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INVESTING IN BIOTECNOLOGY STOCKS 
There are a number of
reasons to invest in biotechnology stocks:
Industry Outlook The success of the biotech industry was built on recombinant proteins such as human insulin, human growth hormone, and erythropoietin. Indeed, Amgen Incs Epogen, recombinant human erythropoietin for anemia, is the most successful drug ever produced by the industry, with annual sales of over $2.0 billion. Anti-cancer drugs Herceptin (Genentech, Inc) and Rituxan (Biogen Idec, Inc/Genentech, Inc) have begun to fulfill the potential of monoclonal antibodies (MAbs). The earliest MAbs were murine (mouse), which often produce an immune response that limited their use. Chimeric MAbs, a combination of human and mouse antibodies, have achieved some clinical success. Today, most MAbs are either humanized or fully human. This has led to products that are safer and more efficacious. Schering-Ploughs Gleevec, a drug to treat a rare form of lymphoma, represents the first drug that targets the specific underlying disease-causing mechanism. It is the first of a number of anti-cancer drugs that are both more specific and have fewer side effects. Other promising new classes of drugs coming out of the biotech industry include Trimerus Incs Fuzeon, a fusion inhibitor approved for HIV/AIDS; Millennium Pharmaceuticals Velcade, approved for the treatment of multiple myeloma, the first drug that targets a structure within cells known as the proteasome; Genentechs Avastin, the first angiogenesis inhibitor to be approved by the FDA, and Geron Corporations GRN163, a telomerase inhibitor in mid-stage clinical trials, with potential to be a universal cancer treatment. Inhaled insulin is being developed by Nektar Therapeutics, Inc (formerly Inhale Therapeutic Systems) and Aradigm Corporation. Alkermes, Emisphere Technologies, and other companies are developing technologies for the oral delivery of macromolecules (proteins). Other promising technologies include RNA interference (RNAi), cancer vaccines, gene therapy, stem cell technology, and regenerative medicine, among others. Anti-cancer drugs Herceptin (Genentech, Inc) and Rituxan (Biogen Idec, Inc/Genentech, Inc) have begun to fulfill the potential of monoclonal antibodies (MAbs). The earliest MAbs were murine (mouse), which often produce an immune response that limited their use. Chimeric MAbs, a combination of human and mouse antibodies, have achieved some clinical success. Today, most MAbs are either humanized or fully human. This has led to products that are safer and more efficacious. Radio-labeled Mabs, such as Biogen Idec's Zevalin and Corixa Corporation's Bexxar, which combine a monoclonal antibody with a cytotoxic isotope, have shown promise for the treatment of cancer. The Media and The Biotech Industry When the mainstreet media hails a "breakthrough" drug that promises to cure some hitherto incurable disease, the public believes that the product will soon be on the market for its benefit. It does not understand the multi-year process of developing drugs, conducting clinical trials, and gaining marketing approval. The classic case is the publicity surrounding EntreMed Inc.(ENMD)s angiogenesis inhibitors, angiostatin and endostatin. On May 1, 1998 the New York Times hailed the company as having found a "cure" for cancer. That day the stock shot up to $88/share from around $12/share, before falling back to $55/share. The public did not understand that EntreMed's angiostatin and endostatin, which showed the ability to dramatically shrink tumors in mice, had not even entered human clinical trials. Under the best of circumstances, it would take a minimum of three years to evaluate the drugs in the human clinical trials required to gain FDA approval. Indeed, angiostatin and endostatin are no longer under development by the company after a variety of problems arose. Wall Street has less than 40 analysts that follow the biotechnology sector. Those that do often follow only those companies that their firm has brought public, plus some of the large cap biotechnology companies. This lack of coverage, especially for mid- and small-cap biotechs, creates buying opportunities for the knowledgeable investor. Valuing Biotechnology Companies Once a biotech company begins to earn money from product sales, it can be valued much like other companies. Development-stage companies, however, are not profitable, often have little income, and are, therefore, more difficult to value. Traditional valuation methods do not apply. One method used is to value a company's market value is to calculate its "Enterprise Value" (EV). First, you calculate the company's market capitalization (# shares outstanding, fully diluted, multiplied by the price per share). Then, add cash and cash equivalent, and subtract long-term debt. The resulting EV gives you the value the market is placing on the companys operations. A refinement on this technique is to take the company's EV and divide it by its Research & Development spending for the past five years. This gives you the value the market is setting for the company's R&D, which is what you are purchasing when you buy a development-stage biotech company's stock. Check the company's IPO prospectus under "Certain Transactions" to see what the venture capitalists paid. This technique will reveal the broad valuations given to development-stage biotechnology companies. It may help you to select undervalued