Equities started the year on the back foot but followers of biotech stocks of small to mid-sized market capitalisation will know this segment has been on the defensive for much longer. From a peak in February last year to the early weeks of 2022, the benchmark SPDR S&P Biotech exchange-traded fund – focused on small and mid-cap US biotech stocks – lost over half of its value. In comparison, the S&P 500 index returned around 12 per cent – the widest performance gap since the 2006 creation of the ETF, better known as XBI. The sector has faced several challenges: uncertainty around drug-pricing reform following the 2020 US election; regulatory surprises and Covid-19 delays; a frothy IPO market; clinical trial setbacks; and, the prospect of rising interest rates weighing on the valuations of long-duration assets. But the sector is not defeated. Many biotech stocks are trading well below their long-term business value, giving investors an opportunity to enter at unusually low prices. To be fair, biotech was due for a pullback. Over the past two years, many drug makers went public at sizeable premiums. And nearly a third of companies that completed initial public offerings last year were in the preclinical stage of development, compared with 18 per cent in 2018. Whereas biotech drawdowns typically persisted for less than 70 trading days and chalked up a 28 per cent loss, this pullback is much deeper at more than 240 days. Many companies now trade below the cash value on their balance sheets, and biotech’s average forward price-to-earnings ratio lags that of the S&P 500 and the sector’s long-term average. Such pricing would make sense if biotech’s long-term growth potential had collapsed, but the opposite is true. Last year, the US Food and Drug Administration (FDA) approved 50 novel therapies. This is on a par with pre-pandemic averages and has been achieved despite Covid-19 delays and a leadership vacuum at the FDA. Furthermore, first-in-class therapies – medicines that use a unique action mechanism – comprised more than half the drugs approved last year, up from 40 per cent in 2020. It takes courage to look beyond the red when a market is in decline. But, in the past, the XBI has gained an average of 53 per cent over 12 months after bottoming out of a downturn of 20 per cent or more, outperforming the S&P 500 by 25 per cent. Some headwinds are starting to abate. The Biden administration has installed a permanent FDA commissioner, bringing more predictable decision-making. Uncertainty around drug-pricing reform, which was prolonged when the Build Back Better bill failed to advance through Congress last year, should ease as lawmakers push for a resolution before the November midterm elections. Low valuations and a cash-rich biopharmaceutical industry could also drive mergers and acquisitions. Last year, biopharma M&A activity dropped to US$108 billion, among its lowest in a decade, from US$261 billion in 2019. Accordingly, some estimate that large-cap firms could have US$500 billion cash to spend by the end of this year. So far, the industry has declined to pursue big deals, possibly over regulatory worries. But large-cap companies have signalled their desire to bolster flagging pipelines by “bolting on” smaller, innovation-driven firms – such as epilepsy drug maker UCB’s US$1.9 billion bid for rare disease drug maker Zogenix in mid-January, a roughly 70 per cent premium. But not all of biotech’s problems are going away. Central bank tightening is likely to be a headwind for high-growth firms yet to turn a profit. Revenue-generating companies or those in the later stages of pipeline development should be well positioned. Why Fed’s hard pivot on inflation has stock markets spooked This should not discourage investors, however. Covid-19 and the corresponding growth rally have overwhelmed returns for the past two years. Now, with the pandemic hopefully waning , biotech should find a better balance. Clinical events over the next 18 months could help restore confidence, including gene therapy programmes in muscular dystrophy, small molecule therapies for Huntington’s disease, and immuno-oncology programmes in melanoma and lung cancer. The sector is also eyeing updates from a trio of medicines that aim to address Alzheimer’s, which could represent a multibillion-dollar market opportunity. Positive data could be positive for biotech – and put the sector back on the offensive. Andy Acker is global life sciences and biotechnology portfolio manager at Janus Henderson Investors