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The key to returning large gains in the developmental biotechnology space is to understand that valuation doesn't indicate actual value. There is a misconception among retail investors that if you invest in a company with a promising late-stage candidate that has a $1 billion valuation or more, that it will return large gains over a course of many years and is more likely to gain a regulatory approval. Although this may often be the case, there are simply too many exceptions for this to be a wise trading method. When a pharmaceutical company trades with a multi-billion dollar valuation in the clinical phase it is usually because data is strong, the demand is significant, and it has successfully executed throughout clinical trials, therefore, providing a clear path to an FDA approval. However, it doesn't necessarily mean that it will return the largest gains, as often the valuations are too high, the expectations are often unrealistic, and the stocks often return a loss either upon approval or after sales fail to live up to the high expectations that come with being a billion dollar clinical phase company.

A good example of this scenario played out with Dendreon Corporation (NASDAQ:DNDN). Dendreon was a $4 billion company before it ever marketed a drug. Aside from the fact that it has run into countless issues since earning an FDA approval, its expectations were insane-- so high that sales could never satisfy the street's expectations. Typically, these companies with excessive valuations prior to or following an FDA approval, will pullback in the first year when sales do not meet such extravagant expectations, as it takes time to manufacture, market, and sell newly approved drugs. When a company is overvalued from the start, there is no room for error. Those that do meet expectations, but are still expensive or overvalued, end up like LinkedIn (NYSE:LNKD), which is a company that would have to post 100% sales growth for several years just to be considered "fairly valued" at current prices.

For some, investing in a perceived safe, guaranteed, and overvalued biotechnology company is their preference, which is fine. I have always preferred companies, such as Threshold Pharmaceuticals (NASDAQ:THLD) and Celldex (NASDAQ:CLDX), which are undervalued as pertaining to clinical data and potential. They could grow accordingly over a course of many years, both during clinical development and after approval. I prefer companies that grow pipelines through acquisitions, are able to find value in the market from underdeveloped drugs and then develop the drugs with either a new indication or further develop a promising candidate that may have slipped through the eyes of large pharma. For some reason, you rarely see large pharma acquire drugs for value-presenting prices. It seems that large pharma would rather purchase companies, such as Amlyn, Pharmasset or Inhibitex, for prices that will take many years to pay off in terms of net income-- that is if the acquisition ever pays off. Whatever the reason, large pharma executives find this approach to be logical and preferable to the alternate bargain-basement deals.

Rather than purchasing $5 billion companies with a lead product that will only return $1 billion in revenue (and may only return $250 million in net income), I prefer $10 million acquisitions of candidates that could return $100 million in revenue, and that could pay off shortly following an approval. The market is full of successful companies that fall in this category, as well as companies that have acquired drugs returning great revenue and continued growth. The problem, to which I have alluded, is that the market places a value on the drug, based on its acquisition price. This often leads to the acquiring company being undervalued, allowing the stock to appreciate with fundamentals and present value for investors.

The fact of the matter is that large pharma often miss opportunities, and rarely even looks for them. Rarely do we hear of large pharma acquiring a late-stage candidate for less than $50 million. However, once the candidate appreciates and reaches a "value" of a billion dollars or more, large pharma often come in and scoop up the drug-- even those drugs that have been acquired for much less by a previous company. For example, back before Zytiga was an expected blockbuster and was acquired by Johnson & Johnson (NYSE:JNJ) for $1 billion, it was acquired by another company for much less. Most people aren't aware that just a few years before JNJ's billion dollar purchase, Zytiga was acquired by Cougar Pharmaceuticals (the company JNJ acquired) for just $1 million! Cougar saw the value in the drug, developed it, and then sold it for a larger profit than the drug will ever return to JNJ. Zytiga may post sales that far exceed $1 billion; however, it will take quite some time before the company actually returns a profit from its $1 billion purchase.

In addition to the Zytiga blockbuster (for Cougar), there are numerous examples of companies acquiring candidates and appreciating with unprecedented gains. Jazz Pharmaceuticals (NASDAQ:JAZZ) purchased Orphan Medical back in 2005 for $120 million and obtained the rights to Xyrem, a drug that returned over $230 million in sales in 2011 and is expected to reach peak annual sales near $1 billion. JAZZ is a stock I purchased back in 2010. I actually contemplated the investment because I felt the $120 million price paid for Orphan was a little too pricey. However, JAZZ also obtained a sales force along with a one-of-a-kind promising candidate that has paid off with huge gains.

