After decades of low returns on research and development (R&D), the healthcare sector is producing a slew of innovations, from drugs to diagnostics. But with many coming from new entrants, will big pharmaceutical companies manage to keep up with the times?

Healthcare has underperformed during the recent economic rebound; given the sector’s defensive characteristics, investors tend to look elsewhere during periods of strong growth and higher inflation. Another factor is legislation which, it has long been feared, could impact future returns.

Investors may not fully recognise potential tailwinds for the sector

Nevertheless, investors may not fully recognise potential tailwinds for the sector. First, given the ongoing pandemic and the current US political scenario, we are unlikely to see significant regulatory change anytime soon. Second, COVID-19 has accelerated innovation and efficiency gains, and highlighted the ability of the pharma industry to distribute products worldwide.

But will these factors result in higher returns for traditional pharma companies, or a new age of biotech? To discuss this question, the AIQ editorial team brought together expertise from across Aviva Investors: Baylee Wakefield (BW), multi-asset portfolio manager, Sora Utzinger (SU), senior environmental, social and governance (ESG) analyst, Matt Kirby (MK), global equities portfolio manager, and Brian Bunker (BB), senior credit research analyst.

They argue that the future might, in fact, lie in partnerships, harnessing the innovative power of biotech with big pharma’s marketing machine. They also discuss the growing importance of ESG to the sector, from biodiversity loss to healthcare access, and from data protection to the social value of new treatments.

Does large US spending on healthcare suggest pressure to cap drug prices will intensify?

MK: This has been a cloud over the sector for many years, even though drugs only account for around ten per cent of US healthcare spending and the biggest inefficiencies in the system lie elsewhere, like hospitals. But tackling the causes of high prices in hospitals is complex, so the debate tends to focus on drug pricing, and surveys say most people are in favour of price caps. Regulation will continue to cloud the sector, but I don't think there is appetite in Washington for meaningful change.

The US has one of the best accesses to innovative medicines of any developed nation

The US has one of the best accesses to innovative medicines of any developed nation and it is the high cost of these medicines that feeds innovation in the rest of the world. It is one of the US’s geopolitical strengths, which we saw during COVID. The BioNTech vaccine was developed in Germany, but the US had early access to it; it teamed up with Pfizer and its population was one of the first to receive the vaccine. The reason the US benefited is partly because it has been fuelling innovation for so long.

There are areas where the disparities in the price of drugs in the US compared to European or Asian markets will reduce, and pricing mechanisms will evolve. But generally, US drug prices will never be transparent because the main negotiators are not incentivised to be so. That is the biggest issue and a key reason why prices have continued to rise.

BB: There is strong appetite for drug pricing reform from around 80 per cent of US voters. Historically, markets have been concerned the government would negotiate drug prices directly, which would be a worst-case scenario for pharma. Given the current makeup of Congress, we believe direct negotiation will be limited to a narrow subset of drugs and other drug pricing reforms are likely to be more incremental. The passage of less onerous reform measures should help alleviate investor concerns; the government can say it has done something to combat drug prices but with less of a negative financial impact to pharma than broad direct drug price negotiation.

With strengthening appetite from US voters, change is becoming much more likely

BW: There have been multiple unsuccessful attempts at introducing legislation over recent years, particularly leading into the 2020 election. There has been disagreement on how to tackle the issues in Congress alongside significant pharmaceutical industry lobbying. However, with strengthening appetite from US voters, change is becoming much more likely.

MK: We are in for a few changes, but we are unlikely to see an international reference pricing approach; and that – or anything related to intellectual property (IP) – is probably what the markets would be most concerned about.

Earlier this year, President Biden supported lifting patent protection on COVID-19 vaccines. Does this herald changes in the US patent system for drugs?

MK: The US is unlikely to touch IP because, without it, the incentive to innovate is removed. Drug development is a tough model and, if you take IP out of it, it becomes harder still. The absence of IP protection would have disincentivised vaccine development and antiviral development; the Moderna, Pfizer, and BioNTech CEOs have been very vocal about this.

The lack of IP protection can create a scramble for raw materials

In times of need, the lack of IP protection can also create a scramble for raw materials; if this had happened during COVID-19, it could have exacerbated the challenges. Today, almost every element of raw materials going into the vaccines only has to go to a limited number of manufacturing sites. We are seeing right now what happens with supply chains all over the world when there's a scramble for resources.

