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Biotech Volatility and The Two-Word Abstraction

The Biotech sector is incredibly speculative for a good reason, a large majority of biotechnology investors use the staple methodology: "Buy the rumor, sell the news." This plays into the wild volatility evident in the up and down swings that occur regularly in any given week of trading for a micro to mid cap biotech company, where 10-20% fluctuations in the share price are considered nothing out of the ordinary. And it's for this very reason that investors are drawn to biotech equities, the monster return always seems to be just around the corner.

However, there's a two-word phrase that really throws fuel into the fire: "FDA approval/denial." As soon as those two words hit the market, one can expect an immediate surge of volume as investors scramble to purchase shares to ride the wave up, or rush to dump their shares so they aren't left holding the bag.

It seems obvious, clear-cut even, but there's something entirely strange about how the market reacts to the two-word catalyst. Without regard for the underlying fundamentals or future valuation, tens, if not hundreds of millions of dollars in value are sheared from or appended to the company in a moments notice. The binaristic outcome catalyzed by the "FDA approval/denial", although logical on an individual investor or "micro" level, is highly illogical on the "macro" level.

In a way, the biotech market is a highly iterative, but clear example of the "mass mania" written about in "Extraordinary Popular Delusions and the Madness of Crowds" by Charles Mackay.

"Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one." - Charles Mackay

The simple reductionist quality of the two-word phrase must be viewed as an abstraction, one that needlessly devalues promissing companies. However, there is an upside: savvy investors have profited by investing in these "fallen angels", whose share prices were irrationally depressed by the erratic mood swings of trigger happy biotech investors.

What exactly is a Fallen Angel in the Biotech Sector?

The dreaded "FDA denial" can crush a promising biotech company, resulting in a precipitous drop in share prices, often far below the fundamental value of the company (comprised of intellectual property, strong management, etc.). As a result, massive sell offs in biotech companies resulting from herd mentality often constitutes a bullish opportunity.

Given that the sell off typically results from the disconnect between investor expectations (prior to the denial) and the current status of the company's pipeline (post-denial), the former highs of the shares can be seen as a realistic expectation of what the shares can be expected to return to, provided that the company continues to operate and makes another attempt in receiving FDA approval.

Therefore, what was initially a ten-fold drop in market capitalization now represents a ten-bagger opportunity. These "fallen angels" in the biotech space are the companies investors should be looking for.

Former Biotech Fallen Angels, and SanuWave, A Current Fallen Angel

It's my firm belief that the methodology to employ, when investing in speculative biotech companies, is to identify the patterns common to development-stage businesses in order to contextualize the opportunities present within the sector. Last week, I wrote an article about SanuWave (OTCQB:SNWV), a medical device company about to re-enter phase 3 clinical trials after receiving FDA denial in 2011 for dermaPACE, a shockwave therapy device that accelerates wound healing with possible broad applications. This week, I'd like to contextualize SanuWave as a current biotech fallen angel by drawing some parallels between it and other companies that recovered after receiving their initial FDA denial.

Such companies include but are not limited to: Acadia Pharmaceuticals (ACAD), Keryx Biopharmaceuticals (KERX), Navidea (Formerly Neoprobe) (NAVB), Vivus (VVUS), and Arena Pharmaceuticals (ARNA). For the purposes of this article, I will identify the pattern that typifies a biotech fallen angel by examining the story and timeline of Acadia, Keryx, and Arena, and illustrate how SanuWave may be following the same cycle.

The First Case: Acadia Pharmaceuticals

Let's start with Acadia's chart:

(click to enlarge)

Acadia stands as a prime example of what I consider to be a former fallen angel. Here's why.

Before plummeting from its former highs of $14-16/share, investors waited on bated breath for the FDA's verdict on Acadia's lead product, Pimavanserin. Pimavanserin promised to answer and profit from the 25 Billion dollar market opportunity for Parkinson's Disease Psychosis (PDP). However, when Acadia failed to key endpoints of the clinical trials in 2008, its valuation tanked, sending it biotech limbo between $1-2/share.

Despite their initial failure of FDA approval, the management at Acadia continued to move forward with the same compound, which brings me to the first point I'd like to make in spotting a biotech fallen angel:

Failure to gain FDA approval does not imply that the underlying intellectual property or the drug are/were valueless. Moreover, when a company decides to continue moving forward with the same compound or similar compound, despite receiving FDA denial, chances are there's something there.

Acadia made a new attempt at FDA approval in 2012, and their release of very positive results in their Phase 3 clinical trial of Pimavanserin, lead to a surge in buying, driving shares to $5+ trading range. The breakout on high volume seems to imply that Acadia is and will be continuing to trade higher until it reaches its former $14-16 range, the high water mark of where investors previously valued it when they expected FDA approval. Acadia's former low of $.70/share in 2010 in comparison to its current share price of >$7/share, Acadia exemplifies how "rational" investors will oversell a company following an FDA setback.

The Second Case: Keryx Biopharmaceuticals

Keryx is another biotech company that fell from grace, only to rally back when investors began hearing the music. Let's start with the chart:

(click to enlarge)

It's surprisingly similar to Acadia's chart shown earlier.

I'm sure many of you have heard of, or may be following Keryx already, but I'd like to briefly recap to provide some context. The Keryx story is the typical story of a fallen angel. When Keryx failed to receive FDA approval for their drug, Sulonex, for Diabetic Nephropathy (Kidney Disease caused by Diabetes) in 2008, shares tanked from their $18/share highs to drastic lows, bottoming out at 11 cents a share.

