A Journey To Add Biotech To The Portfolio

by: Gregory Stuckey

I recently evaluated my portfolio and realized I was completely invested in companies with market capitalizations over $100 billion. With what looks like a recovery to the overall economy of the US, I wanted to reallocate some of my portfolio to gain exposure to small cap stocks. I have always been fascinated by the biotechnology industry and wanted to add a little to my portfolio. The problem for me was I didn't really know much about the industry and that can spell disaster for an investor particularly with this industry which is universally defined as a high risk. The performance of these stocks is tied to the successful completion of phase I, II, and III clinical trials and FDA approval to commercialize the product. Failure at any one of these milestones can destroy the stock's value and subsequently the investor's portfolio. Of course the flip-side of that equation is also true; success in these various milestones can create huge upswings in the stock price.

First I needed to define what my goal was for investing in this industry. I wanted to add positions in companies that were developing new technologies or medicines that did not necessarily already have a solid revenue stream. I was mostly interested in adding stocks that were small in scale to add some diversity to my large cap stock portfolio. So my goal was to add small capitalization companies producing new and innovative solutions in the biotechnology industry and I was not necessarily concerned with companies with negative earnings because they have not brought the product to market yet.

The simplest and safest way to achieve this goal of adding some of these stocks to the portfolio is to invest in an ETF that targets this particular industry. It is safest, in my opinion, because it allows me to effectively take positions in more stocks than I would be able to if I invested in individual stocks. I reviewed five different ETFs:

· First Trust NYSE AMEX Biotechnology Index Fund (NYSEARCA:FBT)

· Market Vectors Biotech (NYSEARCA:BBH)

· PowerShares Dynamic Biotechnology and Genome Portfolio (NYSEARCA:PBE)


· PowerShares S&P Small Cap Healthcare Portfolio (NASDAQ:PSCH)

All of these ETFs were performing well with 12.53% - 33.31% gains year-to-date. Once I began reviewing the information on each fund's stock holding, I realized FBT, XBI, and PSCH were the funds that best fit my small capitalization preferences. FBT invested in 21 stocks with 19% in small cap, 45% in mid cap, and 35% in large cap. XBI invested in 52 stocks with 21% in small cap, 59% in mid cap, and 19% in large cap. PSCH invested in 67 stocks with 30% in small cap and 70% in mid cap. XBI was my top choice mostly because it had a nice low expense ratio of .35% was 100% focused in the biotechnology industry and had a strong exposure to small capitalization stocks.

I also prepared a stock screener to delve into individual stocks in this industry. I was not completely satisfied with taking the higher road and just investing in an ETF in the biotechnology industry and calling it good. I wanted to journey through the industry and see if I could find stocks I could be excited about investing in. My screen started with the following requirements:

· A Market Capitalization of less than or equal to $500 million - This fits my original goal of investing in small cap companies.

· In one of these industries: Biotechnology, Pharmaceuticals, or Healthcare Technology

· Cash and Cash equivalents on hand - I did not set a particular parameter, but I needed this information for some additional number crunching.

· Current Ratio greater than or equal to 2 - I used this to eliminate any companies with too much debt relative to its cash

· Long-term debt - no parameter I just wanted to see this information in my screen

· Percentage of Institutional Ownership greater than 5% - In several articles I read it indicated that this was a strong indication of probable success because the "smart money" was already invested in the stock

· Stock Price greater than $1 - only to eliminate penny stocks which I am not interested in

· 90 day Average Volume of 500,000 - I wanted to eliminate any stock that would be potentially hard to close my position when I wanted to

I created a spreadsheet with the 24 companies that this screen provided me with and moved on to the next step. I felt like 24 companies was too many to try to really investigate and I needed to cut the list a little more. I knew I was looking at a list of very risky investments ones that most likely did not have a proven track record of success or likely a product actually being sold. In order to mitigate the risk of these investments, I crunched two numbers; the amount of the market capitalization held in cash and the years of cash the company had on hand. The first number is pretty simple; take the amount of cash and divide it by the market cap to see what percentage of the market cap was held in cash. For the second number, I took the cash on hand and divided it by the operating loss sustained in the current year. This assumes the "burn rate" would be essentially the same as the previous year which is not a great assumption but gives us some ballpark estimates to work with. Two companies actually had positive cash flow which I kept and I removed any stocks that had less than 1.5 years of cash on hand. This was an arbitrary number but I felt like it was as low as I was comfortable going seeing as moving from each phase would take at least a year in my mind. 2.5 years of cash most likely put the company in a low risk category for needing additional capital if it was in the Phase II or III trials which is the product timeline I was looking for. After removing any company with less than 1.5 years of cash I had 15 companies remaining.

With this shorter list, I started to research the product pipeline for each company looking for companies with multiple products and products in Phase II or III of development. I eliminated companies without this requirement except for Rigel Pharma (NASDAQ:RIGL) It did not have any late stage clinical trials but had 3.5 years of cash on hand, over 70% of its value came from its cash holdings, and institutional ownership topped the list at 93.74%. This left me with 6 stocks to investigate. I have added the spreadsheet for these 6 stocks below:

Name Symbol Market Cap Cash % of MC Institute Price Long Debt burn rate Yrs of Cash
Oncothyreon ONTY 143.6 81.3 56.62% 45.42 $2.51 0 27.3 2.98
Galena Biopharma GALE 206.2 35.6 17.26% 8.79 $2.48 0.051 20.9 1.70
Threshold Pharma THLD 260.1 104.2 40.06% 63.04 $4.60 0 29.9 ?
Vical VICL 309 83.9 27.15% 45.19 $3.58 0 17.5 4.79
Rigel Pharma RIGL 405.2 298.2 73.59% 93.74 $4.65 0 85.1 3.50
Spectrum Pharma SPPI 434 143 32.95% 73.75 $7.23 75 72 C

Market Cap, Cash, Long Term Debt, and the Burn Rate are all in millions of dollars

Threshold Pharma (THLD) and Spectrum Pharma (NASDAQ:SPPI) actually have positive cash flow of $29.9 million and $72 million which is why their Yrs. of Cash column is blank. From a purely fundamental stock perspective, all of these stocks are strong candidates for investment, but of course we need to review their products to really determine which one may be successful. Rigel Pharma and Gale Biopharma (GALE) had the strongest growth in institutional ownership in the last two quarters with 15% and 40% percent increases in ownership, respectively. Spectrum Pharma and Threshold with their positive cash flow are good candidates for investment as well.

The final step is to figure out which one you believe has a strong product that is addressing an unmet need in the market. Carefully review the details of the clinical trials to determine if they actually indicate success, it is amazing how often the trials are poorly designed or do not actually test for successful treatment of the illness. I believe you now have a viable list of 6 companies to complete rigorous due diligence to determine if they are valid companies to invest in. As you complete your research, please comment on this article so we can all benefit from your insights on these companies particular products.

I ended up investing in GALE because it had licensed Abstral sublingual tablets for the treatment of breakthrough cancer pain for patients in the Unites States. The market for this product in the US is approximately $400 million and this is the only sublingual tablet available to address this need, which I feel will allow GALE to achieve positive cash flow in 2014. Successfully creating positive cash flow would prevent GALE from needing to raise additional capital to get its flagship product NeuVax to market. It is also the same customer base that will eventually be interested in prescribing NeuVax in the future allowing the company to create a relationship prior to marketing this new product. The risk for this company is although it has several clinical trials moving forward for different treatments they all center on NeuVax, so its failure to commercialize will destroy the company's product pipeline.

Disclosure: I am long GALE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.