In this week's episode of Industry Focus: Healthcare, host Shannon Jones and Motley Fool contributor Simon Erickson talk with Brad Loncar of Loncar Investments about China's rapidly evolving biotech space. Everything has to start somewhere, and Brad believes that China's biotech industry looks a lot like ours did in the '80s and '90s -- including all that massive upside potential.
Tune in to learn what shifts have radically changed this space in just the last year, how regulators and government play into the picture, some lower-risk ways to get exposure to this admittedly very volatile market, and why investors definitely shouldn't ignore this for the long term.
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A full transcript follows the video.
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This video was recorded on March 13, 2019.
Shannon Jones: Welcome to Industry Focus, the show that dives into a different sector of the stock market every day. Today is Wednesday, March 13th, and we're talking Healthcare. I'm your host, Shannon Jones, with a special treat for our listeners today. Motley Fool Explorer's lead advisor, Simon Erickson, and I recently had the privilege of sitting down with Brad Loncar, CEO of Loncar Investments, to discuss investing in one of the hottest areas in biotech right now, China. I think it's safe to say that Brad Loncar is likely one of the most knowledgeable and honestly nicest biotech investors out there. As an independent biotech investor, Brad uses his extensive experience researching companies to create biotech investment indexes, including a China biopharma index which tracks the performance of a basket of companies leading the way in China.
In this interview, Brad shares with us his thoughts about investing in China from a regulatory front, the trends he's keeping an eye on, and where he sees the biggest opportunities for investors. We hope you enjoy this conversation just as much as we did.
Simon Erickson: Hi, everyone! I'm Motley Fool Explorer lead advisor Simon Erickson, joined by our Healthcare bureau chief Sharon Jones. Our special guest this morning is Brad Loncar. Brad is the CEO of Loncar Investment. One of the topics that he's been very interested in lately is following the biopharmaceutical industry of China, which is the topic of our discussion here today.
Brad, thanks so much for joining us!
Brad Loncar: It's a pleasure! Thanks a lot for having me!
Jones: Brad, let's dive right in! For anybody that's been following you, you've had the opportunity to spend a lot of time both here in the States and in China talking with CEOs, industry insiders, and investors. Generally, many everyday biotech investors have been scared to invest in Chinese biotech. In your experience, when it comes to Chinese biotech, have you noticed a change in investor sentiment?
Loncar: It's a little basic and just beginning, but this is going to be a topic that you can't avoid in the future, in my opinion. China's biotech sector is having a moment. The analogy that I like to use is, I really think what's going on there is just like what our biotech sector was in the '80s and '90s, meaning it's just being born. There's a few really important changes that are happening there right now that are dramatically changing their biotech sector. Before today, all of their drug development and their healthcare sector was almost entirely generic drugs. They're starting to shift toward innovation, and a biotech sector, and a really good one. These are companies that are conducting world-class science and trying to develop drugs that are on the cutting edge that are forming up.
For purposes of time, I won't go into too much depth, but there's three or four things that are making that happen. The Chinese government is supporting it and investing in it. They want to shift their economy away from manufacturing to higher-value sectors like tech and biotech. They've totally revamped their version of the FDA, which is called the National Medical Products Administration now. From a stock market perspective, which we like to talk about here, there's a change that I think is the most important thing, and that's what's happened at the Hong Kong Stock Exchange. Before last year, the Hong Kong Stock Exchange, which is where most of the big globally progressive companies list, had a rule that said, "If you don't earn revenue, you can't list on our exchange." If you think about it, that basically described 95% of biotech companies, because most of them are development stage. The Hong Kong Stock Exchange created something called the biotech rule last April, and it's allowing true biotech companies to list there. Already a handful have. Over the coming years, there might be dozens and dozens. Just like there was a big boom of listings and new biotech companies -- Amgens, Celgenes, and Genentechs of the world were IPOs in the '80s and '90s -- I think that's exactly what's going on there right now.
