sense to prevent the use of the less effective option and withdraw the conditional approval.

It is also worth noting that the FDA’s most recent acceleration programme for cancer medicines (“RTOR”) continues to pay dividends with rapid (i.e. earlier than expected) approvals coming through in 2021 for Roche’s Tecentriq.

Finally, for all the noise about conditional approvals, we would highlight that, since the label amendment for gastric tumours in March 2021, the FDA has granted a different conditional approval for Keytruda in another oncology indication (1st line cervical cancer) and converted a conditional approval to a full approval (2nd line cervical cancer). There is hardly a pattern here at all.

Another cited piece of evidence was the non-approval of Tricida’s veverimer in August 2020. The company received a “complete response letter” despite the TRCA-301 trial seeming to meet its pre-agreed primary endpoint. The FDA was clear (to the company) what issues it had with the study and these were confirmed to investors in October 2020, once Tricida had met with the agency to discuss the issues in detail. Again, it would be unfair to suggest (as some did) that the FDA moved the goalposts here; the trial’s unusual recruitment pattern raised serious questions over statistical validity and Tricida will have to wait for the outcomes study to file for an approval.

We could continue in this vein for several more pages, but hopefully our point is made. Whilst the healthcare investment cognoscenti continue to debate this topic (and, as we noted last month, successful stockbroking for the sell-side is all about having a compelling narrative), we find the prima facie evidence that the FDA has changed to be either less forgiving or less productive to be weak and circumstantial at best.

As such, we have not altered any of the discount rates or probabilities of regulatory success that we use in our scenario modelling when it comes to products that have yet to receive formal approvals. What does this mean? We are beginning to see some compelling opportunities emerging in the Focused Therapeutics space and we fully intend to take advantage of them.

We always appreciate the opportunity to interact with our investors directly and you can submit questions regarding the Trust at any time via: shareholder_questions@bbhealthcaretrust.co.uk

As ever, we will endeavour to respond in a timely fashion. We thank you for your ongoing support of BB Healthcare Trust.

Paul Major and Brett Darke