Gambling With Speculative Healthcare Stocks

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by: Michael J. Ray

Investing in speculative biopharm healthcare stocks has often been compared to pure gambling. I do not agree with this comparison because with gambling, often the outcome is left up to pure chance. In speculative healthcare stocks, whether a stock is successful or not is based upon much more random chance, although sometimes it feels like that. Investors can do their own research and make informed decisions, thereby hopefully increasing their odds of picking winning stocks. That being the case, there are some similarities between gambling and speculative stock picking and it falls into the realms of how the bets are placed.

Roulette is a relatively simple game where we have a table with 38 numbers on it with a small ball and wheel that is used to pick these numbers. Those numbers go from 1-36 and a "0" and "00" for a total of the 38. There are all kinds of bets one can make, but let's focus on just two types of bets I've observed. The first bet is when Gambler X places a \$10 bet on the number 26 with no other bets. If the spin of the wheel lands on the number 26, Gambler X will win big based upon the payout odds. If any other number comes up, X will lose his entire \$10 bet. Our next person, Gambler Y, had a different strategy where she also makes a \$10 bet but puts \$1 on each number between 1-10. Gambler Y was betting on a basket of numbers to increase the chance to win on the next spin. This basket approach to betting is what speculative healthcare stock investors could learn from.

One can quickly see how the basket bet can be applied to trading. For example, X would be equivalent to the investor who takes her whole designated bankroll and invests it in just one speculative stock and hopes for the big payout. The risk is that the company could fail in its mission and wipe out the investor's bet. Y's betting philosophy would have an investor holding a basket of securities where one might have six to 10 highly speculative healthcare stocks. This is where the similarities end though, because unlike Gambler Y, who will at best lose nine out of the 10 bets she placed, the investor's stock picks each have an equal chance of coming out on the winning side of the trade. For example, if one held seven speculative healthcare stocks in one's basket and only three of them were successful, then the gains of those winning positions should more than outweigh the losses of the other four. One will have to pick stocks that are riskier in nature so that the upside potential is large enough to cover the losses that will be experienced elsewhere.

This concept takes some getting used to at first. As the stocks are chosen and purchased, they do not appear in the "basket form" but as any other holding on one's statement of account. It is easy for an investor to quickly forget the basket concept and start to spend inordinate amounts of time on each holding and trade around the position individually. I am not saying that each holding in the basket should not be reviewed from time to time, but one has to remember to view the basket as the investment. It is easy to forget this as speculative healthcare stocks can and will be quite volatile. One day they can suffer steep losses only to retake those losses and post outsized gains on the next day. That being the concept, let's put together a sample basket and see what stocks might be a good fit for investors.

Æterna Zentaris Inc. (AEZS) is a great candidate for our biopharm basket. AEZS is a Canadian late-stage oncology drug development company currently investigating potential treatments for various cancers including colorectal, multiple myeloma, endometrial, ovarian, and prostate/bladder cancer. The company already has one product on the market, Cetrotide, which is administered to women to prevent premature ovulation in order to increase fertility success rate. So far the revenues are derived primarily from sales and royalties from Cetrotide which amounted to \$6.1 million and \$13.2 million for the three-month and six-month periods ended June 30, respectively, as compared to \$5.2 million and \$10.9 million for the same periods in 2010. This is a nice figure but will in no way lead the share price higher to the levels we need for the basket. For that, AZES will depend upon its drug Perifosine. This drug is designed to treat cancers and rights have been licensed to Keryx BioPharmaceuticals (KERX) for North America, Yakult Honsha (OTC:YKLTF) for Japan and to Handok for Korea. Æterna Zentaris holds the rest of the world rights. Multiple trials are currently underway. One of the Phase 3 trials dealing with the colorectal cancer aspect is set to have its primary completion date by December and the study is set to be completed by February 2012. Perifosine’s second Phase 3 study, dealing with multiple myelomas, does not have its primary completion date until September 2012 and a study completion date of October 2012. In addition to these ongoing Phase 3 studies, the companies in question are also exploring the drug in Phase 1 and 2 clinical development trials for several other tumor types.

In the end, if Perifosine proves to be successful at treating multiple cancers, it will make a big splash in the field of medicine. The return for AEZS will be substantial and as a result will move the stock price well north of its current value.

