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Thesis

Investing in the speculative biotech sector isn't for the faint of heart, but the payoffs can be huge, especially given that the risks are typically priced into the shares. Speaking as someone who has followed the small cap biotech space for 5+ years, I actually believe it's easier to get heads on a coin toss 4 times in a row than it is for a development stage company to reach the post-clinical phase. Not only is the developing and testing an incredibly lengthy process, but also incredibly costly; compounded by the fact that each clinical trial phase typically represents an all-or-nothing binary event that can easily make or break a promising company.

In a previous article, I discussed the inherent volatility of the biotech sector. I analyzed the opportunities ("fallen angels") that resulted from the market's tendency to overreact, resulting in an identifiable trend for identifying future opportunities. This time, I'd like to draw focus to another trend salient to the sector: the market's inability to price future catalysts into the share price of micro to small cap biotech companies. I plan on doing so by illustrating the information arbitrage opportunities that have resulted from what I perceive as biotech market inefficiencies. More importantly, by doing so, I hope to demonstrate why I believe an information arbitrage opportunity is present in Sanuwave (OTCQB:SNWV), even after its recent run from ~80cents/share to the ~$1.30/share region.

Market (In)Efficiency

Since the advent of modern finance, the concept of an efficient market has the topic of fierce debate. An efficient market is predicated upon the notion that investors have accurately priced share prices. As such, within such a market, a company's valuation is a direct reflection of all information. In essence, eliminating the possibility of both volatility and excess returns.

For better or for worse, I'm sure you agree when I say this isn't the case. Given the absence of psychic investors, underlying uncertainty in proposed valuations have lead to market volatility. However, what if we had perfect information? Even then, assuming the existence and availability of perfect information, the inherent risk of investors overlooking or misinterpreting information would continue to remain - resulting in the various degrees of inefficiencies within the market.

Going further, the actions taken by these irrational or shortsighted investors strangely tend to be self-reinforcing… As a result, when a certain critical mass of investors creates the illusion of market opportunity, it simultaneously catalyzes the introduction of self-substantiating volatility as investors scramble to reallocate their equity in order to turn a quick profit.

Now, why does this occur? This can be answered by looking at what constitutes information in the market… Everything. Beyond the obvious, such as quarterly filings that provide a breakdown of the company's financial strengths, it's incredible to see how easily share prices are affected by minutiae such as the appearance of certain charts and rumors.

The aforementioned details, in conjunction with the advent of financial technological platforms that have accelerated and broadened the availability/visibility of real-time share prices and volume, have unfortunately resulted in the alarming proselytization of myopic profiteering particularly within the biotech investing community.

Does Market Efficiency Exist For Biotech?

If it can be said that the market as a whole displays some inefficiency, what are the implications for a particularly volatile sector such as biotech?

I believe there's a huge amount of market inefficiency for development stage biotech companies, here's why:

  1. Unlike the majority of companies that file with the SEC, development stage biotech companies typically have very little information that indicate their financial strength on their quarterly filings. Given that pre-revenue companies are racing to get a product to market, the only two metrics that typically matter to investors are cash on hand and how quickly that money is being spent.
  2. Due to the nature of said filings, most investors must rely on other scant sources of information, typically revolving around share price, market valuation, and chart behavior. Because a large percentage of investors must rely on technical analysis for pre-revenue companies, investor consensus for the valuation of a company is tenuous at best.
  3. In lieu of concrete financial information, many investors tend to adopt the trading methodology stated in my earlier article, "Buy the rumor, sell the news." This not only results in the volatile swings present in development stage companies, but also lends to biotech's image of being easily manipulated.

Now if you've followed along carefully, you should have noticed that reasons 1-3 strictly identify the causes of volatility, but remember, inefficiency implies the existence of a fair valuation. The reason I believe there's a disconnect is as follows:

  1. Despite the fact the lack of financial metrics (that are typically utilized to valuate a company) for development stage companies, I believe this is more than made up for by other information the company will release during the development of their product. This information will almost always include: what market(s) their product(s) will address, pre-clinical and clinical data, an expected date for ultimate approval, and a mechanism of action.

From those key pieces of information, a conservative valuation can be extrapolated by looking into the dollar amounts of their target market and competing standards of care and by subjecting the figures to a discounted cash flow model. These DCF models can price the inherent risk into the valuation by typically assuming a generous 25% discount rate in addition to typically assuming a 1-10% market penetration.

