Technology advances in medicine and biology are producing widespread benefit prospects for human health and longevity. For most people in advanced and even emerging societies, such developments are high on the priority list of disposable income allocations.
That attracts both venture capital attention and secondary investor attention. The former tend to have fairly good search and comparison resources. The latter, not so much. A useful current example is Celgene Corp. (NASDAQ:CELG)
Getting the best help available anywhere
One productive source for individual investor wealth-building improvement is to utilize the information gathering systems and skills of the volume market-making [MM] community. In order to provide market liquidity at the scale demanded by their big-money clients, the MMs must frequently put firm capital at risk to complete the other-side-of-the-trade complement necessary to "fill" the client's usually urgent orders.
Despise is an inadequate adverb to help describe MMs' attitude toward risk. They react to risk by developing exquisite skills in the art of hedging and arbitrage, so as to make sweet profit lemonade out of most of their risk-involving encountered lemons, collectively numbering in the thousands a day.
What they are willing to pay to avoid the price change risks they perceive as block-trade market-makers (or demand to be paid to take on the same as prop-trade desk protection sellers) and the way they require such deals to be structured, tells just how far that very knowledgeable community thinks issue-by-issue prices may get pushed. Both up and down.
We analyze their intelligent, highly motivated behavior daily on some 2500+ stocks, ETFs, and market indexes, including over 175 in the pharmaceutical and biomedical industries. Using that information, the following visual comparisons are pictured below. The distinguishing border line between the two groups is indistinct, so no marked difference is intended between inclusion in one picture or the other.
(used with permission)
These maps plot on their horizontal (Reward) scale the percentage difference in price between the subject's market quote at the time of its near-future forecast and the top of that forecast's price range. Near-future means less than 6 months, typically 2-4 months.
The vertical (Risk) scale, instead of being a forecast, draws from actual experiences from prior forecasts for the subject, where the balance between proportions of upside vs. downside had been similar to what is being seen at present. The risk measure extracted from those prior experiences is the average of each forecast's worst-case price drawdown during the 3 months following the forecast date.
So, on these maps, exactly the same kind of risk-to-reward tradeoff is being measured in the same way, regardless of size of company, extent of its resources, or skill sets. What matters is what is being expected now (by extremely well-informed market professionals) for reward prospects, as conditioned by prior actual price change experiences specific to the subject. Good buy candidates tend to be found to the lower right of the maps. The green area contains prospective buys showing Reward-to-Risk ratios of at least 5 to 1. Ones above the diagonal dotted line, where reward and risk have equal measurements, may be regarded (in terms of the tradeoff) as inferior long positions in comparison to others below the line.
What could be unfortunate comparisons in these pictures?
One unequal dimension in the above tradeoffs has to do with the number of risk experiences seen previously that were similar to the present-day forecast of upside-to-downside proportions. A single observation may show up for one subject's history, where dozens or even hundreds of priors were involved in measuring the average price drawdown of another.
The table below lays out in more detail how those risk averages were compiled, along with other interesting (and selectively useful) information.
The MMs' price range forecasts, implied from their hedging activities, are in the first two columns, followed by the market quotes at the time of forecast. We test the usefulness of the forecasts by a simple, time-efficient discipline: Pit the Price Now cost of a buy against the top of the forecast range as a sell target, to be captured at the first following end-of-day opportunity, or taken at the end of 3 months if not previously achieved. That Sell Target Potential is the upside percentage forecast price change seen possible, even likely.
The column next to that reward prospect measures the agony that may need to be endured on the way. It is the average of the worst-case price drawdowns experienced in each of the prior forecasts of the past 5 years that had upside-to-downside proportions like those now seen. This where the uneven comparisons referred to above arise.
We calibrate each forecast by its upside-to-downside prospect proportions. The measure used is called the Range Index, and it tells what percentage of the whole forecast range lies below the market quote on the day of the forecast. The column headed Sample Size indicates how many (days) forecasts of any RI size are available in the past 5 years as the larger number, and the count of those similar to the present Range Index is the smaller number.
Every equity investment candidate has an array of Range Indexes, and investor perceptions cause significant differences in their distributions. Typically, there is a central tendency to RIs, with frequency diminishing as the extremes of experiences approach. The last 3 items in the table above have current forecasts producing RIs that have not previously been encountered, so we have no data to work from. That does not invalidate the forecasts, but it does deprive us of some potentially reassuring (or disturbing) decision-supporting data.
Sample sizes less than 10-15 are statistically too weak to rely upon, particularly when capital may be put at risk. This should always be considered in making investment choice decisions.
Another item in this table that relies importantly on the sample are the Win Odds, that proportion of the sample that either reaches the sell targets, or is closed out at the end of 3 months at prices higher than the initial cost. The %Payoff is an average of all gains and losses in the sample, and can be impaired by too small a sample, as can the average number of market days that the average holding has experienced.
Well then, what is known about Celgene?
