Rockford Coscia's  Instablog

I was watching today as an otherwise outstanding day in the market for me turned into something rather mediocre. The culprit in my portfolio was Arena (ARNA), of which I had purchased on Friday in an emotional rush to ‘get on board’. Buying ARNA was against all of my rules and I paid for it. JPMorgan released the information I already knew for the most part, that Arena’s price surge had priced in an FDA approval and $1+ billion in sales. JPMorgan is on the bearish side of analysts with a price projection of $6.00, but there really is no good reason for ARNA to have these outrageous projections priced in. At any rate, as I watched -4% turn into -10% I thought a lot about my investing rules and wanted to share them, hoping that, rather than speaking as an trading expert – of which I most definitely am not – I could inspire some sort of discussion among the readers about their best ‘biotech trading rules’.

Here’s mine, in rough order of importance:

Only invest in stocks with a market cap below $500M.

There are multiple reasons for this rule. First, with my typical trades lasting only a few months at most, I want to have the potential for relatively large price swings; that just doesn’t happen with the larger cap stocks. Second, smaller market cap companies are often times passed over for trading by the larger banks, quantitative traders, and day traders. This is good, it gives the opportunity for less information to already be ‘priced in’. Third, the companies are usually much simpler in nature. I find it much easier to value a company that has one or two products versus one that has a huge product portfolio. This is by far and away my most important rule.

The analysts have done the math. Don’t buy companies with price targets less than 20% (or better 40%) above today’s price.

This one I realize is controversial to some degree. The reason is that analysts are notoriously wrong. There’s no evidence that sell-side equity research, in general, is any better than anyone else at picking winners, and even if they do, that information is priced into the stock almost instantly. Those statements, in general, are mostly true. However, the sell-side equity research can do the mathematical projections reasonably well, and especially when the product portfolio is so straightforward. There is usually a judgement call made about whether or not a drug will be approved, which could be as good a guess as anyone else’s, but I feel like the sales analyses after that are going to be better than most. Trust that the equity research teams have projected the markets, the discounted the cash flows, and analyzed the sales agreements reasonably well. But never trust one research team, taking all research recommendations in aggregate provides a clearer picture.

There are two big exceptions to this rule, however. First is that the analysts are always always always slower than the market when it comes to adjusting to news. A new approval, for example, may take months to be fully reflected in the price estimates for the stock. Always consider what news and binary events have taken place since the last analyst recommendation. Second, analysts tend to be overly harsh on complete response letters (CRLs) and remotely negative clinical trial results. It’s the easy and safe thing to do to cut to hold after one of these events. It’s almost irresponsible for them to continue to recommend a stock after a CRL, even if the company has a decent shot of getting their sNDA accepted and eventually approved. So I understand their position on these events but you should rely on your own valuations more in these cases.

Don’t ever hold through FDA panels, panel notes release, and PDUFA dates.

There’s a word I use for holding through these dates: gambling. The risk associated with these events are just too high. These events are highly unpredictable and usually the market has priced in all information and odds associated with any particular outcome. In addition, it is so rare that you’ll have some sort of insight that the market doesn’t already know that these rarely end well. There’s no technical or fundamental analysis here, it is just gambling on an event you have zero influence on. The only possible exception to this rule is the ‘free shares’ method in which you sell back your principal investments and keep any profits as shares to ride through the event. I still think this is a bad idea. Although we usually talk about ‘sunk costs’, the profit gained through some sort of run-up to a binary event ought to be called a ‘sunk profit’. It doesn’t matter how you got it, think of it as money you have now that you can lose just as easily as a few bills in your wallet.

Those are my ‘big three’ rules for biotech investing. You can see I violated two of the big three on my ARNA trade and now I feel especially bad about making the trade.

Some other random rules I follow:

Do your research, know the products and the company, but don’t over analyze.The old ‘analysis paralysis’. This may be something more to do with my own personality but, in general, it is extremely easy to talk yourself out of any trade. If the stock fulfills all of your rules and the product and company look good, you’re clear to buy. Go for it!

It never matters how much you’ve gained or lost, evaluate the stock as if you’re buying selling new today: Basically follows the logic of the sunk-cost fallacy. Most stocks will fall into the ‘nuetral’ range, as in you can’t make a call on whether they’d do any better or any worse than anything else you can think of. However, if you’ve dropped 20% on a dog and it looks like a bad investment, get out! If you’ve been making a steady income on something but it mow looks like a good candidate for shorting if you didn’t already own it, get out! This should be obvious to everyone.

Don’t ever carry biotech stocks blindly, have a catalyst date in mind: Biotechs are extremely risky in both directions. Some new clinical data may sink your companies lead compound or they may get an offer from some big pharma tomorrow that double the stock price. Swimming around in the ocean is dangerous, but not so bad if you have a landmark – a catalyst – to keep things in perspective. Always have a catalyst date and an investment timeline in mind or else you’ll get swallowed up by unexpected new information – often bad . Additionally, you have a good idea on what news to expect if you’re zeroed in on a catalyst. For example, candidate crushing news if highly unlikely after NDA and before the PDUFA date (but not including the PDUFA date), so owning in this time period is relatively low risk.

Stocks almost always go down after approval, but don’t get greedy: Share prices almost always drop significantly after approval and the drop is fairly easy to predict, so you can make a lot of money shorting the underlying stock after a drug approval. The two opportunities are almost immediately after approval (with the first 30 minutes) and from the day after approval to about four to eight weeks out. The underlying company’s share price after approval almost always follows the trend: initial pop (>30 minutes after approval), post-pop drop (30-120 minutes after approval), search for the ‘fair’ or ‘right’ price (the next 3 to 24 hours), further profit taking (the following four to eight weeks). There is risk involved, you’ll be hesitant to make the move, and everyone in the Twitter-verse will be wondering who will pull the trigger. Be the one who pulls the trigger. However, you must have a goal in mind or else you will get greedy. I like 10%. If you can make 10% on the ‘post-pop drop’ and then again in the further profit taking period, you’ve made 20%. Feel good about it and stop following the stock.

If you can pick long stocks, you can pick short stocks: Many people feel extremely uneasy carrying short positions. Many say that, since the market tends to go up about 10% a year, holding short positions at all is counter intuitive. For that I have two things to say. First look at the market since 2001. Sideways. I’m not a big proponent of ‘Buy and Hold is Dead’ but it is most certainly catatonic for the time being and no one knows when it’s waking up. Second, it hedges you, making your portfolio less risky, allowing you to add additional ‘good’ risk elsewhere. For example, I pay close attention to the biotech sector because that’s where my specialty lies – I have no advantage in other sectors. In a 100% biotech, 100% long portfolio I expose myself to market-specific risk as well as industry-specific risk. By moving a few of my trades to the short position I remove market and industry specific risk, allowing myself to reduce risk without diversifying outside of my specialty. Furthermore, I find declines to be more predictable and more gradual than rises in share price.

If you’ve followed the rules and lost money, don’t stress, shit happens: Nothing is ever guaranteed and unpredictability is the name of the game. You’re just trying to win most of the time. No one ever wins all the time.

That’s the rules I follow especially closely. As I said, I am a better scientist and chemist than I am a trader, so don’t the preceding rules as gospel. Do, however, take this as an opportunity to create or review your own goals.

What are your ‘Biotech Investing Rules’?

Disclosure: Currently long ARNA. I feel like most of the damage has been done, but I will strongly consider dropping and licking my wounds in the next day or two. It does, after all, still violate at least one of my rules.