Can you make a healthy investment in medicine?

The world’s population is not only growing at a rapid rate - it’s getting older too. According to the United Nations, the global population will increase from 6.7 billion today to 9.4 billion people by 2050, one-third of which will be aged over 60.

And with cancer, obesity and heart disease levels set to rise as a result, this should provide enormous opportunities for companies involved in medical research and drug development.

That’s a prognosis that could look pretty appealing to forward-thinking investors. So is now the time to give funds in the unloved health and biotech sectors a fresh examination? Performance figures certainly suggest this could be the case.

According to Lipper, in the first seven months of the year, the healthcare sector outperformed the FTSE All Share by 7%, while the biotech sector outperformed it by 14%. Dan Mahoney, a fund manager of the Polar Capital Health Opportunities fund, puts the performance down to the fact that biotech and pharmaceutical companies are defensive stocks and therefore able to profit during economic downturns.

“Even when consumers cut back on other areas of expenditure, most are reluctant to cut spending on their health,” he says. “As a result, there’s a lot of mileage in health and biotech companies because they can grow in spite of the recession.”

However, despite the recent signs of solid growth, there’s no escaping the fact that the health and biotech sector has hardly set the world alight over the past few years. After falling out of favour with investors after the dotcom bubble burst in 2000, the sector is seen as a complex and specialist area, far more suited to those with an appetite for risk than for those seeking a safe haven for their money.

But Andy Smith, manager of the AXA Framlington Biotech fund, believes that now is the perfect time for health and biotech to bounce back.

“When the credit crunch kicked in summer 2007, biotech stocks were the first to be sold because they were regarded as very high risk,” he says. “Twelve months on and investors can see that biotech has had little exposure to risky sub-prime investments. The sector has now rebounded because stocks were perceived to be oversold.”

Understanding the risks

If you are thinking of adding a health or biotech fund to your portfolio, however, you need to start by understanding the risks involved, as it’s a highly volatile and specialist area.

Healthcare funds invest in a wide range of medical companies, from blue-chip pharmaceuticals to manufacturers of medical instruments, health insurance companies and those involved with the building of hospitals.

The Schroder Medical Discovery fund, for example, invests heavily in Roche, a provider of prescription drugs that include cancer therapies, anaemia treatments, hepatitis drugs, and obesity and influenza treatments. Roche’s diagnostics arm also provides advanced DNA tests and diabetes monitoring supplies.

Biotech funds, on the other hand, are far more concerned with biotechnology companies, the majority of which are on the cutting edge of research and drug development. The AXA Framlington Biotech fund’s top two holdings are in Gilead and Celgene, biopharmaceutical companies that discover, develop and manufacture therapies for diseases such as cancer.

“Compared with healthcare funds, biotechnology funds can be very specialised – a high level of volatility is associated with this sector,” warns Philip Pearson, an independent financial adviser at P&P Invest. “Over the past three years, the volatility of healthcare funds has been generally lower than that of biotechnology, partly because healthcare has a broader appeal as it’s not so involved with the development of drugs.”

Biotechnology companies, compared with their richer pharmaceutical cousins, are incredibly high risk. The problem is that most companies only have a handful of drugs and little operating revenue, often needing to raise enough ready cash to cover research and drug development for two to three years.

“The health and biotech sector is unlike any other because it can take 10 to 15 years for a new drug to be developed, screened, trialled and approved,” says Ben Seager-Scott, a senior biotech analyst at Whitechurch Securities. “And, because most investors want to see immediate results, they wrongly assume that nothing has happened and so pull their money out.”

Once a drug is successfully developed and approved, the drug company’s registered patent means it has a five-to-12-year period of exclusivity to recoup the money it spent on research and development. But a major problem facing the industry is that drugs with sales worth about $150 billion are set to come off patent between 2010 and 2015 – referred to in the industry as the ‘patent cliff’.