However, this is far more due diligence than typically done before the initiation of a position. Moreover, due to the typically highly technical nature of the information, many investors without a solid background in biology/biotechnology are often unable to establish an initial sense of the future efficacy/safety profile of the product - the core determinant for future success. As a result, detailed research of these development stage companies are often left to analysts that typically cover the biotech sector. This unfortunate reality leads to the information arbitrage opportunity mentioned earlier:

"What I quickly learned was that most small cap and micro-cap companies are kind of 'orphaned' and that there is a tremendous information arbitrage. The big hedge fund managers whom I provided coverage for in my previous life showed no interest in small names where I saw opportunity. They were too small, too illiquid, lacking analyst coverage and institutional shareholders, or just 'too early'. The famous line was "call me back when it gets to a billion dollar market cap." I heard this over and over again. So I realized that if you could find a gem in either a small or microcap company, there was tremendous opportunity there."

As stated by Menachem Kranz, the thin exposure that many development stage biotech companies are faced with, result in a series of consequences such as undervaluation, illiquidity, but most importantly a lack of reliable financial analysis. As a result, for the many biotech companies that happen to fall under this umbrella, the upside/risk ratios are typically improperly priced into the securities, resulting in an informational arbitrage opportunity.

By being able to identify discrepancies (the home-run potential) between the upside/risk ratio and the valuation of a company, one can invest into a biotech company prior to the resolution of the discrepancy. Upon resolution, or the introduction of several catalysts, a cascade effect can be seen: where an initiation of analyst coverage often results in a large influx of liquidity and share price appreciation, at which point the upside potential is priced out of the company.

For better or for worse, these discrepancies are especially large within the biotech space. Consider Netflix (NFLX); even after reporting a monstrous quarter that blew past earnings estimates last night, share prices appreciated 24% from the $170/share region to the $210/share in after hours trading. Although double-digit returns are nothing to scoff at, I would venture to say that a large portion of upside was already priced into the share prices, especially considering its 6-month rally from the $70/share range.


(Click to enlarge)

Informational Arbitrage in Biotech

Why is it that two and three-baggers are considered normal returns for winners within the biotech space, but more importantly, why do these massive rallies occur within such a short period of time? Shouldn't a large portion of these rallies be already priced into the company?

This is a direct result from the shortsighted, rabbit-like behavior of biotech investors. The growing trend of momentum based trading within the sector has lead investors to become reactionary traders instead of proactive investors. This can be easily ameliorated by looking at a company's upcoming catalysts as points of value inflection. These upcoming catalysts, such as preliminary data from clinical trials, initiation of said trials, capital raises, and etc. can be viewed as potential informational arbitrage opportunities for investors looking to appreciate from biotech market inefficiencies.

I'll illustrate how these arbitrage opportunities operate by analyzing how two companies' share prices responded to key catalysts: Acadia Pharmaceuticals (ACAD) and Sarepta Therapeutics (SRPT).

Example 1: Acadia Pharmaceuticals

Acadia, looking to address the multi-billion dollar Parkinson's Disease Psychosis market with its lead Pimavanserin compound, was until recently, stuck in the mid dollar range. Investors, afraid of both the volatility of the biotech sector and the lack of information, were afraid to be the first person to dip their feet into the pool, so to speak. The chart is a picture perfect example of how informational arbitrage opportunities operate within the biotech space.


(Click to enlarge)

The two massive rallies displayed on the chart directly followed the release of two major catalysts:

  1. The reporting of Acadia having met Primary and Secondary endpoints in its pivotal Phase III Pimavanserin Trial
  2. Acadia's announcement of an expedited path to NDA (New Drug Application) Filing after meeting with the FDA

These announcements are similar to Netflix's earnings beat in that they served to confirm a positive outlook for the company. However, why did Acadia's share more than double within the span of two days (Nov. 26-28 2012), in contrast to Netflix's ~30% (Apr. 19-23 2013, after-hours figures utilized)? This is because investors fail to factor in future catalysts into their valuation of biotech companies.

I'd like to point out that the first catalyst could've been anticipated, especially given the data. Acadia completed enrollment for its Phase III trial for Pimavanserin in early September of 2012. Moreover, Acadia reported far in advance what topline results should be expected for the end of November. Typically when a drug undergoing clinical testing fails to demonstrate efficacy and/or patient safety, the clinical trial will be cut short in order to both save money and ensure patient safety. The nearly three-month period of testing between the completion of enrollment and the announcement of endpoints being met, is a positive bellwether in my opinion, and should've been a buying catalyst for investors.

Example #2: Sarepta Therapeutics

A similar case presents itself in Sarepta. Granted, Sarepta is an amazing case, having appreciating just below 3600% in the past year alone.


(Click to enlarge)

Sarepta, a recent sweetheart of the biotech sector, wasn't always loved. Until July, shares of SRPT barely traded above $2/share for a good 4-5 years, and it's easy to see why: there weren't any catalysts for investors to react to.