SU: Over recent months, India and South Africa submitted a proposal to the World Trade Organisation (WTO) to suspend the ‘Trade-Related aspects of Intellectual Property rights’ (TRIPS) agreement, to help them produce COVID-19 vaccines. TRIPS is an international agreement between WTO member states that came into force in the 1990s as a minimum standard of IP protection and trade secrets.

In a surprise move, the Biden administration embraced the proposal in principle, and a lot of NGOs and civil society organisations spoke favourably of it, almost heralding it as the end of IP protection, at least within the scope of COVID-19.

A patent is available for anyone to read and learn from but it only forms part of the story

The difficulty behind this is technology transfer. A patent is available for anyone to read and learn from, but it only forms part of the story because it doesn't tell you how to build a factory or all the equipment you need to produce an mRNA vaccine, which is incredibly complex and labour-intensive. Then, of course, is the added difficulty that mRNA vaccine technologies are very different from traditional vaccine technologies. Developing a process that reliably produces these vaccines at scale is difficult.

That whole body of knowledge Pfizer has is a trade secret for the developer and it's enormously valuable, not just for COVID-19 vaccines, but also to create other therapeutics based on a similar mRNA platform. That's why, in the eyes of many critics, a temporary waiver of TRIPS can't possibly help countries like India get more vaccines to its citizens.

How does this tie into the Sustainable Development Goal of access to medicine?

SU: IP protection and patent sharing have always been a key component of how the market evaluates pharma companies in terms of access, alongside other indicators, but it's always been the focal point of NGOs like Médecins Sans Frontières.

It's more complicated than that though, because of the profit motive needed to spark innovation – as Matt explained. Over the last 20 years, companies cognisant of the access challenge have tried to come up with other ways of improving healthcare availability.

It doesn't have to just be about IP. Some manufacturers are offering products on a non-profit basis

There are aspects of access to medicine over which companies have full control; it doesn't have to just be about IP. It's about health-system strengthening; improving local healthcare professionals’ capacities and skills; differential pricing systems; and making a portion of the R&D budget available for treatments that address an unmet disease burden. Some manufacturers are also offering products on a non-profit basis, such as Johnson & Johnson and Merck.

And there are other ways in which companies can make a product more accessible and affordable. In a lot of low-income countries, many different middlemen inflate prices, with mark-ups of up to 50 per cent by the time a drug reaches the patient. It's about reducing those inefficiencies along the whole supply chain.1

From an access standpoint, Novartis is a company with a positive story; not only has it been in that field for such a long time and steadily built on its access programmes to increase its impact, it has also been very transparent about its pricing approaches from the start. Under its new CEO, its access programme has also reached a new level in terms of evidencing the impact its interventions have on the ground in terms of health outcomes. It has raised the bar.

It is also one of the few companies that is comfortable talking about the difficulties of including ethnic diversity criteria in clinical trial design. So much more could be done within that sector, and not just in terms of the pharma companies themselves. This broadens the debate from access to inclusion.

How has the industry been affected by supply-chain problems?

MK: There has been less commentary on pharma than most other industries, which could imply companies are doing a decent job. Roche has just published its earnings and is confident in that respect. Pharma is weathering this theme relatively well, which highlights the importance of scale in the industry.

Large-cap pharma are the chosen entities to successfully roll out treatments worldwide

We've seen it from BioNTech teaming up with Pfizer, and from Ridgeback Biotherapeutics teaming up with Merck for Molnupiravir. It shows large-cap pharma are the chosen entities to successfully roll out treatments worldwide. Their role is to take an innovation and then, while also innovating themselves, develop and market it.

Building this global infrastructure is difficult and goes back to what the market undervalues in pharma. The amount of innovation in the sector has led many to ask whether pharma is still needed. These supply-chain issues are an example of why it is. Pharma companies build off the innovation going on around them; they can and will continue to acquire biotech companies to help fuel future growth.

Are we likely to see more deals like the one Pfizer struck with BioNTech, rather than acquisitions?

MK: It's what we hope. The optimum outcome is to marry pharma’s distribution and manufacturing expertise with the innovation of biotech. One of the best models of this is probably Roche and its subsidiary Genentech. Roche and Genentech are part of a huge organisation, yet they insist on being kept at arm’s length from each other and have arguably been one of the most innovative institutions in the last few decades. It does seem that, generally, if you give biotech autonomy it works out for the best.

How big a risk is biodiversity loss in terms of jeopardising the discovery and development of nature-derived drugs?

