I’ve been trying to construct a portfolio of high-risk, extremely high-reward biotech stocks over the past six months or so. My idea is that such a portfolio should have prospects for high returns, but with low-to-moderate risk. An added bonus is that because each of these investments is based on specific, extreme catalysts unrelated to the economy or markets, the portfolio should be effectively market-neutral over the long term. I’ll admit that this concept seems far-fetched at first glance. That it sounds too good to be true is an understatement, but let me walk through the reasoning on why I think it should be possible to construct this portfolio.
I want to apologize up front for that fact that, as a scientist, my “financial models” are crude and approximate. With that said, I think these “models” are accurate enough to support my thesis.
First I will outline what I mean when I refer to high-risk, extremely high-reward biotech investments. I’m looking for companies with drugs (or devices, diagnostics, etc.) late in development that, if successful, would increase the market value of the company by 300% or more. At the same time, I want to have enough insight into the clinical and regulatory status of the product that I’m confident (60% probability or higher) that the product will make it to market. That is a very high standard to meet, and I haven’t found too many such opportunities, but I have written about four here at Seeking Alpha this year: Momenta (MNTA, generic biologicals), Pain Therapeutics (PTIE, pain drug), Depomed (DEPO, pain and post-menopausal hot flash drugs), and Vical (VICL, cancer drug).
You might ask, “Why would such favorable, asymmetric opportunities ever exist?” or “Is it possible you’re just wrong in your analysis?” Fair questions. I can’t give a great answer to the second question, except to say that I’m a fairly risk-averse investor and I wouldn’t have invested in those companies if I wasn’t confident in my analysis.
But I do think there are some reasonable answers to the first question. First, these companies are all small (<$1 billion market cap) and generally have limited analyst coverage. Second, the potential issues with their products are complex: There is a limited number of small investors who can accurately assess the strengths/weaknesses of the products (scientific, regulatory, intellectual property, commercial opportunity, etc.) I may be deluding myself in thinking that I can assess these issues accurately, but I have at least had extensive experience with such issues.
Perhaps the biggest factor that creates these extremely favorable opportunities is the fact that the downside in case of an unfavorable outcome is a nearly complete loss. In the face of significant uncertainty and the prospect of a total loss, many investors will simply sell first and ask questions later. And while these opportunities aren’t common (many biotechs are fairly- or even over-valued), the number of biotech companies is so large (I’d estimate 300-400) that even a 1% rate of occurrence offers several to choose from.
If you’ve read this far and believe that these opportunities exist, let’s look at the properties that a portfolio of such investments would have. For the four opportunities I’ve described in my articles, the probabilities of (transformative) success were 60-85% (in the 60% case, the downside was much smaller), and the gains in the event of success are 300-700%.
For my portfolio model, I’ll start with more modest assumptions. I’ll say we’ve found eight stocks with 60% chance of a 250% gain, and 40% chances of a 90% loss. While any single opportunity like this is favorable, I wouldn’t be comfortable putting a significant amount of money into such an investment. But let’s look at the return distribution for our portfolio of eight such investments with $10,000 invested in each:
This distribution of returns is much more appropriate for a significant investment. The chance of significant losses is less than 1%. The most likely outcome is a return of 122%, and there is an 83% chance of returns 80% or higher. This is still too risky for a huge percentage of my capital, but I would be comfortable with up to 25% in a portfolio like this. The one significant caveat here is that for this strategy to work, you must hold on to the winners until they hit the 200-300% gain mark. If you harvest the winners after the first 50% pop on good news, the 90% losers will eventually overwhelm the 50% gains.
Finally, I want to get to my idea that this is a (roughly) market-neutral strategy. Obviously, I don’t mean that this portfolio will be immune to market fluctuations over the short term. These stocks are volatile, and short-term gains/losses will likely be even larger than the market as a whole.
However, in the longer term, the catalysts that will make or break these companies are so large that they will overwhelm any but the most extraordinary market moves. The downside to all of these investments is bounded by zero. No matter how bad the outcomes or the markets, losses are limited to 100%. At the other extreme, if the outcome is favorable, the companies in question will become like small pharmaceutical companies, but without the patent expiration problems.
As such, these investments are likely to be regarded as defensive and countercyclical. At the same time the earnings of these companies, in the event of success, should be growing rapidly. And if you haven’t read my investment theses on these opportunities, I generally assume a modest 15x P/E multiple as the basis for my estimates.
So that’s my argument for a portfolio of risky biotechs as a moderate-risk, high return strategy. I’ve included links to four opportunities that meet the requirements for inclusion in this portfolio. Momenta and Pain Therapeutics have run up 40-50% since my original write-ups, but they still offer good risk-return profiles, especially if they were to pull back a bit.
Another company I’ve included in my portfolio is Trius Therapeutics (TSRX). Jason Napodano has written a good introduction to this company with an impressive antibiotic in phase 3 trials. I will just say that Trius certainly meets my criteria for a >60% chance of a >300% return over the next three to four years. And for a sixth portfolio member, in the next week or two I plan on writing up a small medical diagnostics company with FDA-approved tests and huge potential.