Boston - The nearly $3 trillion biotech industry1 is experiencing explosive growth, rocketed by the rapid development of treatments and vaccines, as well as advancements in critical and previously under-researched areas. But what's good for science and humanity isn't necessarily suitable for investors. This integral industry is characterized by innovation, risk-taking and the improvement of society, and it's crucial to understand what this means for small-cap investors.
Understanding index weighting and number of companies
Over the past decade, the biotechnology industry has become increasingly important within the small-cap Russell 2000 Index. At less than 4% of the index in 2012, the industry peaked during the COVID-19 pandemic, more than doubling to over 10% of the index after surging 53% over the course of 2021. While it has since dipped to 8.4% as of September 30, biotechnology has established itself as a major component of the index and is now the second-largest industry after banks at 10.1% (see Figure 1). While the index weighting has more than doubled over the last 10 years, the number of companies rose from 87 to 187 in that time.
Source: FTSE Russell, FactSet.
Like many small-cap companies in other sectors, biotechnology companies are not household names with well-known products. The majority of small-cap biotech companies lack products, because they are actively engaged in research, development and commercialization of medical therapies. It generally takes many years before a company can obtain the research, testing and regulatory approvals required to bring such a complex product to market and begin to realize revenue and, ultimately, earnings.
Why biotech matters for small-cap investors
The vast majority — 91%2 — of the biotechnology companies in the index are unprofitable, as are approximately 37% of all the companies in the index overall. So these companies don't compare favorably on quality metrics such as return on equity, where biotechnology is by far the worst performing of the 68 industries in the index. Biotechnology is relatively high in volatility, as shares of these companies trade on investor sentiment rather than business fundamentals. Typical fundamental considerations such as sales trends, profit margins and market share are irrelevant until a company has a marketed product, which happens infrequently in the small cap universe.
Reward and risk profile
Biotech investing can be very profitable, as investors may realize potential outsized gains if a product is deemed effective and safe or if the company is acquired. In 2020, 11 different small-cap biotech stocks surged by more than 250%, helping to propel the industry to a 46% return for the full year, despite the median biotech stock returning just 0%.
According to Evercore ISI, however, biotech companies are going public earlier and earlier.3 In 2021, 54% of biotech IPOs were of companies in the pre-clinical or phase 1 approval stage — a dramatic leap from just 11% in 2012. That rise comes as biotech investing has become more speculative, with companies further from product approval and with lower probability of success. As a result, over the last 10 years, the industry has delivered lower returns with volatility more than 50% higher than the broad index (see Figure 2).
Source: FTSE Russell, FactSet. Annual performance differential represents the return of the Russell 2000 Biotechnology Subsector Index minus the Russell 2000 Index return.
We believe the biotechnology industry highlights the potential risks of passively investing in small-cap companies. While this segment may be the most extreme example of what we'd label as "low quality," there are many other examples of unprofitable and speculative companies across sectors that passive investors will own. Such companies have generated higher volatility and lower returns relative to large caps over the last 20 years. An active small-cap investor can choose to invest only in companies with the most compelling business fundamentals and valuations and avoid the large number of companies — 100 in biotechnology alone — that carry heavy risk and volatility.
Bottom line: Biotechnology has emerged as the second-largest industry in the small-cap Russell 2000 Index, and investors should be aware of its potential and drawbacks. The majority of these companies are unprofitable and volatile, and biotech is driven by investor sentiment rather than fundamentals. Passive small cap investors have a high exposure to very speculative stocks and must assess whether the potential for outsized gains justifies the increased risk and volatility.
1 10th biennial TEConomy/BIO report. Biotechnology Innovation Organization (BIO) and the Council of State Bioscience Associations (CSBA). October 2022. www.bio.org/value-bioscience-innovation-growing-jobs-and-improving-quality-life.
2 Proprietary calculations from small-cap Russell 2000 Index data.
3 Evercore ISI Research. www.evercore.com/isi-research/.
It is not possible to invest directly in an index. Past performance is no guarantee of future results.
