As the A-share tech sector experiences volatile highs and rapid rotation of hot themes, the long-quiet innovative drug sector has quietly begun a recovery rally. What factors are driving this rebound? How should investors assess the sector's current value proposition? What can be anticipated from the upcoming half-year report season? Let's examine the analysis from a fund manager at Great Wall Fund.

To begin, the recent rally in innovative drugs is fueled by a convergence of positive factors, including fundamental industry progress, business development (BD) out-licensing, top-level policies, and capital allocation. This represents a transmission of industry prosperity from upstream to downstream.

Fundamental Breakthroughs

A key driver is the historic progress in clinical capabilities. At the 2026 ASCO Annual Meeting, Chinese pharmaceutical companies had 94 studies selected for oral presentations, a year-on-year increase of 30.6%. This included 13 Late-Breaking Abstracts (LBAs). Notably, a study on a PD-1/VEGF bispecific antibody by a Chinese firm was chosen for the plenary session, a first for an original Chinese innovative drug in ASCO's 61-year history. Additionally, research on a frontline lung squamous cell carcinoma treatment achieved dual primary endpoints of overall survival and progression-free survival, simultaneously published in a top-tier international medical journal.

BD Out-Licensing Commercialization

The BD out-licensing sector is entering a phase of large-scale commercialization. In the first half of 2026, the total transaction value for Chinese innovative drug out-licensing reached $99.7 billion, nearly 1.9 times the full-year 2024 total of $52.2 billion and 73% of the 2025 total of $135.7 billion. Upfront payments alone totaled approximately $5 billion, representing 70% of the 2025 total.

Policy Support

Top-level policy directives and optimized centralized procurement rules are helping the industry move away from vicious competition. This year's National People's Congress elevated biomedicine from an "emerging industry" to an "emerging pillar industry." The eleventh round of national bulk procurement shifted its benchmark from the "lowest bid" to the higher of "50% of the average bid price or the lowest bid," plus a requirement for a statement on price reasonableness. This new rule aims to balance price and quality, curbing irrational low-price bidding and protecting reasonable R&D profit margins.

Capital Flow

Capital is flowing out of the high-tech sector into innovative drugs, which is one of the few segments with a "global pricing power narrative" amid an asset shortage. Last year, the theme was "out-licensing expectations," while this year it has shifted to "out-licensing realization plus commercial volume growth." The suggestion that contract research organizations (CROs) are a secondary theme is partially correct. In the first quarter of 2026, some leading domestic CROs saw full order books and strong net profit margin improvements, lifting sector sentiment. However, CROs are more of a follower of the innovative drug beta. The true manifestation of innovation lies with innovative drug companies that can achieve BD realization and commercial volume growth. Furthermore, the alpha for domestic CROs (serving the domestic procurement chain) and international CDMOs (serving multinational corporation transfers) differs, requiring a nuanced analysis.

Assessing the Value Proposition

Share buybacks and insider increases are interpreted as a signal that industrial capital itself does not find the sector expensive. This, combined with the relative performance of non-tech sectors, where consumption is weak, new energy is diverging, and AI is correcting from highs, positions innovative drugs as a rare segment with a "global pricing power narrative."

Using a "three-cycle" investment framework, the current outlook is favorable. The industry cycle is upward, as shown by the $99.7 billion in BD deals and strong ASCO representation. The company growth cycle is beginning to pay off, with some targets reporting half-year net profit growth of up to 575% and four BD collaborations with potential total value over $6 billion. Finally, the capital market cycle is just emerging from a bottom, likely starting a recovery. With two and a half of these three conditions confirmed, innovative drug valuations are deemed reasonable to slightly undervalued. The current level is far from the previous high and certainly not at a bubble stage, leaving the window for sector allocation still open. The leaders in this rally are primarily those with significant fundamental changes, indicating a market shift from "digging for dark horses" to "recognizing white/grey horses," which itself validates the value logic and suggests the certainty premium for innovative drug fundamentals is returning.

Expectations for the Half-Year Reporting Season

For the 2026 half-year reports, two main areas are of focus. First, the profitability inflection point from domestic commercialization needs to gain further certainty. As overseas sales revenue is not yet realized, rapid volume growth and profit release from domestic operations are crucial for stable development, ensuring sustained cash flow for high R&D investment. Second, the clarity of the impact from BD payments on financial statements quarter by quarter and year by year is key.

Key Financial Metrics

Five specific financial metrics are important. First, the recognition pace of upfront payments and milestones. Whether these are booked as a one-time current revenue or amortized directly impacts the quality of profit. Second, whether operating cash flow is turning positive alongside net profit. Many biotechs show positive net profit but still have negative operating cash flow, making the latter a more critical reference. Third, whether the sales expense ratio declines with volume growth. While a high ratio is normal initially, if it rises despite revenue doubling, it suggests channel inefficiency. Fourth, a significant increase in the proportion of innovative drug revenue is essential for a true income shift, assuming stable cash flow from legacy generics. Fifth, the cash runway is a crucial metric, especially for Hong Kong-listed 18A pure biotech companies, to avoid those with potential operational risks in the near future.

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