Aside from Jazz, I also purchased shares in Spectrum Pharmaceuticals (NASDAQ:SPPI) and Questcor Pharmaceuticals (QCOR), which were both instrumental in developing this strategy. Fusilev, which is Spectrum's fast-growing lead drug, was acquired for just $20,000 in 2006, and Questcor purchased its fast-growing multi-purpose drug, Acthar, for just $200,000. Both are lessons that the price paid to acquire a candidate often does not indicate its growth potential, nor does it tell the value of a company. Yet, because all three of these companies acquired candidates for such cheap prices, none trade with gaudy valuations, but have rather grown steadily via fundamentals. Despite the fact that each has proven its doubters to be wrong, some still can't get past the value that each of these companies found while large pharma seems more willing to pay billions for its products. Investors should seek the principals instilled at companies, such as the aforementioned three, in which wise drug acquisitions will carry these companies for years via earnings and fundamentals.

One mistake that I've made is selling all three of the stocks mentioned above, all which would've returned market-leading gains. I settled for mediocre gains of less than 200%, while in the case of JAZZ and QCOR, my gains could've been over 1,000%. I have since re-purchased and own each of the three stocks, and continue to search for companies that I feel possess the same qualities that led to such success for these three companies. Currently, the only stock I own in this category is Galena Biopharma (NASDAQ:GALE), a stock I purchased at the start of the year, which has returned a 300% gain due to early success with its breast cancer drug candidate, NeuVax.

The purpose of this article is not to discuss specific ideas or stocks but rather discuss this strategy so that others understand. However, it would perhaps add to the conversation if I explain my purpose for investing in GALE.

Galena purchased Apthera for its lead candidate, NeuVax, for about $7 million. Galena has been awarded crucial patents, announced very encouraging data, and has enrolled patients in its Phase 3 trial that will test 700-1,000 patients with low to intermediate levels of HER2. Like Spectrum, Questcor, and Jazz, many have doubted Galena, with almost all bears mentioning the price paid to acquire NeuVax, a reflection of the opinion that a drug must be acquired for large premiums to be promising.

In a Phase 2 trial of 187 patients, those treated with NeuVax saw a 50% reduction in the recurrence of breast cancer after standard of care treatment in patients with low to intermediate expressions of HER2. Currently, there is nothing on the market that treats patients for this specific indication. The most common comparison is Herceptin, a $6 billion per year drug that treats patients with high levels of HER2, which only account for 25% to one-third of breast cancer patients. NeuVax, if proven effective, would treat anywhere from 50% to 75% of breast cancer patients, signaling unprecedented potential in terms of revenue. What's even more encouraging is that it will be attempting to meet the same endpoints used in its Phase 2 trial, which already has tested 187 patients and showed a 50% decrease in recurrence. This is a nice indication that it will have positive outcomes in Phase 3 trials.

Based on these facts, you can see the reasons that I chose GALE. The company purchased NeuVax for next to nothing, due to Apthera's financial strains. It has a great scientific team led by world renowned oncologist, Dr. George Peoples. With its current valuation, compared with potential, I felt as though the upside far exceeded the downside. I believe it is the best-in-class of companies that are building a future through cheap acquisitions, although I am always looking for others.

The final point I'd like to make is that this strategy is not for everyone. It is not a "get rich quick" scheme. It requires patience, due diligence, and the self-control to endure excessive volatility, and also the ability to admit defeat when you're wrong. These investments are high risk and should only be purchased in amounts commensurate with the risk tolerance of the individual investor, within this category of biotechnology companies. If a company does find a diamond in the rough, the rewards could be huge; but the risk must be balanced with the potential rewards. For example, a $5,000 investment in QCOR back in 2007 would be worth over $600,000 today. When you put that into perspective and assess the risk versus reward, you can see that by using this strategy of buying undervalued companies, which acquire promising candidates with encouraging clinical data, the upside far outweighs the downside. However, you must stick to the industries you know, use common sense, and also first view clinical data with both eyes open, with a balanced point-of-view. By doing this, you just might realize the level of upside presenting itself in a biotechnology industry that is innovating at an incredibly rapid rate.

Source: Biotechnology: Valuation Doesn't Always Indicate Value