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Investing in speculative biotech equities can be one of the most challenging, and most rewarding, types of trading an investor can do. In this industry fortunes can turn on a dime and riches can change hands faster than the blink of an eye. This being the case, it is most baffling to me how new investors to the industry choose to invest their hard earned dollars with so little thorough research. Time and time again a similar set of events plays out where the retail investor will either read one article or hear by word of mouth of the latest and greatest company with a miracle cure. Instead of starting from that point, the investor jumps right into the stock with no further knowledge other than what they have heard. Needless to say, this wing and a prayer attitude oftentimes winds up as wreckage as the investments fail to materialize. This being the case, this article introduces some basic concepts and thought processes that should be considered before ever buying a speculative biotech stock. This article is not going to be an all encompassing analysis, but should be a good start for any new investor. The article will attempt to use some recent examples for current stocks to help illustrate some prime examples.

Mandatory Reading and Activities

Articles, on Seeking Alpha for instance, are a great place to start to get new ideas and stock tickers. From these articles you can get basic concepts and tidbits of information to help you get started in the analysis process. The most important item to remember is you cannot stop at this point, but unfortunately many people do. No article will be able to give any investor enough information to make an investment decision. For that, one has to start with the SEC filings by the company. An SEC filing is financial statements or other formal documents submitted to the U.S. Securities and Exchange Commission (SEC), in this case by the company one is considering investing in. These are boring, drawn out pieces of literature but most vital for any investor as they are packed with useful information. Bottom line is that you must read them when issued. They are not fun but if you don't then you might as well just throw your money in the trash.

Another mandatory item for investors is to review the company's website. Now some companies do a great job and provide lots of facts and data that are useful, while others may not due to lack of funds or time (remember these are often very small companies). On these sites the investor should review all the possible data corresponding to the company and the products they are working on. Often times CEOs will even have their own blogs that can be a good source of useful information. Bottom line, get to know the website and check it often for updates.

Yet another must is to listen to and observe the company’s conference calls and presentations at special events. One can learn a great deal of up and coming news events and sometimes can even get a little bit of an edge on changes in the business model. During the presentations the companies will often present slide shows and other visual aids to help explain their position. Needless to say, a picture is often worth a thousand words.

Finally, and the most hard to do, is to find yourself a support network. Trying to do one's due diligence and keep up with the latest and greatest happenings is often an impossible task. Inevitably one will miss some vital piece of news or not be able to understand the science/medicine behind the products being presented. Creating this network is much easier said than done. The first rule would be to stay away from the public message boards that you find. For example, Yahoo Finance is a great place to find articles and data but its message boards are clogged with posters with hidden agendas, dishonest posts, and individuals whose writings hold little if any value. Sure there are some worthwhile posts, but who wants to wade thru the nonsense to find them. A better choice, if trying to start a new network, would be looking at the comments at the end of articles (like on Seeking Alpha) to determine if any posters have the knowledge base you might be looking for. Communicate with these individuals and often you will find willing participants to help in your joint endeavors. Sometimes though one can get lucky and stumble into a stock that has a devout following via a private group. A prime example would be the stock Advanced Cell Technology (OTCQB:ACTC) and its relation to the Investorstemcell.com website whose members (science professionals, finance experts, and layman) all work together to track every move the stock makes. This is just one of many examples, but by working as a team with other investors one can pool their resources to make the most efficient use of their time and energy. Needless to say this makes biotech investing a bit less daunting.

Items to Consider

Once one has the above mentioned mandatory readings and activities in place, it is time to start looking at very specific items. With each biotech company being so different in nature, this article will not be able to address every aspect, but at least we can hit the main things one can look for before making their investment decision.

Pipeline

When the new retail investor blindly buys into the speculative biotech stock, often it is based off what they have heard or read about with regards to one of the more publicized drugs of the company. Usually this is the company's product that is furthest along in development, or the one with the largest market potential. A prime example of this occurs with the company Geron (GERN). GERN’s current well publicized trial is dealing with using stem cells to treat patients with spinal cord injuries so they can regain mobility. Don’t get me wrong, if GERN is successful with their stem cell technology it will be a game changer for the company and medicine. Keeping that in mind, one has to remember all the other products in their pipeline. By reviewing their website and reading the SEC quarterly filings one could easily determine the other products that they are working on.