Titan Pharmaceuticals, Inc. (TTNP) is a biopharmaceutical company that develops therapeutics primarily for the treatment of central nervous system disorders and opioid addiction. That might sound like a weird pairing but it just might prove to be a winning combination. First, the company offers Fanapt, which is for the treatment of adult patients with schizophrenia. The drug was approved by the U.S. FDA on May 6, 2009 and Novartis (NYSE:NVS) has licensed the rights to commercialize Fanapt in the U.S. and Canada, and commenced marketing the product in the U.S. in Q1, 2010. Titan is entitled to receive royalties on global net sales of Fanapt equal to 8% on annual net sales up to \$200 million, and 10% on annual net sales above \$200 million for the life of the licensed patents. Net sales of Fanapt by Novartis during the three-month period ended June 30 and 2010 were approximately \$7.5 million and \$0.7 million, respectively, and TTNP was obligated to pay royalties of approximately \$1.1 million and \$0.1 million to Sanofi-Aventis (NYSE:SNY) on June 30 and 2010. Once again this is a nice revenue stream for the company but not enough to take the share price to the lofty heights our basket needs.

Now consider Probuphine, which is in Phase III clinical trials for the treatment of opioid addiction. Worldwide, it is estimated that there are 6 million opioid addicts. Approximately one-half of this potential patient population is addicted to illicit opioids, such as heroin, and the other half to prescription drugs, such as oxycontin, methadone, and codeine. As of 2002, physicians can be certified to prescribe opioid addiction medications in an office setting, which has greatly expanded patient access to opioid addiction pharmaceutical therapies. Currently, there are more than 750,000 people globally receiving medicinal treatment for opioid addiction. The market for such a product is large. Worldwide, sales for oipioid addiction treatments were \$1.1 billion in 2009 and approximately \$900 million of these sales were in the United States. Since the drugs U.S. approval in 2002, the number of doctors certified to prescribe these drugs has grown to approximately 20,000 in 2010.

RXi Pharmaceuticals Corporation (RXII) is another biotechnology company that has the potential to be part of the basket. What RXII brings to the table is its lead product candidate, NeuVax. This product stimulates T cells in a highly specific manner to target cells associated with breast cancer. With over 200,000 women in the U.S. diagnosed with breast cancer annually, the market for RXII would be huge. Based on a successful Phase II trial, the FDA granted a Special Protocol Assessment for the Phase III study. This Phase III multicenter trial is expected to commence in the first half of 2012. If NeuVax is as good as the company suggests, the price per share will move to a much higher level than where it trades today. Before it becomes a contender, one should check the most recent financial reports.

As of June 30, cash, cash equivalents and short-term investments totaled \$17.9 million, compared with cash and cash equivalents of \$6.9 million at December 31, 2010. This \$11.0 million increase is attributable to the closing of two underwritten public offerings that provided net cash proceeds of \$18.2 million after fees, offset by net cash used in operating activities of \$7.2 million for the six months ended June 30. The research and development expenses increased to \$2.7 million in the second quarter of 2011 from \$2.3 million in the second quarter of 2010, and increased to \$4.8 million for the first six months of 2011 from \$4.2 million for the first six months of 2010. The increase was primarily due to an increase in research and development cash expenses due to a ramp-up in NeuVax. The question will be if RXII has enough cash to burn as RXII conducts the Phase III trials.

Novavax, Inc. (NVAX) could be another candidate for the basket. NVAX is a clinical-stage biopharmaceutical company focusing on developing recombinant vaccines for infectious diseases using its virus-like particle platform technology. Its vaccine product candidates target pandemic influenza, (including H1N1 and H5N1 strains), seasonal influenza, Respiratory Syncytial Virus, and Varicella Zoster Virus that causes shingles. The company has a joint venture with Cadila Pharmaceuticals Ltd. to develop and commercialize seasonal influenza and H1N1 pandemic vaccine candidates for the territory of India. It also has a co-marketing agreement with GE Healthcare for a pandemic influenza vaccine solution.