Following Sarepta's name change and reverse 1-for-six reverse split, the company released positive topline clinical benefits for its lead Eteplirsen compound. Their drug is an orphan drug designed to treat patients with a rare and devastating disease called Duchenne Muscular Dystrophy. Despite the release of positive data and the following appreciation from the $7/share to the $16/share region, it becomes clear that investors again failed to price in the upside/risk ratio, especially when considering the massive rally to $44.93/share after Sarepta reported that its Eteplirsen compound met the primary endpoint of its Phase IIB study in early October.

Given the opportunities created by the inefficiencies within the biotech sector, it's about time investors snapped out of their short-term mentality in favor of looking toward future catalysts for appreciation.

How Sanuwave Demonstrates Potential for Continued Appreciation

Sanuwave is a company I've covered several times, and given the upcoming catalysts, I believe an informational arbitrage opportunity currently exists. Sanuwave, like the aforementioned biotech companies, falls into the development stage category. Currently in the medical device space, its lead dermaPACE product seeks to address the $2 Billion market opportunity for diabetic foot ulcers, a debilitating complication from diabetes that often results in amputation.

What excites me about the medical device company is that it's about to reenter a Phase III clinical trial much like Acadia recently did. In doing so, major catalysts associated with the pivotal trial will also debut. However, the future catalyst or the value inflection point that draws my interest is the completion of patient enrollment, which is expected at the end of this year. There are several points to be made regarding this upcoming catalyst.

Sanuwave's second Phase III clinical trial, while similar to Acadia's in that both demonstrated efficacy in their first Phase III trial that failed, is interesting in that it can be viewed as a follow-up study to its first trial. This is demonstrated in the structure of its second trial (as stated in its 10-k filed on 3/26/2013), where not only will 90 patients be enrolled on a rolling basis (while the study is currently being conducted), but given the efficacy and safety profile demonstrated in its previous trial, the FDA has allowed for the usage of Bayesian statistics such that upcoming data from the new Phase III trial will be allowed to be appended onto the results from its previous trial. This will presumably result in an accelerated Phase III trial.

Moreover, the new Phase III study (slated to begin enrollment this quarter),

"allows for controlled interim monitoring of the data by an independent Data Monitoring Committee ("DMC") to determine whether study success has been achieved…. If study data achieves pre-defined statistical and clinical success criteria associated with wound closure favoring dermaPACE, then the clinical trial can be stopped, and we will submit a PMA for approval. The controlled interim monitoring plan also includes a provision for DMC review of data prior to enrollment of the 90 subjects."

In other words, this looks to be the catalyst that won't stop giving. The independent DMC will allow for transparency of clinical trial data, providing an ongoing status report on the efficacy of Sanuwave's dermaPACE device. As a result, provided efficacy can be demonstrated, investors should expect a clear-cut report with top-line data by the end of 2013.

What risks can be expected?

As stated in all my articles, there are inherent risks involved in the biotech space, particularly within development stage companies. The two most salient risks are financing risks and clinical trial risks. As with all development stage companies, the limited amount of cash on their balance sheets result in the race to complete the development, testing, and marketing. Therefore, companies typically must conduct another round of financing to complete their goals. Unfortunately, this can be exacerbated when companies are illiquid and are unfairly valued by investors.

Fortunately, Sanuwave, similar to Acadia, has enough money to continue testing until its next major catalyst (enrollment completion). In regards to the clinical trial risks, Sanuwave has demonstrated a strong safety profile in its previous clinical trial. In addition, the FDA's concession for Bayesian statistics and the implementation of the independent DMC leads me to believe that in contrast to the strong binary hit-or-miss nature of clinical trials, Sanuwave has broken down the singular event into many smaller binary hit-or-miss events that distribute the clinical trial risk over a period of time with the structure of its new Phase III trial.

What Is The Level of Informational Arbitrage Opportunity for SNWV?

Provided that Sanuwave behaves anywhere remotely similar to Acadia and Sarepta did in response to its catalysts, I have reason to believe that despite Sanuwave's recent rally to ~$1.30/share, shares continue to demonstrate potential to appreciate significantly in light of the upcoming inflection point that has major consequences for Sanuwave's valuation. In fact, with the massive opportunity present within the diabetic foot ulcer space, where even 4x valuation multiple to a 1% sales penetration nets a valuation of $80M, in addition to the majority of warrants priced above $3/share, I believe that a huge level of discrepancy exists between the upside/risk ratio and market valuation for Sanuwave. For biotech investors looking to invest beyond volatile short-term gains, I recommend playing the market inefficiency by holding Sanuwave, a company that stands to benefit greatly as it gains visibility from significant catalysts expected over the next year.

Source: Analyzing Market Efficiency: Why Future Catalysts Imply Sanuwave Still Has Room To Double