You have all these elements coming together at the right place and right time, creating this sector. Getting to your original question, U.S. investors are starting to hear about it because these companies are forming partnerships with U.S. firms and starting to run trials, not just in China, but in the U.S. So you're starting to see it in the news every single day. I think most people are still trying to figure out what's going on. But over time, if this turns into a real big and important biotech sector, it's something that I think biotech investors won't be able to miss and can't ignore. This is just the very beginning of that.
Erickson: That's great, Brad! As you mentioned, there's a boom of a whole bunch of new biotech companies. I wanted to ask about, maybe one of the pieces holding back that is the people aspect of this. We've heard anecdotally that there's a shortage of qualified people that are available in China to actually run and manage the clinical trials. I know that China's tried to address that with the Thousand Talents program, to attract Western talent either from the U.S. or Europe to manage those trials. Have you seen if there's still a shortage of good people to develop new drugs and run the trials over in China?
Loncar: Definitely not. That's something that's changed a lot for the better over the years as well. I don't think there's a shortage at all. Just as you said, a lot of people who studied in the U.S. and other places in the West, and have experience at very high levels in our biotech sector, who are returning home and starting these world-class companies. There, the universities are really focusing on this area as well. There's no shortage of talent.
Now, developing a drug that gets approved by the FDA is a pretty unique thing. You can't teach that to somebody in school. That requires experience for people who have gone through it here, or guidance and teaching from the management teams. But no, there's definitely not a shortage of talent.
In terms of actually conducting clinical trials, I'll give you a crazy statistic. There's a research organization in China called PharmCube that focuses on our sector. They recently put out a statistic in a report that shared that there's 800 CROs in China. Literally, like every year, there's like 100 that are that are formed. Their major CROs, there's a big one that's really integral to our industry worldwide now called WuXi AppTec, and a sister company called WuXi Biologics that focuses in the biologic space. It's really turned into a specialty of theirs.
I would watch for China to become a leader, if not the leader, in the clinical development of drugs. They have the scale. They have this great focus on the CRO model. And have some hospitals and institutions that see 20 times the patients that our MD Anderson and Memorial Sloan Kettering of the world sees. It's bound to turn into a big area where clinical trials are done. It may be the preeminent place in the world here in a few years.
Erickson: That's perfect! So you're seeing the CROs of China playing the same role as they do in the U.S., to outsource a lot of the development and the trials running in China the same way they do here.
Loncar: Absolutely! The country, until you really visit it, it's hard to really articulate the massive scale of everything there. Their CRO industry is absolutely booming right now. The quality of clinical trials has increased, and the regulator oversight of them has increased. One thing I focus on a lot, because I like following on oncology and cancer, a hot thing in the U.S. and worldwide right now is cell therapies like CAR-T. Well, there's more cell therapy trials going on in China right now than there are in the U.S. That's another important aspect to this. They're approving trials and getting new technologies into clinical trials faster than we are. A lot of people here have raised concerns about us losing our edge. There's a famous developer of CAR-T treatments, Carl June at the University of Pennsylvania, he's been very outspoken about this, how if we don't work at the same speed as they do, we may lose our edge in some of these really cutting-edge technologies like cell therapy and gene therapy. In many ways they're starting to have advantages.
The regulation is totally different. Before the beginning of last year, for example, for cell therapy trials, you didn't even have to file an IND. An IND is the regulator's approval to start a trial. Now, they're closely matching the process that we have here in the United States. From all aspects, they're really stepping up their game and really trying to cultivate a world-class clinical trial system and biotech sector.
Jones: Brad, you talked a little bit about some of the changes that are happening. I want to dive deeper into the regulatory framework and their system. What progress has China made with its regulatory review process? Do you think that there are more changes to come that could make it even better?
Loncar: The biggest thing is, they made a big statement about a year ago, there's a consortium of drug development regulators. The FDA and the EMA and the Japanese regulators, they created a consortium called ICH. The goal behind it is to create international regulatory standards. About a year ago, China joined that for the first time. It was really a statement on the country's part to say, "We want to have the same global standards that all of those other places have." That was a big message to the world.