Despite this failure, management pivoted quickly by promptly cutting their cash burn in order to fast track another drug that was on their pipeline: Zerenex. Keryx's new lead product can be seen as a continuation of their failed Sulonex drug, in that it still targetted the kidneys. But more importantly, Zerenex, a compound that promises to help elevate the standard of care for patients with end stage renal disease (ESRD) had a much larger market opportunity ($40Billion).

But here's where I believe Keryx diverges slightly from the typical fallen angel company. Starting from 2009, investors began to look past the biotech stigma of being formerly denied by the FDA and began to acquire shares of the promising biotech company. After trading back to a $4-5 range, a shareholder class action lawsuit drove the shares back down to the $1-2 region. Fortunately for Keryx, they achieved very positive results from their long-term phase 3 study for Zerenex.

As with all biotech companies, the release of positive results brought back the bulls, leading to an analyst at Roth Capital to put a price target from $7 to $15/share. More visibly, shares of Keryx rallied from $3/share to over $7/share in less than two weeks. I'd like to contextualize just how irrationally oversold Keryx shares were following their FDA denial by pointing this out: If an investor purchased shares of Keryx when they bottomed out in 2009, they'd currently be sitting on a 6200% unrealized gain...

The Last, But Certainly Not The Least Case: Arena Pharmaceuticals

I saved the best example for last, Arena Pharmaceuticals, the ideal example of a redeemed fallen angel.

(click to enlarge)

I think the chart speaks for itself, but I'll elaborate.

Maybe you were one of them. The investors who watched with widened eyes in 2010 as Arena more than doubled from $3/share… to $7/share on rising expectations of an imminent FDA approval. Unfortunately, that wasn't the case for Arena and their shares belly flopped to ~1.60/share. I can fully understand why, what investor wouldn't be excited for a company that promised to release the first approved weight loss drug in over a decade... for a condition that was widely becoming more prevalent?

So when share prices hit the floor (dipping as low as $1.26), prudent investors waited out the calm, only to be handsomely rewarded when the FDA approved Belviq in 2012, which drove the shares as high as $11.18/share before consolidating at a very respectable $8-9 trading range.

Mass hysteria appears to typify the behavior of investors looking to invest in the biotech market, and for better or for worse, this seems to lend to a cyclical pattern when examining micro to small cap biotech companies. As always, it's a matter of timing.

A Fallen Angel You Should Consider: SanuWave

I believe there's a distinct pattern at play that's readily apparent when gauging former and current biotech fallen angels, so which company is still on the ground?

I believe its SanuWave, here's the chart:

(click to enlarge)

And here are the reasons why(Basis for the reasons can be read in my previous article):

  1. SanuWave's chart and story conforms to the typical fallen angel pattern. The recent run up from 20 cents a share to north of 80 cents on low volume is remarkably similar to the small run up (relatively speaking from a big picture perspective) that usually prefaces the massive run up that occurs from positive news or FDA approval.
  2. The market opportunity for SanuWave's device is huge, with $1.2 Billion spent on Diabetic Foot ulcers, and Diabetes expected to affect 438 Million individuals by 2030, you can expect the market opportunity to continue growing.
  3. SanuWave's PACE technology can be applied to a variety of other markets such as broad wound healing, orthopedics (bone fractures, arthritis, tendonitis), plastic and cosmetic surgery, and ischemic heart disease. Resulting in continuing and growing streams of revenue as SanuWave continues to gain meaningful attention.
  4. The FDA has allowed for a second run at the pivotal phase 3 study. Moreover, in response to the positive results from SanuWave's first attempt, the FDA has allowed for a modified, somewhat accelerated, and transparent Phase 3 trial.
  5. Because the redesigned trial allows for a portion of the data from the previous trial to be appended onto the upcoming trial's data, this will accelerate the pre-market approval process.

As with any biotech, let along nano-cap equity, there are a number of systemic risks involved and factors to consider before investing in SanuWave. The most salient risk to consider is the possibility that SanuWave may fail to meet critical endpoints in their second phase 3 clinical trial, which is slated for Q2 2013. Another risk to consider is liquidity, given its current "fallen angel" status, which tends to result in thinly traded stocks. Equity dilution is also a key factor to consider, the $2Million bridge financing completed in February seems to imply that SanuWave may conduct an offering in the future in order to finance clinical trial costs, as well as any other costs that may appear. Finally, even if SanuWave possibly receives FDA approval, the final factor to consider is product adoption, as marketing can be very costly for a fledgling biotech corporation. If you decide to initiate a position, I strongly recommend you conduct your own due diligence (which should be a given in the first place), their SEC filings can be read here, in addition to company literature located on their site.

Given SanuWave's high water mark of $5.72/share in 2011 in comparison to its current trading range of roughly 80 cents a share, I believe it's still undervalued despite its recent appreciation from the 10-20cents a share bottom. In my eyes, it has all the markings of a biotech "fallen angel", especially when you consider its market capitalization of roughly $17 Million. An laughably small figure when you consider its current status in the clinical trial process, but again, risk is an inherent feature of the biotech market.

Ben Graham, the father of value investing said this of the stock market:

"In the short-run, the market is a voting machine... reflecting a voter-registration test that requires only money, not intelligence or emotional stability - but in the long-run, the market is a weighing machine."

It's a perfect description of the biotech sector.

Source: Biotech's Fallen Angels: Identifying Irrational Market Behavior