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Buying shares of GERN will get you exposure to all of the products in the pipeline, not just the stem cell trials. With these other items comes the benefits and costs associated with the attempt to bring each to market.

On top of what is in the pipeline, one has to consider where it is in the pipeline. Development of drugs and technologies can take years to come to fruition. This article will not attempt to explain all the inner workings of the FDA and its approval process, but once again the websites and SEC filings often times give a clue as to estimated completion dates. In the cash burn section below one will see how this becomes an important piece of information when deciding when to buy or sell a stock.

Demand/Competition

Before buying that latest and greatest biotech company, another consideration is the demand/competition aspect of the product(s) in question. The basic concepts here are quite simple but often overlooked by many new investors. First and foremost, is there any demand for the product(s) that are being developed? Any product being developed to ease pain and suffering is a positive, but if the number of end users is very small then the revenue flow from sales will not make much of an impact on the stock price. Often companies will give such demand figures within corporate presentation materials that are presented at conferences and eventually post on their websites.

On the flip side of the coin is the competition component. If a company has a very effective new drug coming out that treats an ailment with a high demand, it might not have that much effect if several other drugs in the field already exist. New drugs and technologies that are introduced don’t just get immediate market share. Physicians and the public have to be made aware of the new products and this takes time and money. If you have several established drugs already in the marketplace which are heavily entrenched, it will be an uphill battle trying to batter one’s way in. Once again, companies will present such issues within presentation materials that they will present at conferences. Also during conference calls companies will often give their basic plans of how they intend to get their new drugs to market. This is also a great topic to be handled by the support network to help in determining what the competition is.

It’s not hard to see that the most optimal scenario is one where the company in question is developing a product with high demand and no competition. This can be a bit difficult but in the end there are lots of companies that can fit the bill. One good example is Advanced Cell Technology, which is currently in FDA trials for the use of stem cells to treat macular degeneration. This ailment currently has no viable treatment options and is classified as an unmet medical need. The market for the disease is valued at $30 billion. This is a great example as there is ample demand, strong financial value, and no competition.

Cash Burn

One of the most important concepts in analyzing small biotech companies is cash burn. Most companies that you come across in your search do not generate revenue from products they sell. They will have cash inflows from irregular events like grants, royalty or milestone payments, or newly issued shares of stock. That being the case, the concept is basically how fast they are spending (burning) the cash they have on hand in keeping the company going and trials in motion. This is very important to investors because as the company runs out of funding, they often have to issue new equity and dilute current shareholders, which is never viewed as a positive experience. The basic concept one is looking for is if the company has enough cash on hand to complete their stated goals. Every company is different so the endpoint for each can really vary.

At first glance, one would think that calculating the cash burn rate would be a rather straightforward affair. Simply take the cash and cash equivalents on hand and divide that by the expenditures for a given period to determine how much time is left. Seems easy but the devil is in the details. First, the expenses do not always remain the same from quarter to quarter as trials are beginning or ending, plus a host of other cash outlays can occur at nonrecurring intervals. On the other hand, the irregular cash inflows are usually not on the radar of most retail investors. Add these two ever changing values and the cash burn is not as easy to calculate. This is where the SEC filings and quarterly corporate conference calls can come into play as this is usually one of the main questions the company tries to communicate to investors. In our example here let’s look at an SEC filing from AEterna Zentaris, Inc. (AEZS) where the company makes mention of the burn rate.


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Finally, it should be noted that the use of a support network often works well here. Instead of waiting to hear the specifics about a company’s finances via the filings, a group of individuals can usually put their heads together and often times determine accurate figures prior to the actual events. A head start is always a good thing.

Partnerships

As often happens with new investors, they are enticed into the speculative biotech stocks by promises of miracle drugs that will take over the world. A small exaggeration I know, but it’s not hard to see how in investors' minds they can match up unmet medical needs (demand) and new drugs and then attempt to calculate what the cash flows could be worth when product is deployed. What is forgotten is the partnership aspect of the equation. There are all kinds of partnerships but the two we will talk about are the acquisitions and marketing types.

