Editor’s Note: This article covers a stock trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.
General Remarks on Our Approach to Biotechnology
First off, we should point out that when it comes to biotech, we are in the same position as any other layman with regard to the science: we have no special insight in that respect and depend on publicly available information and the judgment of experts. It struck us however that biotech research companies have a few things in common with a sector we know somewhat better, namely the mineral exploration business. Both businesses are capital intensive and have to deal with a plethora of regulations. Another characteristic they share is that the odds of success are small, but if success is achieved, the rewards can be quite sizable.
Obviously, both are also in the highest stages of the economy's production structure, which is to say that between the point in time when the first dollar is invested in a new venture and the date when a consumable product emerges as a result of this investment, a lot of time will pass. As a rule, more capital will flow into the higher stages of the production structure when interest rates are very low (to explain this in the simplest possible terms: the lower the discount rate, the more valuable capital goods that are temporally far removed from the consumption stage become on a relative basis).
Which sectors within the higher stages precisely will benefit the most from capital inflows due to low interest rates depends on contingent historical circumstances. As can be seen in the chart below, biotech companies have definitely been beneficiaries of the current low interest rate era:
BBH, the biotech ETF, weekly
Warning Signs for the Sector
The sector appears quite overbought by now, so one should not be surprised if a bigger correction eventuates in the not-too-distant future. On the other hand, there is as of yet no evidence of a trend change, although there are warning signs indicating things have become too frothy. One of them is sector asset allocation in the Rydex fund family. Although the amounts in Rydex funds are relatively small in the bigger picture, they represent a microcosm of sentiment and positioning that has historically proven to provide valuable information.Click to enlargeThe Rydex biotech sector fund. Assets in the fund currently represent more than 35% of all Rydex assets combined - this has traditionally at a minimum represented a short-term warning sign (and in some cases a long term one).
One must also keep in mind that the BBH ETF consists mainly of well-established, large cap businesses. Gilead Sciences (NASDAQ:GILD) has a 14.77% weight in it; Amgen (NASDAQ:AMGN) a 10.76% weight. In third place there is Biogen Idec (NASDAQ:BIIB) with an 8.67% weight, followed by Celgene (NASDAQ:CELG) with a weighting of 7.48%. A mere four stocks represent 41.68% of the ETF. These are also not really the types of stocks that interest us here - they do have significant research of course, but in these companies several stages of the production structure are vertically integrated, and they are certainly no longer primarily research companies. We are only showing this chart because it proves that the contingent environment of the current low interest rate era is indeed especially favorable for this sector.
Obviously, with the population of the developed nations aging rapidly, health care provision becomes an ever larger and more important part of the economy. So we have two major factors serving as tailwinds for biotechnology stocks at present: very low interest rates and the demographics backdrop, which provides the underlying 'story'.
It must be stressed that the broader trend of the sector is not overly important when it comes to the successes or failures of small companies focused on research. The returns delivered by these stocks depend mainly on whether they succeed in producing commercially viable new drug compounds.
Alzheimer Related Research
With these considerations in mind, we came across an article posted in February by Justin Gallagher, which summarizes the current state of research related to Alzheimer's disease (AD). He presents a concise digest of the scientific backdrop and also discusses a few investment opportunities in this space. Alzheimer's disease research appears an especially interesting sub-sector to us. For one thing, it is directly related to the aging trend, as the disease strikes elderly people. Secondly, it is an area in which no breakthrough in terms of treatment has occurred as of yet. In fact, it would be correct to state that currently, no actual treatment for the disease exists. All the drugs on the market today are focused solely on symptomatic treatment. The drugs that exist at the moment are therefore all worth improving upon. Thirdly, the FDA is expediting reviews of Alzheimer's drug related applications ('accelerated approval mechanism'). Another data point of interest, to put some numbers on how strongly illnesses producing dementia are growing in our aging world and how large the costs already, is: according to the World Alzheimer's Association the global cost of dementia is about $600 billion every year, and growing. By 2050, more than 115 million people are predicted to be living with dementia across the globe.
