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Are Biotech Stocks a Good Hedge Against Higher Inflation?

By Alex Carchidi - Mar 27, 2021 at 6:30AM

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It's worth putting a few of your eggs into this basket if you're worried about a big increase in prices.

With concerns about inflation mounting in the U.S. thanks to ongoing stimulus measures during a prolonged period of low borrowing rates, investors everywhere are looking to protect the value of their portfolios. Value-retaining assets like gold are evergreen investments for guarding against inflation, but gold doesn't necessarily have a massive potential for growth when there isn't much inflation going on. 

Plus, expectations of inflation might not be correlated with the real thing, so there's an (immense) opportunity cost involved with keeping your nest egg in bullion. The same isn't always true for stocks, however. Biotech stocks aren't traditionally considered an effective safeguard against inflation, and they shouldn't be the only tool that investors use. But they do have a few properties that might be useful in the near future. 

Woman in cafe looking at laptop and papers

Image source: Getty Images.

Higher inflation could be a boon to indebted drug developers

Early stage biotech companies often finance some of their research and development (R&D) work by taking on debt. That way, they don't need to worry about producing positive cash flows before their product has had the years that it likely needs to go through the clinical trial process. Consider BridgeBio Pharma (BBIO -5.52%), which reported a hefty $497.49 million in debt in the most recent quarter.

In an inflationary environment, outstanding debt is worth less as time passes because the value of each dollar declines. So, biotechs could actually benefit from inflation, because the debt they've already taken out will be cheaper to repay in the future than it would be if it were repaid today. For a company without significant revenue like BridgeBio, that makes the prospect of paying down its debt much less daunting. 

But that doesn't necessarily mean that companies that are taking out new debt will get such a good deal. Lenders anticipating a given level of inflation will adjust their interest rates accordingly so that they don't get the short end of the stick. Thus, if the fears of inflation turn out to be true, it's the companies that have debts outstanding today that stand to benefit the most, as the principles are already on the books.

Furthermore, taking out new debt might even be costlier than normal if expectations for higher inflation fail to materialize after being priced into the interest rate.

Is intellectual property worth its weight in gold?

One thing that biopharma companies have in spades is intellectual property (IP) like patents and copyrights. Take Halozyme Therapeutics (HALO -2.97%) as an example: Its primary line of business is licensing out its drug delivery system and collecting the royalties, which provides it with reliable, repeat returns.

For medicines or technologies that are commercialized, IP protections ensure that nobody else can copy the product and steal the revenue. This means that the maker can, in principle, eventually recoup the full value of its investment -- and maybe even more. As a result, IP covering commercialized medicines is worth quite a bit, and it's common for companies to buy, license, and sell IP to widen their pipelines or generate cash.

Researcher filling vials in lab

Image source: Getty Images.

The trick to understanding how IP affects valuation is to recognize that it's an intangible asset. If inflation is rising, all a seller of IP needs to do to adapt is adjust the asking price accordingly, because the valuation isn't set in stone. That's excellent news for biopharmas, as they will still be able to trade their portfolios of IP assets without worrying about them losing value.

On the other hand, holding onto revenue-generating IP isn't risk-free. In Halozyme's case, existing revenue from technology licensing might be difficult to maintain in the face of inflation, if the terms of the royalties agreements preclude price hikes. Likewise, in pharma companies, adjusting for inflation may mean that drug manufacturers may need to raise prices, which could lead to public backlash that has consequences for the business and its shareholders. 

What about the value of intellectual property for projects that aren't anywhere near regulatory approval for sale, though? Many biotechs have no products on the market, and their pipelines are often chock-full of programs in the early phases of clinical trials which might take years to yield any cash flow.

Here, inflation matters less. The value of early stage IP is typically less than the value of commercialized medicines -- after all, a work in progress isn't worth as much as a finished product -- but its revenue-generating potential is largely untouchable by price phenomena because it's entirely in a company's control. 

If inflation is rising, a biotech can simply adjust the expected revenue from its unfinished project, and the value of the IP will change accordingly without any friction. Later, when it comes time for commercialization, the medicine can be priced for the expected degree of inflation.

Holding cash could be a problem, but there's a solution

The final thing to consider about using biotech investments to guard against inflation is that cash can be a liability. While early stage biotechs aren't known for hoarding cash, as they need to spend it on R&D, there's no way around the fact that liquid holdings are very vulnerable to inflation. In this vein, competitors with broader pipelines might fare better, as they'll have more projects to invest in to grow the value of the cash in the long term instead of letting it erode as it sits unused. 

Overall, it's important to recognize that fears of inflation are common, but often overblown. If inflation does start to tick up, biotech stocks could fare better than stocks in other sectors thanks to their use of debt and their IP-generating activities. Nonetheless, investors who are nervous about inflation should aim to diversify their holdings into a swath of different securities wherein biotechs could play a helpful part.

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Stocks Mentioned

Halozyme Therapeutics, Inc. Stock Quote
Halozyme Therapeutics, Inc.
HALO
$43.14 (-2.97%) $-1.32
BridgeBio Pharma, Inc. Stock Quote
BridgeBio Pharma, Inc.
BBIO
$7.02 (-5.52%) $0.41

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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