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The Four Things You Must do to Make Money in Biotechnology

By Rob Fannon, editor Phase 1 Investor
Thursday, November 2, 2006

Two weeks ago, I wrote How to Play Pfizer’s Buyout Binge in these pages...
In that essay, I described how Big Pharma is trolling through the biotech sector in search of new products and technologies – and making biotech investors a lot of money in the process. Buyout premiums are at least 30%–50% when a big player scoops up these tiny companies.
Two days ago, subscribers to my biotech newsletter, Phase 1 Investor, reaped the benefits of this cherry-picking buyout trend directly. Except it wasn’t Pfizer (PFE) on the hunt this time... it was Pfizer’s rival, Merck (MRK).
Merck coughed up $1.1 billion for Sirna Therapeutics (RNAI), a stock we added to the portfolio in February. The $13 per share cash buyout was an overnight 100% windfall for Sirna investors – and a 200% total return for subscribers.
As you can see, finding these small buyout candidates is hugely rewarding... but very difficult.
While it takes a lot of time, travel, and research to find winners like Sirna, the gains in the biotech space are simply too big not to shoot for. Let me show you our four criteria for finding these stocks:
1. People matter.
We know the most important thing about any biotech venture is the people.
To give one example, Jean-Pierre Sommadossi, the CEO of one of our recent Phase 1 Investor recommendations, was directly involved in the development of almost every single early HIV drug. Sirna’s CEO, Howard Robin, spent 21 years at Schering. He forced the company to focus on RNA interference technology and saved it from bankruptcy.
I could go on. But the principle is clear: If you don’t know a lot about the guys behind your biotech investment, you’re making a big mistake.
2. Time the market.
Every Phase 1 Investor recommendation must be within three years of product revenue. We’ve found that buying these companies based on expected product revenue often allows us to get the company’s pipeline “for free.” More often than not, the market completely discounts the pipelines of early-stage companies. This is the big secret to small-cap biotechs.
3. Buy with a partner.
The other strategy we’ve developed to reduce risk is to look for small companies that already have a partner in place. The best situation you can find is where a Big Pharma company has agreed to pay for all of the development costs in exchange for the right of first refusal to market the product. These partnerships help reduce your investment risk significantly.
4. Be conservative – and then be more conservative.
It’s a fact of life in the biotech sector that most new products won’t make it to the market. And not every little company we recommend is going to be bought out by Merck.
That’s why, when we estimate the value of a new product with near-term revenue potential, we discount the future value by at least an additional 25% on top of the normal probability estimates for approval. This “double-discount” creates a larger margin of safety for us. We’ve learned the hard way – gambling in biotech doesn’t pay.
As a result of our research focus, we’ve managed to generate a consistent stream of investment results. We currently have nine recommendations. Seven are up significantly. Two are trading around breakeven. The average gain is now 46%.
And as Sirna investors found out this week, this four-legged approach can bring triple-digit gains.
Good investing,
Rob Fannon

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Oil Service 136.18 +1.5% +14.8%
Big Pharma 64.13 +0.6% -3.3%
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Semis 16.03 +2.1% +28.9%
Utilities 31.21 +0.3% +1.6%
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Nanotech 9.99 +1.3% +0.0%
Alt. Energy 9.95 +1.4% -4.4%
Water 18.31 +1.1% +12.2%
Insurance 16.07 +1.2% +18.3%
Biotech 20.58 +1.1% +27.1%
Retail 19.65 +0.1% +28.4%
Software 24.59 +0.9% +24.1%
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