SU: The risks are obvious when you look at the rate at which we're losing species. Modern extinction rates are about 100 to 1,000 times greater than extinction rates calculated over the past era. This ongoing loss of biodiversity is altering the ecosystem functions and the ability to provide goods and services, with implications for human health and wellbeing.

Our planet is losing at least one important drug every two years because of biodiversity loss

In terms of drug discovery, according to some estimates, our planet is losing at least one important drug every two years because of biodiversity loss. Likewise, there is a loss of traditional knowledge on the medicinal use of certain plants and animals, so there is a social angle as well.

I don’t think companies are actively managing this. When we talk about biodiversity with them it's more around what they're doing to reduce the direct impact of their operations on the environment; that could be through increased recycling rates, making sure waste has been disposed of responsibly and doesn't contaminate the soil or doesn't fuel antimicrobial resistance. This is the extent to which biodiversity thinking goes in pharma.

How far have discussions gone on how to identify who is creating social value in pharma?

MK: The value of early diagnostics and detection is gaining appreciation from the UK’s National Institute for Healthcare Excellence and its peers across the globe. But it is very difficult to understand value creation in the system overall.

BB: There are exciting new areas of innovation like gene therapies, some of which are curative and therefore one-time in nature. How do you go about paying for those types of drugs that are expensive to develop and given one time versus over many years?

We are going to have to see a shift in what is deemed value

MK: The investment needed to bring these drugs to market is enormous; scaling them is hard and the manufacturing capacity is still not there. This is a one-time treatment, as Brian said, and there's a real focus on value-based approaches. As the most innovative types of therapies come to market over the next five to ten years, we are going to have to see a shift in what is deemed value.

SU: The debate also needs to balance value creation against ESG risks like the ethical implications of gene editing or the social impact of the opioid crisis. It is a very complex topic that we are researching at the moment, so we can take these risks into consideration going forward.

BW: Gene editing is a fantastic tool that has huge potential but there are significant underlying risks, which is why the industry is being particularly cautious. There are concerns around off-target effects (gene edits in the wrong places) and mosaicism (gene edits not being taken up by every cell) but ESG risks are just as important. For example, boundaries are needed to prevent gene editing for non-therapeutic uses such as enhancements.

There is also concern that these treatments will only be available to those who can afford them, widening existing wealth disparities in healthcare. A lot of these issues will be managed with policy and regulation, and specifically there is a focus on aligning regulation internationally.

Are new technologies being developed more on the pharma or biotech side?

MK: We'll probably always see more innovation in biotech. It is the same across industries: the smaller players are generally more innovative, until they get acquired.

One of the key areas of innovation is in diagnostics

To me, one of the key areas of innovation is in diagnostics, because an important barrier to being able to treat something very complicated is knowing more about the target or the patient. It is really exciting to see companies leveraging gene sequencing technologies from the likes of Illumina, Pacific Bioscience and Oxford Nanopore to accelerate personalised medicine. One of these companies is Invitae, whose long-term strategy hinges on its ability to successfully democratise genetic testing, from detecting diseases at birth to diagnosing hereditary cancer earlier.

Invitae is also interesting because it is all about access. It needs to gather data from more and more people to improve its tests, so it is creating all sorts of outreach projects, across the globe and across populations, to learn more about certain disease characteristics. But other bottlenecks in manufacturing and regulation also need to be overcome. The regulatory framework is struggling to keep up with the pace of innovation.

Biological products tend to require greater manufacturing sophistication

BB: Biological drugs continue to grow as a percentage of overall pharmaceutical sales. Biological products tend to require greater manufacturing sophistication and COVID-19 has accelerated the focus on adding biological production capacity.

BW: During the pandemic, we've seen how quickly technologies like mRNA can come to market. mRNA isn't new. Companies had been trying to produce vaccines for decades but there hadn't been much success. Now, with manpower and money behind them, they have finally come to market and we are seeing how effective those technologies are.

What about data protection in an age of ever greater technology and personalisation of medicine?

SU: From an ESG standpoint, it’s a huge area of risk that we're seeing alongside product safety. Not only do these companies collect a lot of personal information, but also scientific data of high importance and sensitivity, so the data landscape for pharma companies is becoming increasingly complex.

The data landscape for pharma companies is becoming increasingly complex

Comprehensive data compliance policies are essential for these companies to narrow the gap between the legal requirements and where they are now. We want to see how this issue is being governed internally, and whether there is specific executive accountability and oversight. The landscape is still patchy.

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