companies and avoid buying overvalued companies. None of these methods really works well. Biotechnology companies need to be evaluated on the basis of their technology, intellectual property, clinical trial results, partnerships and alliances, financial strength, and management experience. The biotech investor needs to understand that the safety and efficacy of an experimental drug cannot be known until large clinical trials are carried out in patients with the disease. What analysts can evaluate is the state of knowledge about a given indication, the validity of the drug target, the maturity of the underlying technology, and the drugs clinical trial results. Investors must also understand that biotechnology companies need substantial cash to develop and test their drugs in order to gain FDA approval to market them to the public. This means that these companies must periodically find sources of money to finance their operations. Check the company's quarterly report or 10-Q for its Statement of Changes in Financial Condition to determine the company's "burn rate," the amount of cash spent during the quarter. Divide that number into the cash and short-term investments left on the balance sheet to determine the number of quarters the company can survive at its current burn rate. Less than two years of cash may be a cause for further investigation. Less than one year of cash means a potentially dilutive financing is coming, which may be detrimental to current shareholders, at least in the short term. Stock Selection Stock selection is the single most important variable for successful investment in the biotech industry. Because drug development is an inherently risky enterprise, it is essential that the biotech investor diversify his or her holdings among a number of biotech companies. In evaluating companies for investment, look for the following characteristics: 1) Leaders in their field of science, with publications in the leading journals, such as Nature, Science, Cell, Proceedings of the National Academy of Sciences, Journal of the American Medical Association (JAMA), and others. 2) Strong intellectual property, especially patents. 3) A proprietary platform technology that has broad applications. 4) Partnerships and alliances with large pharmaceutical companies or successful biotechnology companies, which offers an independent validation of the companys technology and drug candidates. 5) Strong management, with experience in bringing products to market, the ability to communicate with investors, and a commitment to maintaining shareholder value. 6) Cash and cash equivalents required to bring drug candidates through clinical trials. Ideally, this would be two years at the expected burn rate. Diversification One of the basic principals of investing in stocks is of especial importance for investing in biotech stocks: diversification. Diversification is needed to spread the risk of investing in a risky sector. The investor should purchase at least five biotech stocks but probably closer to ten. These stocks should represent the three tiers of the biotech universe: large cap biotechs, which are basically profitable biotech companies with a market cap over $1 billion; mid-cap stocks with market caps ranging from $250 million to $1 billion; and small cap biotechs with market caps below $250 million. The third tier small cap biotechs often have much more upside potential- but greater risk. Another form of diversification is to include mid- and small-cap biotechs with a range of promising new technologies. What to Avoid The following is a list of the types of companies and situations to avoid when buying biotech stocks: 1) Companies with drug candidates targeted at diseases that are complex or little understood (e.g. sepsis), which greatly increases the risk of experimental drug failure. 2) Companies whose clinical trials are poorly designed, do not offer a "proof of concept," are too small to produce statistically significant results, or attempt to leap into pivotal trials without adequate prior clinical results; 3) Avoid hype. News about preclinical or early-stage clinical studies does not necessarily translate into a successful drug. Most drugs must undergo three phases of clinical trials, which will take a minimum of three years, likely more. Positive preclinical results may be an early sign of a potential success, but the investor should be patient and not pay a premium for immediate gratification; 4) Companies whose drug candidates have not offered a "proof of concept," been examined in peer review journals, or validated through a partnership with Big Pharma; 5) Companies without strong management and a sound business plan that includes the necessary financing to bring a drug to market. Timing Timing is essential to investing in the biotech sector. Because the biotech sector is inherently volatile it is best to buy biotech stocks when they are periodically undervalued. Biotech stocks fluctuate on average some 50% between annual highs and lows, so purchases should be made when the stocks are out of favor. Averaging down is a good principle. As long as the fundamentals of the company remain strong, however, the investor doesnt need to react to day-to-day price fluctuations. Selling a biotech stock is often a difficult decision. In a rapidly rising market, ask yourself if you would be willing to buy the stock at the current price. One solution is to sell part of your holdings and then sell more if