As Mr. Gallagher points out, for the big players in the industry that are currently selling drugs treating AD, like Pfizer (NYSE:PFE), Novartis (NYSE:NVS), Johnson & Johnson (J&J), Forest Labs (NYSE:FRX) or Eli Lilly (NYSE:LLY), this area is of course very interesting, but it represents just one of their revenue streams. Smaller players with an exclusive focus on this area of research are obviously far more risky investment propositions, but potentially offer much greater rewards. In fact, it would be correct to state that currently, no actual treatment for the disease exists. All the drugs on the market today are focused solely on symptomatic treatment.
Looking at Pfizer (PFE), which sells the drug that currently dominates the market for Alzheimer's drugs (Aricept/donepezil), it has a market cap of roughly $210 billion and $52 billion in annual revenues. Donepezil represents $4 billion of that revenue stream - a significant contribution to be sure, but not big enough to be a decisive factor in PFE's performance as an investment. PFE incidentally has done quite well in the bull market since the 2009 low. From the point of view of big companies like Pfizer, a breakthrough in AD drug research would of course be of the greatest interest, given the likely growth potential of this market.
As Mr. Gallagher discusses, there are two major strands of research at the moment: symptomatic treatment (which is incidentally what all the drugs that are currently on the market are attempting to provide) and research into drugs designed to prevent the disease, respectively reduce the disease's rate of progression. Virtually all the research centers on amyloid plaque removal, or the prevention of amyloid plaque build-up, as the build-up of the beta amyloid protein in brain cells is a major symptom associated with Alzheimer's disease (again, we refer you back for more details to Mr. Gallagher's article on the topic - there is no need to repeat all of this here). He presented two small research companies, Prana (NASDAQ:PRAN) and Anavex (NASDAQ:AVXL), both of which are involved in Alzheimer's disease modification related research. We will review both of these stocks as well and take a look at a few aspects he has not discussed in great detail.
Prana, 40.24m shares outstanding, market cap $419m
Prana is based in Australia and focused on research into neurodegenerative diseases, primarily Huntington's disease and Alzheimer's disease (it also studies Parkinson's disease, in a pre-clinical study funded by the Michael J. Fox foundation). The main thrust of its research concerns the connection between biological metals and the build-up of amyloid plaque, a treatment approach that has recently received a boost by a new independent peer-reviewed study as well as the successful conclusion of a phase 2 clinical trial focused on Huntington's disease. Prana's main product is the compound PTB2, which is intended to treat both Huntington's and Alzheimer's disease. The company is reasonably well funded (approx. $20m in cash per last quarter) and has executed well in recent years. It also has some revenue, stemming from subsidies granted by Australia in the form of so-called refundable tax offset plus a little bit of interest income from its cash holdings. The product pipeline and execution time line in terms of clinical trials can be seen here:
Prana's progress in terms of clinical trials for its main compounds
The phase 2b clinical trial of PBT2 for AD currently underway (named the 'Imagine' trial, details here) will be quite decisive for the company's future. In other words, much hinges on whether or not it is crowned with success. The results of the trial are expected to be released quite soon (within a month). The market is obviously expecting the company to continue to succeed, as it accords it a fairly hefty $419m market capitalization. Partly this is of course justified by the successes already achieved. Note in this context that similar to AD, there is a paucity of treatments for Huntington's disease as well. From a technical perspective, the stock has acted extremely well, but one must of course be cognizant of the risk posed by the imminent release of the results of the clinical trial. A recent article discussing the scientific background and the risks in some detail has been written by Michael Sacerdote, and it indicates that one should perhaps not expect too much from PBT2.
