Over the last few months I have turned much of my attention to biotechnology. The industry produces the most number of 100% gainers in any given year, and gives value investors the best opportunity to buy undervalued stocks that have yet to appreciate. In the past, I would only hold one or maybe two biotechnology stocks at any given time. Yet in 2012 I added four biotechs to my portfolio making it my largest industry holding, due to my opinions of it having the greatest number of catalysts in 2012. However, catalysts in biotechnology are much different than those in technology and there are many investors who simply don't understand the drivers of these stocks.
Categories of Biotech
In biotechnology there are three categories of investments: large pharma, growth biotech, and developmental biotech. Large pharma are companies such as Bristol-Myers (BMY) or Pfizer (PFE) that are well established and considered among the largest and most dominant within the industry. The growth biotech class is filled with companies such as Spectrum Pharmaceuticals (SPPI) and Questcor Pharmaceuticals (QCOR) that have approved drugs and are growing rapidly, but still rely heavily on a pipeline for further growth. The developmental biotech category consists of stocks without an approved drug, or consistent revenue (clinical phase). The developmental biotech category accounts for the majority of all biotechnology stocks, and is where the majority of large gains can be found, if bought at the right time.
At some point all biotechnology companies were considered small and speculative. There is no company that was created as a multi-billion dollar powerhouse, all good things take time to develop, and with biotechnology patience is the key virtue. The majority of gains for these stocks occur throughout the clinical phase and into the early years following a drug's approval. However, with the number of biotechnology stocks being so plentiful it can be a challenge to find that diamond in the rough that is both under-the-radar and positioned to return market-leading gains for several consecutive years.
Buying Developmental Biotech
Back in January I bought a very small, under-the-radar stock in ImmunoCellular Therapeutics (IMUC). At the time it met all of my qualifications for finding and buying a biotechnology stock to return large gains; and I told myself that no matter what I am holding for five years. My decision to hold for five years may sound crazy, but you have to understand my reasoning: You see, I have been part of some of the greatest biotech rallies of the last five years. I bought Spectrum Pharmaceuticals back when it was just $3, I also bought Jazz Pharmaceuticals (JAZZ) when it was $8.5, and the best was Questcor when I bought at $3.25. Unfortunately, the story takes a turn for the worse, because not only did I sell each stock for mediocre gains but also I ended up buying back each stock at a later time for 3-4x my initial buy price. If I only would have held the stock and not been so preoccupied with immediate gains, then perhaps I could be sitting on a yacht somewhere near the Bahamas. As a result, I told myself that from now on I will buy low and will not sell until the potential of the company is evidently clear.
Biotechnology is the ultimate industry of immediate gratification, but it can also be an industry of great defeat. In order to be a great biotechnology investor you must think outside the box, have patience, and be willing to endure the ups and downs that plague a very volatile group of stocks. You must also be able to identify value, innovating technologies, and any rallies that may surround a particular area of treatment. Biotechnology investments (specifically developmental biotech) are very unique and are unlike any industry in the market, because it is driven by catalysts, speculation, and potential, rather than fundamentals. For example, when Apple (AAPL) trades higher it is usually related to news that could impact its earnings, because after all, a stock is nothing more than a reflection of past earnings and future expectations. But developmental biotechnology stocks are valued according to the potential of lead candidates, the likelihood of lead candidates being approved, the track record of executives, and all the many developments throughout clinical trials that allow us to speculate over a drug's potential to be approved or acquired.
As an investor, biotechnology is perhaps my favorite class of stocks to own. I enjoy filling my portfolio with growth stocks and speculative biotechs that I believe to be significantly undervalued. In the past I have had great success because biotechnology has the largest degree of value over any other industry. I prefer to buy small undiscovered stocks with lead candidates that have the potential to be awarded an approval and enter a large market, which also gives these stocks the most amount of upside throughout trials. This strategy is evident with my previous biotech buys of QCOR, JAZZ, and SPPI, which all had valuations under $100 million at some point in the last five years.