Starting with the sample size, its 26 prior experiences over a nearly 4-year period should provide reasonably reliable comparative data. Most importantly, all 26 of those times, CELG stock either reached its sell target or closed 3 months later at a price average 9.1% higher than its beginning price. It took 50 market days, or ten weeks to get that to happen in the average case, so in combination with other positions over a few years, the gain could be compounded a bit more than 5 times during one year's passage (and investment) of time. That is how (and why) the average annual rate of gains of +56% is shown.
That +9.1% %Payoff average of gains following prior forecasts with RIs of 26 was not as large as the current upside sell target of +12.4%, so the present prospect's credibility is suspect to the extent that only 0.7 of it is represented by the size of prior gains under similar forecasts. Since the upside 74% of the range now was also the 74% of the ranges then, what is implied is that the uncertainty of the range now is larger than it was in the past.
This does not mean that the present forecast is less likely to be achieved, just that it may occur in more volatile surroundings. The MMs' forecasts, remember, are their best judgments of what is both possible and likely to occur, both at past points in time and at the present. It just seems more comforting to the typical observer to know that present-size forecasts have actually occurred in the past.
That comfort is provided handsomely in Regeneron Pharmaceuticals (NASDAQ:REGN), where the present upside Sell Target of +13.7% has been accomplished in nearly double amounts, as shown by its Credibility Ratio of 1.8. Moreover, those gains of +24.6% were each achieved in only 20 market days, or 5 weeks, producing a fantastic 4-digit annual rate of return. But then, REGN's gains only numbered 5, during 5 years. They could have been the result of brief, abnormal stretches of time in those years, or just infrequent, rare opportunities. Personal judgment and preferences will color the investors' balance in considering these kinds of issues.
A contrast of CELG with Jazz Pharmaceuticals (NASDAQ:JAZZ) now sees a larger upside prospect of nearly +16% for JAZZ, and prior similarly-proportioned forecasts at least as great in number for CELG. And JAZZ's average gains of over +14% were captured in shorter holding periods of only six weeks and a day, resulting in substantially greater annual rates of wealth accumulation. An offset here is that CELG, at its current RI, had no losing experiences in our standard test, while JAZZ had one outright loser among its 27 prior similar RIs.
The absence of any losers among test experiences is no guarantee against future losses, just a strong reassurance that loss experiences may reasonably be considered a less-than-frequent occurrence. Like maybe, one out of 27.
Where CELG may be considered at a disadvantage to JAZZ is in the Reward vs. Risk comparison. CELG: +12.4 to -7.7%, or a 1.6 ratio; JAZZ: +15.9 to -2.8%, a 3.5 ratio. Still, this is not a tragic or "deal breaker" situation for CELG. In the Reward vs. Risk Tradeoff maps that started this article, JAZZ is at location  in the first map, and CELG is at location  in the second one. Compared to the bulk of the alternative candidates for investment, both stocks have enviable positions. It's just that JAZZ is better.
And then there's Questor Pharmaceuticals (QCOR), with a MM-perceived upside of over +19%, that has achieved essentially those-sized gains over 100 times in the last almost 4 years, with winners coming up 92% of the time. Sounds sort of promising, given that the average-worst emotional stress encountered in the processes was only -6%, not even a third of the % Payoffs.
Plus, the quality item of the industry, Biogen Idec (NASDAQ:BIIB), with a 93% win rate on a current +14% upside prospect, has a history of like forecasts returning over +11% on dozens of opportunities, to provide annualized wealth increments at a +94% rate.
Not to mention The Medicines Company (NASDAQ:MDCO), that under current market duress, is priced at only 4% of its full price range above the bottom of that forecast, to provide an appealing upside prospect of +18%. It's only been this cheap 7 other days out of the last 5 years - is it on the sale rack?
Guys, learn something from the gals who spend so much time in the stores. They're not just spending, their recreation is shopping. You might benefit from their instincts and training. Your "store" is the "market." More time spent shopping between various goods in the same line of satisfactions may up your sense of achievement in the same way that they get turned on by finding a "$400" handbag on the clearance table for only $38.
But ya gotta make the effort of comparing prices and examining the quality of the goods where it counts. Is this stock one that will "wear well," or is it just an item that "will be out of fashion before the season is over?"
Of course, if you're "too busy" to be bothered that way, then you might hire a "personal shopper" in the nature of an ETF to do it for you. There are a couple of reputable ones by the names of SPDR S&P Biotech (NYSEARCA:XBI) and iShares Nasdaq Biotech ETF (NASDAQ:IBB). But the cost of their attention is not so much in the commission they charge for their services of diversity and liquidity. They come through with risk exposures of only -3% to -4% at today's forecasts, but you give up the double-digit upside prospects of the above stocks for only +6½% to +7½% promises. Promises that haven't been kept all that well in the past, following RIs like the present, where 1/3rd to ½ of the forecast range is to the downside.
Still, the quicker turn on an XBI compared to a CELG makes it near-competitive on a rate of return basis, and it has had risk exposures only half of CELG. There's a fitting room right down the hall; maybe you should take XBI in for a look too, along with some of those more "JAZZ-y" alternatives. They're so much more appealing than that market clearance-table staple, the old-fashioned SPDR S&P 500 (NYSEARCA:SPY), which has produced returns less than half of buying Medical Technology issues blind.
Happy (and productive) shopping!
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.