In addition to that, there's a lot of important changes they've made. It's really 180 degrees different than it was years ago. There was a famous story in 2015 -- this is going to sound like a crazy story. There were like 1,500 open applications at the Chinese FDA back then. It was mostly for generic drugs. Back then, everything was getting approved, and the quality of the applications was very low. The regulator went back to all these companies and said, "We want you to seriously reconsider all of these applications that you have pending with us. We're going to change our standards significantly going forward. If you don't think your existing application is up to these new standards that we want, we want you to pull it." And out of the 1,600 open applications they had there, like 80% of them got pulled. It literally was like pressing a button in one day, saying, "We're going to do this totally different going forward."
They've made a lot of other constructive changes since then, like joining that ICH. They've caught up on a huge backlog of applications that they had pending there. They've also started to -- with our FDA, we have very clear and transparent rules and timelines and things that are written in stone. If you're an U.S. company and you file an application, you know how long it's going to take and you know what the process is. They're starting to really clarify all of their rules and regulations and have certainty and transparency added to the mix. They're using our FDA and others as a model that they're trying to replicate. A lot of the leadership there are actually people who have returned home having had experience working at our FDA. The goal is to bring it up to standards and replicate what we're doing. They're not 100% there yet, but compared to where they were back in 2015, it's literally day-and-night different. It'll get even better as we go forward.
Erickson: Brad, I wanted to talk a little bit about reimbursements. China's got a national reimbursement drug list, it has a couple of thousand drugs that are basically covered for anybody in the country. We've seen the data that shows that the drugs that are covered on the NRDL are selling significantly better than those that aren't. That's probably not too surprising. But there used to be several years between the amount of time when the NRDL was updated, the new drugs list would come out on this. We've seen the time frame drop significantly and much more frequently for the new drugs that are actually getting coverage out there right now. Is this having an impact on how drugs are being created by companies and bringing them to market?
Loncar: Absolutely. You're right. In some cases, it literally took almost a decade for a drug to get approved. Now, that's dramatically changed. This is being recorded, ironically, on a day where AstraZeneca just announced earnings. Amazingly, AstraZeneca gets 18% of its revenue from China now, and it's even growing. One of the drugs they highlighted in their earnings report today, as an example of how things are changing in China, is a lung cancer drug called Tagrisso. Not only was that approved with lightning speed there, but it was put on the national reimbursement list in less than a year. That's because they have a lot of urgency to bring these really important world-class medicines into the country. That's another example of something that's dramatically changed. Something that used to take five to 10 years, now in many cases is taking a year or less. When you're a company that's trying to decide whether to make an investment and to bring a drug to that market, that's a huge factor that would encourage you to do that. It's a perfect example of something that's changed dramatically, night and day, for the better.
Erickson: Do you think that it's influencing in any way the types of drugs that companies are developing? You saw Merck's Keytruda got approval in half a year. Opdivo, too. PD-1s, broad-based drugs. Is there more of an interest in companies developing those broad labels for China to try to get that national coverage, lots of indications? Or are they still also developing those rarer diseases that might not have as much of a broad label to them?
Loncar: No. For those, I think what's going on there is, last August, the country actually published a list of 46 drugs that they actively want to be approved there. Literally, they published the list and said to all these multinational firms, "These are important medicines that we don't have here now that we would love to have." There's two things they're doing to encourage them to bring them to China that are important reforms. The first is, until about a year ago, one thing that they've changed is, they're now allowing foreign clinical trial data as the basis for approval, especially for diseases where there is a big unmet need. Some of the ones that you mentioned, like Keytruda, Merck did not have to run a gigantic Phase III trial in China in melanoma to get that approval. Much as the approval was based on just the existing data that they already had. This AstraZeneca Tagrisso drug was the same. That's an important incentive to get these companies to come here. They know that they don't have to reinvent the wheel, basically develop those drugs from scratch within the country like they would have had to in the past.