the stock continues to rise. If the stock moves lower, the investor can put the money back in. Most importantly, investors must exercise patience. The biotech sector is characterized by a boom and bust psychology, but the scientific foundation of the industry continues to advance and will produce the drugs of the future. Risks and Rewards The risks of biotech investing comes from a number and variety of sources. The sector is characterized by a boom/bust psychology. Valuations can reach extremes, from the heights of euphoria to the valleys of gloom. Annual fluctuations of biotech stocks are on the order of 50% between highs and lows, often more. The risk of drug failure is always present- despite earlier success in preclinical and early-stage clinical trials. Failure of pivotal trials can trigger losses of over 50%, and even the demise of the company. Biotech companies require substantial amounts of cash to bring their drug candidate through clinical trials. Raising money may prove difficult, especially when the sector is out of favor, and will come at the expense of shareholder dilution. Another risk comes from short sellers. Short selling is a classic bearish strategy. It involves borrowing shares and quickly selling them, in anticipation of replacing the borrowed shares at a lower price in the future. The rub is that, whether or not the stock price actually falls, short sellers must eventually repay their loan by buying the underlying stock. When there is a large short position it signals that many buyers are lined up. This indicates that these investors believe that the companys experimental drug will fail. Investors should evaluate this carefully. Historically, investors in biotech stocks have always faced short sellers. During the biotech downturn of 2001-2002, short sellers did well in the biotech sector. By selling the shares of stocks with a small float, short sellers can push these shares lower in the short term. However, short selling is a double-edged sword. When the shares rise, due to good news about the sector or an individual company, short sellers are forced to buy back the stock, thus adding positive momentum in an upward direction. Another risk comes in the form of powerful institutional investors who attempt to move shares higher by timing big purchases in certain stocks with a low float or low volume. Holding a large block of shares can work for them if they want to buy more. However, if they buy too large a position it can become illiquid and hard to sell without putting downward pressure on the shares value. This can work against them if theyre trying to get out fast. These types of moves often happen at the end of the quarter when fund managers, seeking to boost performance buy shares en mass, bidding up the price. This is called window dressing. One reason this works is that it takes advantage of the short sellers. By outspending the short seller, a large investor can force the shorts to cover their bets that the stock will fall by buying stock at higher and higher prices. If timed well, this can spark momentum on the upside, drawing in other investors who want to join the ride. It does not take a large percentage of shares of adopt this strategy. Most stocks only trade a small percentage of their float in a day. Buying several hundred thousand shares in a thin stock can make a big difference. This is a good example of Wall Streets greater fool theory, which maintains that as long as theres another sucker out there willing go buy shares at higher prices, shares will go up. Ultimately, marking up shares in a company is illegal. Federal Securities law requires any 10% owner of a stock to return to the company any profit made on short-term purchase or sale of that stock. In 2004, two biotech companies, Aksys and Esperion Therapeutics, have forced the Sacane Group to pay for just this type of manipulation. Short selling can be useful measure to gauge investor sentiment. Paradoxically, if short interest is high enough, it may signal a (short-term) buying opportunity. While the risks of investing in the biotechnology sector are substantial and should not be underestimated, the rewards can be tremendous. Buying shares of small biotech companies with drugs in the early stages of clinical development is very risky, but the gains can be equally rewarding. For example, the market cap for a biotech company with its lead drug candidate in Phase I clinical testing is often less than $100 million. When the drug advances to Phase III clinical trials, the company's market cap can rise to $300 million or more, especially in a strong market. An investor can triple his money simply by picking companies that make it to Phase III trials. A company that gains FDA approval has an even greater markup, as high as $1 billion. An investor in promising early-stage companies can realize a potential return of 10-to-1 when that company succeeds in bringing a promising drug to market for a major indication. On the day that a company gains FDA approval its stock will rise significantly. Most investors think that they have already missed the boat. However, studies show that these stocks will continue to move significantly higher over the next six months. There is still an opportunity to make a substantial profit with less risk. These risks can be reduced, however, by constructing a portfolio of promising biotech companies representing different types of experimental drugs at different stages of development. |