Looking at the stock's chart, we can see that it has been in a very strong uptrend last year, which has left it in an overbought condition. Currently, it is in a consolidation phase that will most likely take the form of a triangle, while the market awaits the trial results. Unfortunately, there is no way of telling beforehand which way it will break once the results of the trial are released - even good results may result in a 'sell the news' scenario for instance, if they are not seen as exceptionally good. Conversely, it is also conceivable that the market will cheer middling results on the basis that they still show sufficient promise compared to competing products. Our feeling is that with a market cap of $419 million, the company cannot afford to stumble at this stage, but we are frankly uncertain what the market would actually regard as a 'stumble'. Clearly though, expectations are by now somewhat elevated.
PRAN has performed very well and remains in an intact uptrend. How the current phase of consolidation resolves will largely depend on how the market interprets the upcoming results of the 'Imagine' trial, a phase 2b study of PBT2 on AD patients.
The weekly chart is interesting for mainly one reason: it shows that the market is willing to reward positive clinical trial results greatly even if they remain as of yet far removed from the stage when a commercially viable product emerges. This is especially so in areas that are seen as having extraordinary growth potential. While we cannot infer anything about PRAN's future from this chart (given that it depends on continued success and the uncertainties associated with this), it does show how the value of an intellectual property portfolio in the field can be enhanced over time by conducting successful trials, even relatively early stage ones. Importantly, shareholders have benefited greatly in spite of the fact that like every company engaged exclusively in research, PRAN had to repeatedly engage in financing activities that have diluted their holdings. In short, successful clinical trials are quite a powerful force in terms of value creation (of course, the general uptrend in biotech stocks has probably helped a bit as well, but as noted above, is unlikely to be a major factor when it comes to small research-focused stocks that have as of yet no sales).
This chart shows the initial news-related short term spikes, which have later given way to a steady, stair-step type advance as execution and successful trials proceeded. Obviously, the stock is by now overbought and reflects fairly elevated expectations. However, this cannot tell us how the market will receive the next trial results. The only recent indication we have is the reaction to the Huntington's disease trial highlighted on the daily chart, which was positive, but not overwhelmingly so. The AD 'Imagine' trial is definitely the more important one though.
Lastly, there is always a little bit of 'takeover premium' in stocks like PRAN - market participants are in other words according a certain premium for the growing likelihood that the trial results will be 'good enough' for a bigger company looking to enhance its pipeline
Anavex 37.64m shares outstanding, market cap $16.4m
After reading up on this company and looking at a short profile and its key data, we first checked if there were any obvious red flags and if the company is 'legit'. The stock's price has declined a lot since its early 2011 high, and AVXL will evidently need funding, as its current cash holdings don't suffice to see it through for very long at its (lately much reduced) burn rate. Also, it will need to fund the next stage of its planned clinical trials, and those are expensive.
At the moment, the company's greatest and only noteworthy asset is its intellectual property portfolio, especially the ANAVEX 2-73 compound aimed at Alzheimer's disease modification treatment (more on this further below). The company has a number of other properties as well, but this is without a doubt the one on which its hopes for success mainly depend. Given the obvious uncertainties over funding, the value the market assigns to the company's intellectual property is well below the 'sunk cost' of developing it (which amounts to close to $40 million by now, compared to a market cap of currently approx. $14 million). We hasten to stress that 'costs' and 'value' are of course both subjective concepts. In other words, by referring to the sunk cost we are not claiming that the IP portfolio should be valued at this cost; we are merely saying: this is the capital investment that has already occurred, and the 'waiting' that has already been performed, and hence does not have to be repeated. The main question is of course whether and how a different valuation can be achieved in the future.