The second thing is exactly what you asked about, the reimbursement. I don't think it's really a distinction between big, broad indications or rare diseases. I think what they want is, they want innovative medicines. Right now, they have all generic drugs. They want the best things for their families, the same that we have for ours. It's really a matter of having the best medicines and the most impactful medicines. I don't think the indications really matter because they're approving them for broad indications, and actually, just two days ago, they announced the big tax incentive for companies that are developing rare disease drugs. That was a big boost for the sector on Monday's trading. They're really focused on everything. It's not really about size, it's more about quality.
Jones: Brad, as we all know, globally, the debate on drug pricing continues to take center stage. Can you talk a little bit about China's drug pricing system? From your perspective, do you see the larger, more global players vs. the domestic generic players, who's going to win that race when it comes to government price controls?
Loncar: Without a doubt, I think eventually it's going to be the domestic players that win. A good case example of this is Keytruda, which you just brought up. Keytruda was approved in China for melanoma five or six months ago. Then, in December, there's a domestic company called Shanghai Junshi Biosciences, which just had its IPO on the Hong Kong Stock Exchange on Christmas Eve. It has a PD-1 that was also approved for melanoma in China. You may have heard, it didn't make a lot of news, I'm surprised, in the U.S. But when Merck got their approval, and they announced their pricing, the price of Keytruda was like half of what they're charging globally. That made a lot of headlines. The price in China is half of what it is in other places. Well, this Chinese competitor, after they got their approval, announced that their price depends on the weight of the patient, but essentially will be either a half or a third of Keytruda's. [laughs] So, the cost that they're able to produce there and sell these drugs is so much lower than what we're used to here that I think multinationals for many drug categories will be the first ones to have a drug on the market, but as soon as a Chinese competitor is able to get a drug approved and enter a race, it's going to be really hard for those multinationals to compete with them.
Now, the consumers there place a high value on foreign brands. One thing that's interesting is, even for a lot of drugs where there's a generic available, people who are able to afford it out of pocket or who have insurance sometimes are willing to pay a premium price for the foreign brand. The thing we're talking about today is, the vast majority of people there get their healthcare paid for by the national government reimbursement system. For those, there's really going to be a winner-take-all, and I think it's going to be hard for multinationals over the very long run to compete with some of these local players just because their costs are so much lower and they're so much more competitive than we're used to thinking about here in the U.S.
The other important thing there is scale. A good example of how their reimbursement system works, one drug that was recently reimbursed there is Avastin. That's one of Roche's big cancer drugs. To get on that national reimbursement schedule, they took like a 70% price haircut. But, the country scale is so huge that ever since they got on that, even with that huge price discount, the sales of Avastin have ramped very nicely. It's going to end up being very lucrative even given that huge price cut. That's really how it's going to be there. Companies are going to have to deal with big price cuts, but for those that get approved on that national reimbursement system, the scale of the country is going to make up for it.
Erickson: Brad, one thing that you were explaining to us earlier is that you are the creator of the Loncar China BioPharma index. That's not the ETF that people can buy. That's run by someone separately. The ETF that actually replicates your holdings is CHNA, that's the ticker on that. You're still the one that's in charge of putting the companies into the index, selecting them and judging the weightings and everything else. Our audience here is individual investors. They would certainly have an interest in this. I wanted to ask you, how do you go about picking the companies that you're putting into the index and also figuring out what kind of allocation you want to put behind each one?
Loncar: The idea here is to give exposure to the entire space. In the U.S., we have the NASDAQ Biotech index, for example. There's like 200 companies in that. The goal of that is, rather than focusing on an individual company, to follow the industry as a whole. With this, right now, we have 29 companies. Twenty-three of them are listed in Hong Kong and include some of these new IPOs. Six of them are listed here on the NASDAQ. That's one thing that I think is really important for people to know. There's a handful of really world-class Chinese biotech companies that are listed right here on NASDAQ. BeiGene or [unclear 25:32] are good examples of companies like that.
