How to Maneuver the Biotech Sector

by: Spencer Knight

Seasoned traders find it difficult to predict where the market will go when the media and financial reports are negative. One day it appears the bull run will continue, and the next the bears take control and everything plummets. One reason for the turbulence is world wide conflicts and unaccountable events that the media runs with and ignites fear into investors.

However, one sector that can gain momentum in a very short time is the biotech sector. Losses are just as common in the biotech sector; maybe even more common due to the FDA tightening down on approval rates. But if you have the courage, and have done your research, the biotech sector can be a great place to expand your portfolio while you wait for the rest of the market to steady. You may indeed end up investing long term in some biotech companies, since they have amazing pipelines and will continue to grow for years.

One company that has a very strong pipeline and is facing an FDA decision is Lannett (NYSEMKT:LCI). Lannett is a generic drug company that is taking advantage of consumers preference for generic drugs that cost less. Currently the stock price and P/E are low, but it has a very good chance of rising 10-15% before April if the FDA approves its New Drug Application (NDA) for Morphine Sulphate Oral Solution.

Lannett is very confident about an approval, as President and CEO Arthur Bedrosian stated

the FDA indicated to us that it will approve our Morphine Sulfate NDA subject to our manufacturing facility passing the Pre-approval Inspection (PAI).

Despite the positive outlook, anything can happen and I warn people to be cautious about biotech companies. If the NDA can be approved, Lannett will show investors how a biotech company can make sharp runs independent of other market variables.

Human Genome Sciences (HGSI) recently received a monumental approval from the FDA for its Systemic Lupus Erythematosus (SLE) drug Benlysta. Lupus is an autoimmune disease; which means the antibodies attack the healthy cells and cause constant inflammation. Human Genome's stock price rose 13% on approval, but has since dropped back down to pre approval levels. The large jump in share price was due to overzealous investors committing money to the company since this is the first new Lupus drug in 56 years. Also, I believe people committed money to the company without reading some of the safety precautions below:

------------- WARNINGS AND PRECAUTIONS ------------

• Mortality: There were more deaths reported with BENLYSTA than with placebo during the controlled period of clinical trials. (5.1)

• Serious Infections: Serious and sometimes fatal infections have been reported in patients receiving immunosuppressive agents, including BENLYSTA. Use with caution in patients with chronic infections. Consider interrupting BENLYSTA therapy if patients develop a new infection during BENLYSTA treatment. (5.2)

• Hypersensitivity Reactions, Including Anaphylaxis: Serious reactions have been reported. BENLYSTA should be administered by healthcare providers prepared to manage anaphylaxis. Monitor patients during and for an appropriate period of time after administration of BENLYSTA. (2.2, 5.4)

• Depression: Depression and suicidality have been reported in BENLYSTA studies. Patients should be instructed to contact their healthcare provider if they experience new or worsening depression, suicidal thoughts or other mood changes. (5.6)

• Immunization: Live vaccines should not be given concurrently with BENLYSTA. (5.7)

On the other hand, Benlysta should be a successful drug and help millions of people. HGSI is a recent example of a company that has overcome the FDA and shown that in a turbulent market, biotech stocks can succeed.

A better example of how a biotech stock can grow exponentially is Clinical Data (NASDAQ:CLDA). Clinical Data was able to get approval of its Major Depression Disorder (MDD) drug Viibryd on January 21st of this year. Clinical Data plans to release the drug sometime in the Second Quarter of 2011. Since approval, the stock has risen from $15.03 to $34.95 before the announcement of a possible buyout at $30 a share with a $6 per share incentive by Forest Laboratories (NYSE:FRX). Since that announcement the share price has hovered between $30 and $30.50.

Viibryd's approval caused a rocket in share price because the sexual side effects are far less than other treatments. The results state that

Among the common adverse reactions (≥2%) related to sexual function with Viibryd compared to placebo were decreased libido (4% vs. <1%), abnormal orgasm (3% vs. 0%), delayed ejaculation (2% vs. 0%, males only), and erectile dysfunction (2% vs. 1%, males only).

These results are very positive and will lead to many prescriptions for patients who are struggling with current treatments. Clinical Data is one of the best examples of how biotech companies are great additions to your short term portfolio. If not for the buyout, Clinical Data would have been great as a long term holding since it would have grown much higher than it is now.