Looking through the filings, we took note of the following: in July last year, the company cleaned up its balance sheet by means of a private placement that allowed it to convert open liabilities into equity. While this obviously diluted existing shareholders, it also resulted in the company surviving to fight for another day. Concurrently, a Chicago based investment company, Lincoln Park Capital, invested in the company and entered into a $10m financing commitment valid for three years. The company can issue shares to Lincoln Park at its own discretion. The agreement also contains an undertaking by Lincoln Park not to hedge its shareholding or engage in short sales of the common stock (this is frequently a problem when micro-caps get funding via private placements). Further details of these transactions and the company's balance sheet can be seen here: the official press release. Here is the link to the company's filings.
Moreover, a new CEO took over the reins at AVXL: Dr. Christopher Missling, who is probably exactly the person the company needed at this stage, as he has an extensive background in both the pharmaceutical and financial industries (he worked inter alia for Immunogen (NASDAQ:CFO), Aventis and Hoechst (Head of Financial Planning at both), and also at Deutsche Bank's corporate finance and investment banking department, where he was specialized in pharmaceutical, biotech and diagnostics companies).
Based on this information - and we caution readers that publicly available material forms the sole basis for our conclusions - we believe that the company is indeed 'legit' and has the means to carry on with its plans for now in light of the Lincoln Park funding commitment. However, additional funding will most certainly be required.
Moreover, there can be little doubt that ANAVEX 2-73 is a promising compound. AVXL has, for example, recently entered into an agreement with the well-regarded Roskamp Institute to pursue the development of ANAVEX PLUS, a cocktail of the 2-73 compound with Pfizer's Aricept/donepezil, which is believed to be an especially promising combination. It has also appointed a clinical trial design specialist to its scientific advisory board late last year, evidently in preparation for the next phase of trials.
According to the company, its plan is to perform a clinical phase 2 study (Phase 1b/2a) in Alzheimer's patients to confirm the efficacy of ANAVEX PLUS, possibly with a partner. Alternatively it considers taking on a partner after the study has concluded (we were informed of this after sending a query per email).
The results achieved by modeling the anticipated ADAS-Cog response of the cocktail (ADAS-Cog is a measure of memory improvement in patients) seem to be very encouraging (for details on this we refer you to this recent company presentation, pdf). This combination of drugs evidently has the greatest potential commercial merit of the company's patents portfolio, provided the necessary funding for the study can be obtained and the study confirms the results anticipated by the model. From a risk standpoint it is advantageous that such a trial would involve an already approved drug. In addition, encouraging news were recently received from an outside source in the form of a research paper published by Life Sciences. According to the study, so-called sigma-1 receptor (S1R) agonists (ANAVEX 2-73 targets the S1R receptor) significantly lower the risk of heart disease. This is important because elderly patients (and most Alzheimer's patients are elderly) are susceptible to heart disease as well.
However, we must caution readers that one can view the stock only as a kind of call option on the value of its IP portfolio at the moment. However, as noted above, it is clear that in order to pursue its plans regarding further clinical trials, more funding will be required (this is a task for which Dr. Missling seems to have the necessary competence based on his background). At present the company estimates it will have a monthly cash burn rate of approximately $60,000 ($180,000/quarter) without clinical trials, and anticipates this to rise by about $500,000 per month ($1.5m/quarter) once a new trial is underway.
You may well wonder whether further dilution (which is inevitable if the company is to succeed) means that the stock will be pressured further if/when fresh funding is indeed lined up.
This is actually not necessarily the case (as PRAN's example shows). Keep in mind that the market at the moment assigns a value to the company's IP that is well below the sunk cost and probably reflects none or only very little of the potential upside. The receipt of fresh funding would increase the chance of eventually monetizing the IP, and the market would likely revalue the stock upward in that event. In other words, post funding, the freshly diluted stakes in the company would likely become more valuable than the undiluted stakes were. This would be all the more probable in light of the compression of valuation that has taken place since the 2011 high in the stock. As the example of Prana shows, the mere fact that a trial is underway can already add some value, even if the outcome of the trial is still uncertain.