As you can see from the chart above, each company was trading with penny stock valuations just a few short years ago, but has since returned market leading gains. In fact, if you would have bought just $5,000 worth of JAZZ shares in 2009 then your return would be around $350,000! Not bad for a three-year investment. The truth is that biotechnology presents the most upside in a short period of time with a small investment, but only if you can find that diamond in the rough. With that being said I decided that when I bought shares in a developmental biotechnology company I was not going to settle for a 100% gain, and was going to be patient and wait for an even larger return.
Back in early February 2012, IMUC met all of my qualifications as a developmental biotechnology stock with the potential for incredibly large gains. It had a market cap under $100 million, a late phase candidate, a transcendent technology, encouraging results in early trials, and it operates in an industry that could become somewhat of a bubble in the next few years (because of recent advancements in oncology). And when I asked the question, "does it present the possibility for unprecedented gains?" I believed that it did and does with such an attractive valuation. With that being said, let's look at the areas that I believe are most important when deciding on developmental biotech investments and how it relates to one of my own choices, IMUC (this criteria can be used when deciding on any developmental biotech investment).
Market Cap Under $300 Million
The market cap of a speculative biotechnology company should be weighed heavily when deciding on an investment. You must first consider all reasons for a valuation such as its management, lead candidate, and years till approval. IMUC is a Phase II company, and for Phase II companies I prefer to never buy any stock with a valuation over $300 million. Because in my experience a company with a ridiculously high valuation has too high of expectations and will almost always experience a large pullback. This must be considered because you are buying a developmental biotech stock and trying to determine future revenue, and if expectations are ultimately not met it could lead to significant loss and or metrics that don't match the fundamentals of the company.
A good example of a valuation possibly being too high during the clinical phase is with Amarin (AMRN). Now I must say that I am a fan of the company and believe its lead candidate AMR101 has great potential, and could very well reach a billion in revenue, or more. Yet the company is valued at $1.3 billion, and had traded with a market cap over $2 billion in 2011 (which is not unusual or excessive in biotechnology). But let's say the drug is awarded an approval and the stock trades with a valuation of $2 billion. Then in its first year it reports $200 million in sales and another $20 million in earnings (theoretically). It would be a great start for the company but would value AMRN with a P/E ratio of 100 and a price/sales of roughly 10. However, very few biotechnology stocks trade with such a high valuation, most experience pullbacks at some point in the first year or two. Therefore, I prefer companies that are fairly valued and trade higher over a period of several years such as SPPI, QCOR and JAZZ.
Over the long-run AMRN may offer great value, but as of now, its high valuation could actually hinder its performance in the first few years of approval because of such high expectations. Therefore, when I seek a developmental biotech stock I look for late-phase companies that trade with valuations of less than $300 million (Phase II) and that will have healthy trading metrics once approved.
Late Phase Candidate
In conjunction with a reasonable valuation I want my clinical phase biotech investment to have at least one late-stage drug. IMUC's lead candidate is ICT-107, which is a vaccine that treats glioblastoma, one of the most deadly forms of brain cancer that exists. The valuation should always be measured against the status of a candidate to determine whether or not its over or undervalued compared with other companies in the industry. For example, Verastem (VSTM) is a company that uses a very similar technology but is still pre-clinical and is three (possibly five) years behind IMUC in the FDA approval process. Yet it trades with a valuation of more than double of IMUC. As a result, you must then compare data and find reasons why the later-phase company is valued less. It could be a weakness in the candidate or perhaps it's because the company is unknown, and could be a diamond in the rough.
The technology and results of a candidate is what ultimately earns an FDA approval, so you want to understand the theory behind a company's technology. One of the primary reasons that VSTM is valued so high is because analysts believe its technology, of targeting cancer stem cells (CSC's) as a treatment, will attract significant attention over the next few years. It is a treatment that is gaining incredible momentum because of early results within the industry. IMUC falls in this category with a therapy that targets and treats the root of cancer rather than a specific area, such as radiation and chemotherapy. One reason we have had trouble with advancing the treatment of cancer is because it is constantly evolving and mutating into different forms that a single vaccine cannot treat.