Acquisition type partnerships are relatively easy to understand. It should be known that small biotech companies do not just come up with these experimental products all by themselves. Often times these companies will partner with others to get access to the products for development. Needless to say, this comes at a price and that will vary from agreement to agreement. Investors need to be aware of the specifics of these agreements in helping to determine what is to be expected if and when the products ever become marketable. A prime example I have seen deals with the company Keryx (KERX). KERX is a biopharmaceutical company focused on the acquisition, development and commercialization of medically important pharmaceutical products for the treatment of life-threatening diseases, including cancer and renal disease. KERX actually has two drugs in the pipeline but it will be Perifosine that will make the biggest impact. This drug is designed to treat advanced colorectal cancer. If one did not dig any deeper they would assume that KERX would be selling this drug to the whole world once approved. If one followed that logic, the derived potential revenue numbers would be staggering but incorrect. Perifosine was derived from a commercial license agreement in 2002 with Zentaris AG, which is a wholly owned subsidiary of AEterna Zentaris Inc. In the agreement KERX holds the rights for North America. AEZS has other agreements in place with Yakult Honsha for Japan and to Handok for Korea, while holding the rest of the world rights for itself. Without this vital piece of information it is easy to see how one could make inaccurate conclusions about a company like KERX.

Marketing type partnerships are another type of agreement that must be considered as well. Getting a product through all the test phases of the FDA is one thing, but actually getting the product in the hands of consumers is something totally different. This concept is often overlooked by investors who think that once past the FDA approval process, the company somehow magically has access to the total market value for the product in question. Far from it as the costs of “going it alone” can be staggering for many of these little companies. What often happens is that larger entities will partner or license with the small biotech company for marketing and distribution rights. Needless to say, they do not do this for free and will take a sizeable share of the profits. That being the case, investors will have to look at each agreement to try to determine what the revenue flow might be.

A prime example of this deals with a company called Antares (AIS). This small pharmaceutical company has a business line that focuses on self injection technologies and topical gel-based products. AIS has several agreements but the one we will focus on is the one dealing with the topical gel Anturol for overactive bladders. Currently 33 million adults in the United States suffering from overactive bladders, and that makes for a market that exceeds $1.8 billion, but that is not what AIS is going to get. To get the drug to market, Watson Pharmaceuticals Inc. licensed the potential treatment from Antares. Watson will make a payment to Antares if the Food and Drug Administration approves the drug. Watson will also market the drug and make payments to AIS based on sales. AIS will also get royalties based on sales of the product in the U.S. and Canada. This is just one of many agreements the company has in place. Potential investors would need to analyze each product held by AIS and any agreements that may exist for them. Once again here is where a network might prove useful in helping to share the load.

Insider Buying and Institutional Holders

Another item to look at when deciding on which biotech deserves your investment dollar is who is actually holding and buying shares. Plowing your money into these risky stocks is scary enough, so it is often somewhat reassuring to see that company employees and institutional holders are doing the same. Now it should be mentioned that if your stock has both types of holders, it is by no means any type of guarantee of success. But it could be a lead indicator that they have faith as well and stand to profit from any positive move in the stock price. That being the case though, one has to determine how insiders derived their shares. This can happen lots of different ways from outright buying the shares on the open market to being gifted the shares for nothing. Also companies can hand out options or warrants which can further confuse the process. News on insider buys and sells can be found with the SEC filings and institutional holders also have to file their holdings if they represent enough of a percentage of ownership for the company. Recently, a prime example of this insider buying occurred with a company named ZIOPHARM Oncology Inc. (ZIOP). ZIOPHARM Oncology, Inc., a biopharmaceutical company, focuses on the development and commercialization of in-licensed cancer drugs in North America. An insider for ZIOP recently bought about $4 million worth of stock. If that was not enough there were also past purchases of about $29 million worth of stock back in January and $10.9 million worth of stock in February. By itself, one does not really want to read anything into this but at least it does seem to be one very large vote of confidence.

In conclusion, this is just a start of necessary items to consider when thinking of buying that speculative healthcare stock. For each stock in question there are many other items one must consider. This article was unable to address them all but should at least give the new investor a solid foundation to begin. In the end, anyone buying based upon one article or by a simple recommendation of a friend or acquaintance is just giving their money away.

Source: Due Diligence And Speculative Biotech Investing