In fact, the inability to obtain the requisite funding was probably a main reason for AVXL's decline following the successful phase 1 trial completion in 2011. In short, the main risk is actually that no additional funding can be sourced. The potential reward is a distant prospect, but it could come in two stages: in form of a likely immediate revaluation of the stock price once funding is obtained and a trial commences, and a second stage thereafter, which will depend on the results of the trial. Positive results would make the company a potential takeover target.
With regard to the likely results, we cannot say with certainty what the predictive value of the modeled ADAS-Cog score is. However, the cortical network model employed has been successfully used by large pharmaceutical companies in a number of instances in the past to predict the efficacy and side effects that would later be revealed in clinical trials concerning a variety of drugs for the treatment of neurological diseases. So the modeled results at the very least add some degree of confidence to the potential outcome of a clinical trial (see also Mr. Gallagher's remarks on this point). Obviously, this will in any case only become relevant once funding for the trial is lined up.
Keeping all these caveats in mind, here is a look at the technical situation of this 'call option'. First we take a look at the weekly log chart. As you can see, the stock so far remains within the confines of a well-defined downtrend, but there are momentum divergences (price/RSI, price/MACD) forming on the weekly chart, which are often a precursor to a trend change.
AVXL weekly: the downtrend remains intact, but its momentum has decreased. Since the change in management and the announcement of the Lincoln Park agreement, there has been a considerable increase in trading volume.
On the daily chart, a sequence of two higher lows has recently been established. We have indicated on this chart where the next two levels of lateral resistance reside, as well as highlighting a day in early November 2013 which may have established a 'capitulation low' on an intraday basis (a sharp high volume sell-off, followed by a significant intraday rebound). This trading activity as well as the final leg down in November/December may well have been tied to tax loss selling.
The daily chart shows a certain degree of improvement lately. There are now two higher lows so far in 2014, with the first following on the heels of a bullish wedge that formed after the initial rally out of the December closing low. RSI is back above the 50 level and the MACD histogram is in positive territory. It seems likely that some tax loss related sales taking place late last year were reversed early this year. Note however that there exists significant overhead resistance both laterally and from the trendline shown on the weekly chart.
Note that these technical considerations are independent of the fundamental situation. The technical picture can be said to be improving, but the evidence is only tentative so far. The real test is still ahead - the question is obviously whether resistance can be overcome. We suspect that this is likely to happen if/when the company succeeds in starting its planned phase 2 trial.
Obviously, AVXL represents a highly speculative and risky investment proposition. On the other hand, if one simply looks at it as a call option on the successful monetizing of the company's IP, then the current depressed market cap represents a considerable counterweight to this risk.
There can be little doubt that there is great opportunity in finding new drugs for the treatment of neurogenerative diseases that are producing dementia. Alzheimer's disease especially has become quite a scourge, and apart from the terrible emotional burdens it imposes on patients and their families, its costs to society at large have exploded and continue to rise. So far, no breakthrough treatment exists, which means that there is a very large potential market for companies that find more efficacious drugs. This article is best seen as a companion piece to Mr. Gallagher's article from late February. We want to stress that it does not constitute a recommendation on way or the other, we merely wanted to shed light on a few aspects that were not discussed in the earlier article. It should be stressed once again that while there is great potential opportunity in small cap biotech stocks, there is also great risk: from the ability to attract funding to the outcome of trials, uncertainties abound. Nevertheless, in a time of extremely low interest rates (always keeping in mind that they are artificially suppressed by the central bank), it is generally a good time to look for opportunities in the higher stages of the economy's capital structure, which will tend to attract more capital. However, be also warned that once interest rates begin to normalize, relative prices will shift in favor of sectors closer to the consumption stage and many firms in the higher stages could find themselves in trouble.
Chart sources: Stockcharts.com, Sentimentrader.com, Prana Inc.
Disclosure: Currently I own none of the stocks mentioned in the article, but I am considering investing in the sector over the next two to three months, including the stocks discussed in the article (depending on the upcoming news flow).