As soon as a drug’s patent expires, generic companies are free to copy the drug, and so the company that developed the drug loses its monopoly.

“Because drug sales could literally disappear overnight, this increases the pressure on pharmaceuticals to diversify,” says Tom Becket, manager of PSigma’s balanced managed fund of funds. And, as biotechnology companies lack adequate resources to stay afloat, they look to be acquired by pharmaceuticals. This has led to a degree of overlap between health and biotech funds, yet health funds all differ in regard to how much they are exposed to the biotech sector.

Future potential?

Big pharmaceuticals recently made a bid for two of the largest biotechnology companies, ImClone and Genentec – a fact that Mahoney believes shows real potential for the future.

“Right now big pharmaceutical companies are sitting on mountains of cash and, faced with dwindling pipelines and the knowledge that their blockbuster drugs will soon come off-patent, acquiring a biotechnology company with a promising drug makes commercial sense,” he says.

But it’s not all plain sailing, as the drug development process itself is fraught with risks, as Ben Seager-Scott explains: “Less than one-in-five drugs actually make it to regulatory approval. One that succeeds can bring with it rich rewards, but for the ones that fail the losses can be extreme.”

He points to ArkTherapeutic’s successful clinical trial of a treatment for malignant brain tumours in July 2008, which saw its share price rocket by 70%. However, after gene development company Oxford Biomedica suffered a high profile clinical trial failure of its drug Trovax, a cancer vaccination, its share price nosedived by 60%.

Shares in the company did soar again after it turned down a takeover bid by Genethera, highlighting not only the sharp volatility in the market, but also the increased interest in biotechnology companies, particularly British ones. “It’s simply boom and bust in biotech,” says Seager-Scott.

Nick McBreen, an IFA at Worldwide Financial Planning, warns that investors choosing to invest in a biotech or health fund certainly need to have the stomach for the rollercoaster ride.

“Investors need to have a specialist understanding of the sector and the courage of their convictions, because there is still global growth going on,” he says. “And due to the specialisation of the market and subsequent volatility, investing in this area should only ever be a small holding of around 2-3% within a diversified portfolio.”

Yet investors who don’t have quite such a voracious appetite for risk can still profit from some of these trends, without investing in such specialist and volatile funds.

“Many of the top-performing UK equity funds will have a weighting towards blue- chip pharmaceuticals such as GlaxoSmith-Kline and AstraZeneca,” says Gavin Haynes, an IFA at Whitechurch Securities. “These companies will feature in a lot of mainstream investment portfolios, but investors can also benefit from an ageing population through companies that invest in retirement homes and leisure pursuits such as cruises.”

Despite the credit crunch rumbling on, Tom Becket is confident that the future for health and biotech is bright. “The world is now entering a golden age for biological and medical development,” he says. “Pressures from an ageing population and the emergence of a new middle class in the developing world will re-shape the global healthcare system. And don’t forget that we also live in dangerous times, with the threat of bio-terrorism always there.”

Dan Mahoney agrees. “Cures will arrive for diseases not cured before, medical technology will improve, and as the world’s population gets older so will the demand for a better quality of life.” He points to the US, where the current post-war baby boomers are in retirement and are more demanding than previous generations.

“They want to maintain an active lifestyle and demand more quality products to do it, such a top-end hip and knee replacements,” he explains.

Mahoney also believes that structural changes, such as the privatisation of hospitals in Germany and the NHS continuing to outsource hospital services to private companies, will affect investment.

“The way you invest in medical services today is fundamentally different from 10 to 15 years ago,” he says. “It’s not just about drugs and blue-chip pharmaceutical companies anymore, it’s also about devices, services, insurance companies and hospitals – the whole value chain of healthcare.”

Choosing to invest in a health or biotech fund requires a great deal of patience, a long-term outlook and a large appetite for risk. Although you are unlikely to see rewards overnight, the growing demand for medical services means that investing in a healthy future could be profitable for many years to come.

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