Attraction of high-risk biotech stocks



The current investment scene is pretty dire. The US and European stock markets, which tend to move in tandem, are at risk of another major sell-off if any of the ticking credit-spree time bombs goes bang. Safe havens like money funds will be paying next to nothing by the time the Federal Reserve finishes slashing short-term interest rates.

 

Emerging market stock indices are due for some serious correction of speculative fever.

It’s true that with central banks back at their game of creating excessive money supply, some of the reckonings may be delayed.

 

But it’s anyone’s guess into which markets the easy money will flow. In this environment, the only stock-market investment idea that I can get excited about is development-stage biotechs. I’m not talking about mature biotech giants such as Amgen, Genentech and Biogen-IDEC. Their value is largely tied up in products that have been on the market for years, some of which are now under attack over safety or are facing resistance because they seem less effective at treating disease than promised, or are set for competition as patent lives expire.

 

I’m talking instead about tiny firms with market capitalisations that may not even reach $100 million (Dh367m). These are names that you’ve almost certainly never heard of, like Zymogenetics, Repros, and GTCB. They have promising data from mid- or late-stage clinical trials on products to treat unmet medical needs. Zymogenetics has just been approved for a new coagulant, and they have products in the pipeline for lupus and kidney cancer. Repros’s lead product is for uterine fibroids and endometriosis, both of which affect many millions of women worldwide. GTCB’s lead product is initially targeted for a much rarer syndrome called hereditary anti-thrombin deficiency, but may also treat a common sepsis symptom. 

 

Yes, I know what you’re thinking. “Midas has taken leave of what little sense he ever had. Now is not the time to take on more investment risk. Only a daredevil seeks out the kinds of stocks that can lose 85 per cent of their value in a single day. The overall stock market volatility in January this year should have provided enough thrills for the most foolhardy investor, without looking for more.”

 

Be reassured. I’m not suggesting that any retail investor or any money manager, for that matter, should put more than perhaps five per cent of a portfolio into small-cap biotech. Even if you back half a dozen of the highest-potential drug developers, you could possibly lose the whole lot. In each case, you’re betting on the success of one or two drug candidates.

 

Even if you follow superb expert advice about which firms have strong programmes and also back only those companies that are in an advanced stage with a product, which will have the market to itself, it’s probably a 50-50 proposition, at best.

 

In some ways investing in these small firms is like being a venture capitalist, except that they are quoted companies, so you don’t have the high transaction costs of venture investing. It’s guaranteed that you’ll have some failures, but a few winners could bring you outsized returns. That has been my experience to date, and I believe it’s not due to luck but to market imperfections. These stocks are priced as if they will almost certainly fail. In most cases very few shares change hands on a given day, so it does not take much volume to move the price disproportionately.

 

Short interest in their stock is often high relative to total share float. They are too small for many of the big mutual fund companies to take much interest and to demand balanced brokerage analysis. It’s a lot of trouble to take a discriminating look at the clinical, regulatory and commercial prospects of the many biotech firms that are doing therapeutic development.

 

In addition, inside rumour has it that hedge funds systematically short these names and some of the brokers who serve these funds put out negative analysis to help out their clients. All these market imperfections mean that if good news breaks for one of these companies, its stock price rockets.

 

For a serious money manager, almost as impressive as the prospect of significant gains in small biotech is the fact that returns will not be linked to overall stock market moves. A company that has a new drug breakthrough goes up in value regardless of the business cycle, sub-prime and all those systemic issues. Drugs that meet an unserved medical need fetch good prices whatever the economy is doing. Revenue growth for a company that goes from no sales to a mini-blockbuster is something managers in any other industry can only dream about.

 

My enthusiasm is not merely theoretical. A 100 per cent gain on Dendreon last April, a 186 per cent gain in Corcept last autumn, and a measly 40 per cent gain in Biomarin last December are some recent trophies. Those who were lucky or astute enough to get in nearer the lows and jump off nearer the highs would have done considerably better than me.

 

Oh yes, I’m not trying to mislead you: I did lose 85 per cent of the money I had in Virrex when the good early results of their ovarian cancer therapy were contradicted by the completed trial. In another, DORB, I took a 20 per cent haircut when the FDA, after dithering, refused to accept their drug, a decision that I’d anticipated well enough to limit my losses. Overall, my highly selective portfolio of biotech stocks in development stage earned me a very substantial return in 2007.

 

A specific example will illustrate the potential. Repros has a drug called Proellex with mid-stage trial data showing strong efficacy in relieving symptoms of uterine fibroids and endometriosis. There are no good treatments available for either painful condition. The company recently presented a very credible estimate that if approved Proellex could achieve $3.5 billion in annual revenues. That could be worth somewhere around $500m in net royalties to Repros.


I calculate that the current stock price implies that Proellex has only a one in 20 chance of success. The stock looks very cheap now, but that can change as fast as good news convinces a few new investors. We’ll be seeing more trial results over the next few months. Repros hopes to submit a package to the FDA for approval of Proellex in a year or so.

 

If you have the psychic and financial staying power to “fire and forget,” buy some RPRX shares with what you consider “play money” and hold them until one of the following things happen:

 

1. Clinical trial progress allows Repros to file for Proellex approval in one indication and present good data in the other indications. A major pharmaceutical company makes an attractive buyout offer for several times your cost basis in the shares.

 

2. Or there is a nasty surprise on safety data that shoots down prospects for Proellex. The stock price plummets.

 

Many retail investors find it very difficult to be that disciplined. If, as frequently happens in this sector, the stock drops by 10 or 20 per cent after they’ve bought in, they start to second guess their buying decision, even if there is no bad news to justify the stock move. And of course my auto-pilot advice outlined above may be thrown off by some unforeseen contingency.

For technical insight, you could subscribe to a specialist service called Biotech Stock Research, biotechstockresearch.com, that follows a portfolio of these companies, including RPRX, assesses their prospects in detail and updates its assessments whenever news of trial results or regulatory or partnership action comes out.

 

If you have significant funds to put to work, the enormous potential upside in individual development-stage biotechs makes it worth the effort to try and pick the future winners. Making profit on such stocks requires monitoring the news flow on the biotechs in your portfolio, and weighing various interpretations of the news by analysts. That expertise is available and worth seeking out. With the right advice to guide you, a sensible dose of stocks from this high-risk drug development sector may be just what the doctor ordered for your portfolio.

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