Biotech stocks can avoid the normal patterns of the market due to mergers and acquisitions (M&A). Smaller cap biotech companies that receive an approval are often bought by biotech or pharmaceutical giants. However I must warn you that a buyout is not guaranteed post approval. Therefore do not invest in a company expecting a quick acquisition.

Nevertheless Clinical Data is an example of a company that is in the process of being acquired by Forest Laboratories (FRX). As of now, Magnolia Acquisition, a wholly owned subsidy of Forrest, is in the process of purchasing all outstanding Clinical Data shares at $30 a share according to Forest Laboratories. The buyout did not give investors any premium on the share price, but if the contingent consideration is maxed out then investors will make just under 20% on the current share price. Investors who took the gamble on Clinical Data 8-10 weeks ago were rewarded for that risk. Sanofi-Aventis (NYSE:SNY) gave Genzyme (GENZ) investors a premium after purchasing Genzyme for $74 per share with a maximum of $14 per share in incentives up to 2020, as seen below:

The one-time milestones and payments can be summarized as follows:

  • $1.00 per CVR if specified Cerezyme®/Fabrazyme® production levels are met in 2011

  • $1.00 per CVR upon final FDA approval of Lemtrada™ for multiple sclerosis (NYSE:MS) indication

  • $2.00 per CVR if net sales post launch exceed an aggregate of $400 million within specified periods per territory

  • $3.00 per CVR if global net sales exceed $1.8 billion

  • $4.00 per CVR if global net sales exceed $2.3 billion

  • $3.00 per CVR if global net sales exceed $2.8 billion

Even though this deal has already been completed, Genzyme is still a solid investment because if all the contingent deals are reached, you will make 18% on your money. This deal has been in the making for months now and I'm glad to see the companies finally came to an agreement. These are just two examples of how M&A cause biotech stocks to jump up or down, even if the rest of the market is poised downward.

So far I have mentioned "happy ending" biotech companies that show how this sector reacts when the FDA approves a blockbuster drug. However, rejections from the FDA far outweigh the approvals. One company that faced a debilitating rejection was Mannkind (NASDAQ:MNKD). The drug in question is Afrezza, which is an inhaled insulin for diabetes. Unfortunately the FDA sent a second Complete Response Letter (CRL) to Mannkind instead of an approval. What this means is that the FDA requires more information from Mannkind before approving Afrezza. The reason for this is because Mannkind decided to switch inhalers during their trials; which was a red flag for the FDA to require new trials to be completed to make sure both inhalers give the same results.

Now that Afrezza has been delayed, Mannkind is in a tight crunch to keep the boat afloat until Afrezza can be approved. Investors reacted to this in a very negative way and the stock plummeted into the cellar. The share price fell around 40% in one day as investors understood the CRL as meaning that Afrezza will never get approved. As of now, it is difficult to tell if Afrezza will get approved because the company is in vast need of financial support and nobody is stepping forward to fill the void. Mannkind is a perfect example of how biotech stocks, with extremely profitable products, can completely crumble in a matter of seconds.

Another company that recently faced a CRL, and a 23% stock crunch, is Salix Pharmaceuticals (NASDAQ:SLXP). Salix was expecting an approval for Xifaxin 550mg a few weeks ago, but it was turned back for more trials. Therefore the stock plummeted more than the rest of the market. Despite both companies completely crumbling, they are great examples of why you are supposed to do full research before making any purchases. And even if your research cannot find any holes in the trials, sometimes the FDA can be overly cautious about our safety.

Obviously buying into a biotech company with a bright future can be rewarding, but if the company faces any hiccups you will regret the decision. The toughest part is that these stocks may increase only 15% on approval and decrease 30% on a CRL; therefore your money is at risk.

Some people call this sector a speculative game that involves constant research of all the trials conducted by the company. Not only should you follow the trials, but you must understand the data and see if it makes sense and whether or not it will lead to an approval by the FDA. So remember not to invest too many marbles into any one company prior to an approval of a blockbuster drug. By doing this you may miss a 10% jump, but on the other hand you may save yourself a loss of 20-30% if a CRL is issued. As always, nobody can stop you from investing in a company, so if you believe you found a winner, then pull the trigger before its too late.

Disclosure: I am long MNKD, short LCI.