NVAX might make an interesting choice as new warnings are popping up about new cases of flu oversees. If any of these reports were to turn into a real worldwide concern, NVAX could find itself and its products pushed to the front line of the war on the pandemic. The share price would increase on a rapid scale. In the meantime, investors will have to focus on Novavax’s financial reports. Novavax reported a net loss of \$5.0 million, or \$0.04 per share, for the second quarter of 2011 compared to a net loss of \$8.9 million, or \$0.09 per share, for the second quarter of 2010. For the six months ended June 30, the net loss was \$12.4 million, or \$0.11 per share, compared to a net loss of \$19.2 million, or \$0.19 per share, for the same period in 2010. The primary reason for the decreased loss for the second quarter of 2011 as compared to the same period in 2010 was higher revenue associated with the company's activities under its contract with the Office of Biomedical Advanced Research and Development Authority within the Office of the Assistant Secretary for Preparedness and Response at the U.S. Department of Health and Human Services, awarded in February, as well as lower research and development spending to support the company's clinical trials related to its vaccine candidates.

Research and development expenses for the second quarter of 2011 were \$5.6 million as compared to \$6.3 million in the same period in 2010. General and administrative expenses were \$3.3 million for the second quarter of 2011 as compared to \$3.1 million in the same period in 2010.

As of June 30, the company had \$22.3 million in cash, cash equivalents and short-term investments compared to \$31.7 million as of December 31, 2010.

MannKind Corporation (MNKD) is another example of a perfect stock that could be part of the basket. MNKD's going to be a high risk/high reward type equity that brings the volatility that is needed. MNKD is a biopharmaceutical company that focuses on the discovery, development, and commercialization of therapeutic products for diabetes and cancer. The lead product MNKD's trying to bring to market is Afrezza, which is rapid acting insulin that has completed Phase 3 clinical trials for the treatment of diabetes. If ever approved, this would be a game changer for MannKind and for diabetes patients as well. This drug can be inhaled, which is a better prospect for patients than treatments with needles. The downside is that the company has had two rejected applications to the FDA to sell the product. The company received two response letters (CRLs) regarding its insulin platform from the U.S. FDA, in March 2010 and in January 2011. The problem is that as the FDA asks for more information, it delays any chance for a revenue stream in the near future. As Mannkind addresses the FDA’s concerns, the delay is bleeding cash. As of June, the company had approximately \$24.7 million left with a burn rate that will eat that balance up in short order.

Here is the good news. The FDA has not written off MNKD and there is still a good chance that approval will happen. The trials to get to the results will probably not be completed until late 2012 or into 2013. The concept for inhalable insulin is going to be a winner if the company can get by the FDA. Anyone who has diabetes and is eligible for the product will probably switch over from using the needles rather quickly. MNKD's share price will be at a much different level if and when that happens. In the meantime a partner or joint venture can always materialize which could bolster the company's strapped cash issue.

It would be hard to imagine a basket of speculative healthcare stocks without a mention of Geron (GERN). GERN is a biopharmaceutical company that develops biopharmaceuticals for the treatment of cancer and chronic degenerative diseases, including spinal cord injury, heart failure, and diabetes. GERN actually has a pretty deep pipeline and has multiple Phase 2 trials dealing with cancer therapies. That being the case, the real catalyst for the company is the Phase 1 clinical trial dealing with treatment of spinal cord injuries with stem cells. Regenerative medicine could prove to be the next big leap in medicine, and if it does happen, GERN will be one of the companies on the tip of the spear. What is interesting about this company is that GERN's stem cell trial is attempting to tackle spinal cord injuries. The spinal cord is one of the most complex parts of the human body. Any success here will make GERN and its stock move to a different level. The initial human trials are well underway and the test subject has not shown any adverse effects from the treatments. In May, the study added a second subject as part of the trail so the process is moving forward. It remains to be seen how long the trials will go and how successful they might be.

GERN reported cash, cash equivalents and marketable securities at June 30 were \$192.2 million, compared to \$221.3 million at December 31, 2010. The company also stated that this cash reserve plus the income GERN receives will be sufficient to fund the current level of operations through at least December 2012. GERN also states that future capital requirements will be substantial as several trials are moving forward, yet another example of a high risk/high reward stock that might fit well into the basket.

This is by no means a recommendation which should be copied and blindly invested in. To put together a basket, one needs to truly dig deep into each potential candidate company. Skimming an article or two on a financial website is a good start but cannot be deemed a viable substitute for reading SEC filings, listening to conference calls, and viewing company presentations. There are critical questions that must be answered before any stock is allowed into the basket.

Disclosure: I am long KERX, RXII.