Monday, December 29, 2008
Most investors follow a predictable pattern when it comes to biotechnology...
Early in their investing careers, they hear about a few gigantic winners... small companies that develop blockbuster drugs and turn early investors into millionaires. Seeing the wealth-multiplying power of biotech, they spend years trying to pick the next big winner. They suffer a handful of 70%... 80%... or 90% losses. Frustrated and poorer, they swear off the entire drug sector forever.
These investors don't know the truth about biotech investing: Picking biotech losers is far easier than finding winners.
Drug discovery is a high-risk endeavor. Of all the drugs in Phase II trials, 70% will fail. One third of all drugs in Phase III are duds. And even when drugs pass clinical trials, nothing guarantees the FDA will give its seal of approval.
But until recently, shorting questionable biotechs has not been all that profitable. Cheap capital has flooded the market over the last five years. So even companies with terrible drugs had access to cash. Smooth-talking executives suckered millions from naïve institutional investors looking to add some juice to their portfolios. Private-equity shops took lousy companies private via cheap debt offerings. And hedge funds doled out millions in various financing deals. All that money propped up the stock prices of even the most dreadful biotechs.
Now, the credit crunch will expose companies that didn't deserve funding in the first place. And we can profit by shorting those companies all the way to bankruptcy. Just during December, biotechs Rigel, Xenoport, and Pain Therapeutics dropped 38%, 35%, and 21%, respectively, in a matter of minutes. All three companies had drugs that either failed clinical trials or were rejected by the FDA.
Here's what you should look for in potential short candidates:
1) A lousy pipeline. Companies that are only developing one drug are almost always ideal short candidates. If that compound has subpar clinical data or unacceptable side effects, it's even better. Look for Phase III trials conducted without positive Phase II data. It happens more than you would think. And these drugs fail twice as frequently as conventional Phase III programs.
2) Incompetent management. Many biotech executives don't care about creating shareholder value. They are either running the company as their own fantasy research lab or looking to cash in millions of dollars from stock options. Bad management can kill the prospects of a perfectly good drug by botching clinical trial design or choosing the wrong patients to test. Worse yet, arrogant management can squander shareholder money by paying too much for questionable acquisitions.
3) Unjustified prices. Speculators can go into frenzy when a drug actually works. Unrealistic expectations will send stocks soaring, sometimes to an incredible 50-100 times projected sales. Stock prices may stay stratospheric for a couple months. But it rarely ends well. At the earliest hints of delay or setback, the stock collapses.
Using this checklist, you should be able to uncover more than a few promising short candidates.
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