IMUC is transcendent for three reasons: It is treating cancer via targeting CSC's, it uses immunotherapy to activate the body's immune system to fight the disease, and it targets several antigens compared with other vaccines that only target one. IMUC is one of the only biotechnology companies using this combination of targeting CSC's via immunotherapy, which allows it to both find and then treat individual cells without harming healthy cells, resulting in better results and less harmful side effects. But what makes it so unique is the company's success at targeting several antigens. As I said, the problem with treating cancer is that it mutates and evolves. IMUC is constantly acquiring new patents and intellectual property of various antigens that are highly expressed in other cancers to test its vaccine. So far the company's lead candidate ICT-107 targets six antigens (compared with Dendreon's Provenge, which targets one), which means it can destroy these cells even if one or two or three mutations on those antigens occur. This basically means that ICT-107 is not only much more effective but could prove to treat a large number of cancers with only one vaccine, making it a transcendent technology.
Encouraging Early Results
I have already explained that glioblastoma is one of the most deadly forms of cancer, if not the most deadly. It has an average life expectancy of just 14 months, and a 24 month overall survival rate of 26.5%. However, in early trials, ICT-107 had a 24 month overall survival of 80% and a 3 year disease free rate of 40%. This proves that the company's drug, and its technology, is highly effective in treating one of the most deadly forms of cancer known to man. Therefore, we can only imagine its effectiveness at treating other less deadly cancers that ICT-107 is believed to treat based on it being able to target multiple antigens that are highly expressed in other cancers.
Over the last six months companies with a late-stage candidate that treats Hepatitis C were all trading higher after high premiums paid to acquire Pharmasset (VRUS) and Inhibitex (INHX) among others. As a result nearly all companies that had a HCV drug in development traded with momentum in hopes of being acquired (and several were). With the advancements in the field of oncology it is very possible that companies treating CSC's could become a hot ticket. And with IMUC's innovating therapy it could very well be in the pack. There are already companies such as Micromet, BioVex, and Boston Biomedical that have been purchased by large pharma for very large premiums. Therefore, it seems logical to imply that more acquisitions could occur and these companies could trade significantly higher.
If you are lucky enough to find a good undervalued biotechnology company that meets all of your criteria you still want to know that there are some immediate drivers for gains. I bought IMUC back in early February, and it has since returned a gain of nearly 100%. Yet with a very promising candidate and several upcoming developments it seems as though further gains could develop. And although my goals are long-term it is still important to identify all drivers.
In 2012 IMUC has been driven by the results from its ICT-107 trial, optimism surrounding CSC targeting treatments, and several key developments regarding additional patents and intellectual property. The next round of news will most likely include a listing on a large exchange. As of now the company trades OTC and hasn't been able to attract corporate or institutional investors in the same way as a similar company that trades on one of the larger exchanges. When IMUC announces this change it could result in large gains and a new degree of optimism for the company. In addition the company will be announcing its five-year survival data at this year's ASCO meeting, which is one of the biggest events in biotechnology. If ICT-107 shows any positive data in treating glioblastoma over a five-year period then it will be very encouraging for investors.
Biotechnology as an industry always produces the best-performing stocks in any given year, and has had the most number of 100% Q1 performers in 2012. The tools needed to find a good biotechnology investment are much different than what you use to find a good investment in the transportation or services sector. Developmental biotechnology stocks are valued on potential and quarter-to-quarter developments that determine potential revenue, and earnings, rather than actual revenue and earnings. I have always felt comfortable buying Phase II biotechnology stocks that trade with valuations under $300 million because it presents the highest level of potential upside, and limited downside.
The FDA has made some goofy decisions over the last 10 years, and the last thing I want is to be holding a clinical phase company that is valued at $2 billion before an FDA decision. I would much rather hold a sub $600 million company with an equally good product that is going before the FDA. Because if approved it will be better valued once the drug is sold, and won't trade with ridiculous metrics because of its high valuation. The smaller biotech companies with solid candidates in potentially large markets present the most amount of upside. And I believe that IMUC meets all this criteria, which is why I purchased the stock. However, the most important point to remember is that buying biotechnology is much different than other investments because it involves a great deal of speculation. And if you buy at the right time and understand what drives the stock it can be very rewarding as a long-term investment.
Additional disclosure: The information in this article is not intended to determine any investment decisions. All investment strategies should be discussed with a financial advisor to assess risk and determine whether or not it fits into your individual goals.