Domestic Equity—Growth | January 2014

Innovative biotech companies may have underappreciated growth potential

By Thomas Ognar, CFA; Joseph Eberhardy, CFA, CPA; and Bruce Olson, CFA—Portfolio Managers, Wells Fargo Advantage Premier Large Company Growth Fund

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In today’s tepid growth environment, we believe that it’s important for investors to focus on those select companies that have the ability to deliver robust growth throughout a full economic cycle. Rapidly growing companies have been scarce in this market environment, making companies that offer innovative solutions more likely to be successful. We believe there are investment opportunities within the biotechnology industry that have robust, sustainable, and underappreciated growth potential stemming from one or a combination of the following:

  • Large and often expanding drug pipelines
  • Multiple applications or medical uses of existing drugs
  • Increasing geographic exposure
  • Successful conversion of research and development pipelines

In our view, several well-established biotechnology companies possess sustainable double-digit earnings growth potential that can last for several years to come. We believe that other investors have underappreciated the ability of several of these companies to capitalize on multiple revenue opportunities. Many of these companies offer drug solutions for rare and life-threatening diseases and other unmet medical needs. As an example, Gilead Sciences, Inc., has a core franchise with dominant market share in the HIV market, but the company has recently made strides to expand its reach into the hepatitis C virus (HCV) market. The firm recently received approval from the U.S. Food and Drug Administration (FDA) in December 2013 for an oral regimen to treat HCV. Gilead currently has minimal competition in this space, with a considerable patient population to treat, which we believe is an investment opportunity that is underappreciated by other investors.

The drug approval environment for biotechnology firms appears to be improving

We believe the overall biotechnology industry should continue to benefit from the FDA’s increasing efficiency in its drug-review process. Over the past two years, the FDA has become more responsive to biopharmaceutical companies and improved its internal procedures. As evidenced by Chart 1, the number of drug approvals has recently been well above the 10-year average. The FDA drug-review timeline has been improved to bring much-needed drug solutions to market, which has benefited select biotechnology companies. As the drug-review process has become more efficient, many biotechnology companies have been increasing their research and development (R&D) spending in hopes of identifying innovative therapies to treat specific illnesses. The larger, more established biotechnology companies have often been successful in maintaining solid revenue growth in an environment of generally increasing R&D spending. As a result, R&D spending as a percent of revenue has been relatively unchanged for many of these companies, which has provided support for profit margins.

Chart 1: The number of FDA drug approvals for new molecular entities has significantly increased over the past two years.
The number of FDA drug approvals for new molecular entities has significantly increased over the past two years.
Source: FDA
Past performance is no guarantee of future results.

Several established biotechnology companies may possess multiple drivers of growth

While investor sentiment has recently been positive for the biotechnology industry, we believe that it is important to focus on those best-in-class firms that have demonstrated a successful history of converting drugs in the pipeline into revenue. In our view, those firms capable of producing innovative therapies for critical medical needs are more likely to benefit from faster conversions of drugs in their pipeline. We believe this should, in turn, lead to stronger and more sustainable revenue growth. Companies such as Celgene Corp. have relied on robust pipelines and solid demand for existing drug solutions. Other biotechnology companies such as Alexion Pharmaceuticals, Inc., have been effective at substantially growing their businesses by expanding the application of existing drugs and reaching new geographies. Alexion generates the vast majority of its revenue through its flagship drug Soliris, which treats rare blood disorders. The firm has been successful in generating sales beyond its initial indication for treatment of paroxysmal nocturnal hemoglobinuria with a sizable opportunity in a new application for atypical hemolytic uremic syndrome. Alexion has also effectively expanded into Europe and more recently into Japan, which should diversify and enhance its revenue opportunities.

Concluding observations

Our bottom-up research has identified several companies in the biotechnology industry that we believe have reasonable valuations, innovative drug solutions, and a pathway to sustainable organic growth. While we believe that there are tailwinds for the broad biotechnology industry, we encourage investors to be selective in identifying investment opportunities based on diverse company-specific revenue opportunities. In particular, we continue to have a favorable outlook for several established companies that demonstrate growth potential through a combination of factors such as expanding drug pipelines and increasing available markets for existing therapies.

The portfolio managers also manage the Wells Fargo Advantage Growth Fund,1 the Wells Fargo Advantage Large Cap Growth Fund, and the Wells Fargo Advantage Emerging Growth Fund.2

Stock values fluctuate in response to the activities of individual companies and general market and economic conditions. Certain investment strategies tend to increase the total risk of an investment (relative to the broader market). This fund is exposed to foreign investment risk. Consult the fund’s prospectus for additional information on these and other risks.

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