What we do is, we limit our exposure to those two exchanges because we view Hong Kong and NASDAQ as global, transparent, credible exchanges. We look at every Chinese drug developer or distributor or service provider or diagnostics company listed on those two exchanges, and we put them in a basket together. There's 29 companies like that currently. The way that we decide the weighting is, we have what's called a modified equal weighted methodology. We take those 29 companies, and we start by giving them all the same weight every six months. But for companies that have a market value greater than $10 billion, they get a little bit of a higher weighting. For companies that are between $1 billion and $10 billion, they get a medium weighting. And for companies that are below $1 billion in value currently, they get a smaller weighting. That gives credit to the larger companies for their stability and the role that they play in the sector. We do that process every six months.
One thing that has me excited is, with this Hong Kong Stock Exchange rule, and this big pipeline of companies that will likely IPO there, right now, we have 29 companies in this. Over the coming years, that will grow every six months. Two or three years from now, that may have 60 or 70 companies in it. It just all depends on how many Chinese biotech companies list on those two exchanges.
That's how we have it set up. It's a basket of 29 companies. The idea is that it will hopefully go up and down as the fortunes of that sector goes up and down. Just like our biotech sector in the 80s and 90s, biotech is volatile, and especially in a place where it's brand new and they're just getting used to it. It'll have a lot of ups and downs. It's very scary to focus on individual biotech companies, especially in a case like this where it's a very emerging thing. I'm a big fan of taking a macro view of things. That's why we've created this. It allows people to focus on the long-term theme and hopefully long-term growth without getting too into the weeds of the individual companies and the risks that come along with that.
Jones: Brad, you hit the nail on the head. As long-term investors here at The Motley Fool, you really couldn't have said it any better. To close us out today, what should individual investors be watching in this space specifically?
Loncar: The most important thing, I would get back to saying you have to have a long-term view of this. If you look at a chart of our biotech sector since the '80s when it was started, it's been a roller coaster. There's lots of ups and downs. I think it's important to think of this from that long-term perspective. China has a policy that makes a lot of headlines. It's called Made in China 2025. That's really having a big influence on what we're talking about. The goal of that program is to transform their economy to higher-value sectors. They've singled out pharmaceuticals as one of those. They want to have a world-class, competitive pharmaceutical sector by 2025. You see a lot of stories every day about an IPO that was a big success, or an IPO that didn't go very well, or something like that. Or you see, something like, there was a vaccine scandal in China last year. That made a lot of news. There's going to be a lot of positive things you hear, a lot of negative things. It's going to be a roller coaster, just like biotech naturally is.
But if you think about all these important changes that are happening, the investments, the people coming home starting companies, their version of the FDA, all the reforms there and the stock exchange rule change, if you think of all of those arrows and where they're pointed together all at the same time in the context of what is this going to look like in 2025, or over the long term like that, I think it has a very promising future. The most important advice that I could give is, try to think of it from that long-term perspective. This is, I think, a mega-trend that's worth putting on your radar. Think of it that way. Don't get caught up in the individual news stories or the ups and downs. Try to think of it over the long term like that.
Erickson: Certainly a trend that individual investors should be keeping an eye on. Again, Brad Loncar is the CEO of Loncar Investments. If you want to look more at the ETF that follows his index, tracking biopharmaceuticals in China, the ticker on that again is CHNA. Brad, thanks so much for the time with us here this morning!
Loncar: It's my pleasure! This has been fun! Thanks for having me!
Erickson: For Simon Erickson and Sharon Jones, we appreciate you tuning in. Until next time, Fool on!
Jones: Well, that's it for this week's Industry Focus: Healthcare episode. Hope you enjoyed the interview with Brad. As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is produced by Austin Morgan. For Simon Erickson, I'm Shannon Jones. Thanks for listening and Fool on!
Shannon Jones owns shares of Merck. Simon Erickson owns shares of BeiGene and Celgene. The Motley Fool owns shares of and recommends Celgene. The Motley Fool recommends Amgen and Nasdaq. The Motley Fool has a disclosure policy.