An Investment Approach Designed To Survive Current Trends In Biotechnology

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Includes: IBB, XBI
by: Strong Bio
Summary

Early long investments do not pay, but matching short positions do.

Take small positions deep in phase 3, after negative press, dilution, and price crushing.

Minimize exposure until pivotal trial analysis by FDA.

Investment in biotechnology, though risky, is one of the most exciting areas of the market for the retail investor to enjoy. Breakthroughs in medicines designed to fight perilous diseases contribute significantly to new economic growth by creating and expanding new markets as well as extending and preserving consumer's quality of life and working careers.

However, the landscape of biotechnology has become treacherous compared to the 1990's and early 2000's. One should not fear this change, however, as it is comfortably predictable. Rapid internet communication has increased the momentum of stocks that get hot, and opposite forces have acted more deliberately and drastically on this momentum in recent years. Whereas the early arriving long investor fared well in the 1990's and early 2000's, during which times several interested big pharmaceutical companies commonly raised bids in a gradual stepwise manner for a couple of years heading into a potential buyout, with reasonably steady price ascension interspersed with punctuated spikes.

In more recent years these trends are proving to be the exception rather than the norm. Early short positions now fare very well. This article will focus on surviving as a small retail long in the treacherous, drastic, but still highly predictable modern biotechnology investment landscape.

If one still likes investing in biotechnology after the savage changes that have occurred in the past 10-15 years, the first thing an investor needs to do is create a watchlist and start following companies that catch the eye for one reason or another without taking a position. Plunging long into a biotechnology stock is just not advisable without careful timing and it's important to know what stage of development a company of interest is in, which can take some time, even weeks of following, to properly decipher.

Things that create good financial results for a retail long include treatments that intend to treat large potential markets, break into unmet medical needs or subpopulations, improve upon safety of current therapies, and do not stray too far from the common understanding of the Street. Big scientific leaps may make perfect sense to a well educated medical or science student or professional but are not generally well rewarded by Wall Street, who is run by people with scarce understanding of scientific fundamentals.

For example, look at low valuations of stem cell technologies even after ample evidence exists to support absolutely stunning breakthroughs, new markets, and curative therapies. In contrast, small niche generic drug companies, selling discoveries nearly 75 years old, have fared well over the same period.

The reason: It is easier for people who run the markets to understand the value of simple treatments. Simple treatments are generally brought to market first in an emerging information age. Small steps that are easily digested by the Street tend to have a better immediate result in the stock market, and may require less total time to assess by financial firms that are lacking in expertise to properly evaluate cutting edge technologies. The same can be said about regulatory agencies that treatments must pass through as well.

Buying large long positions in companies that are in early stages of development should be avoided. Short positions of such companies, even those that succeed, in contrast, have done very well in the past 15 years. Although one good strategy would be a simultaneous long and short, such hedges are done easier with put (or call) options trading. This is all that will be mentioned in passing for hedging bets in biotechnology, because most retail investors do not run hedges or margin accounts.

Simply put, it's too long of a process to get a drug or treatment approved to invest in any phase 1 or phase 2 money-hungry company. It should be patiently watched with no position as it develops. Occasionally a phase 2 result can generate a buyout, so one shouldn't completely eliminate phase 2 companies from investment, but it's so rare that it's probably safer not to invest or to invest only a little at these stages. Investments can be reinforced on dips deep into pivotal phase 3 data, preferably after one or two dilutive events, and coupled with negative press in spite of positive interim data and results.

This approach also avoids exposure if the company comes up short with data, or is perceived as such by the Street. This isn't to say that one cannot make money trading intermittent surges in price after a good result is announced. But the strategy here is maximize gain through an end buyout event at the maximum premium possible. And just like most retail longs do not hedge or buy options, most do not sit in front of a trading platform trying to beat the day trading markets either.

Here we will analyze how a $6,000 investment should be made with late purchases just before critical FDA inflection points, rather than early bird buying and long holds which do nothing but strand retail investors in a sea of shorts, stock crushing, and dilutive events. This is the current reality in biotechnology investment.

Small initial purchases ensure that if a stock makes a good run an investor didn't miss out, while minimizing exposure to downward pressures. Well timed small additions can amplify the gains of a run up, should one occur. There are important times to go heavier in a biotechnology stock. Stock prices appear to be manipulated according to how it benefits the larger players. It's important for small retail investors to understand that small purchases do not influence these manipulations in price at all. Shorting can occur by suitors, brokers, market makers, competitors, transfer agents, management dilution, and at nearly every level of the market.

It is not a warm fuzzy world in biotechnology if you don't understand how easy it is to predict when to make the right moves. You can expect to be beaten down over and over, then starved, then beaten again. So avoid the long fight, and jump in late. The hardest part of reaching tremendous success in biotechnology recently has proven to be that you have to rely upon the fact that stocks continue to be manipulated lower (or not allowed to rise) and sometimes even a lot lower right up until the FDA makes a decision on approval (which is certainly only infrequently the case).

Below is a table (Table 1) with some general guidelines to maximize leverage for success, and minimize losses or exposure if something goes awry deep into trials. Don't be afraid to hold cash or spend it on things you enjoy. Waiting for FDA is a long process and there is no sense in buying stock prematurely or emotionally. Save the biggest positions for deep into phase 3 with good data in hand and seemingly strange manipulation of lower and lower prices per share coupled with dilutive events, sometimes unnecessary, and negative press that doesn't have much merit, especially if pumped out from sources that commonly bash on many stocks over and over.

Stocks with promise can and will trade with a market cap below their cash value in spite of a mature pipeline candidates that seems to be meeting FDA approval criteria. Don't let this frustrate investment, rather, borrow from these forces to maximize handsome profits. Currently, being late to the party is favorably "down with that".

Even if one has millions of dollars to invest, an initial position of $100 is plenty to get the ball rolling to track a stock and start following a company's trends, headlines, and behaviors at a personal level. Stay diverse by tracking multiple mature candidates and having multiple positions. The 1% rule is a great rule, take no larger than a 1% total position in any speculative stock. It's best to track stocks with a watch list and no position, but on the rare chance that a technology should become a darling of Wall Street, it's nice to own a little in case it runs wild. If the stock is unlikely to run wild it's not as good of a candidate for a portfolio as one that has that potential.

Positions should be taken on days with low volume descending price and well separated from any appreciable peak, and preferably in middle to late phase 3. Sometimes these positions are best before interim data is released, but sometimes after, even if the data is good. There is just a lot of negative force on biotechnology stocks in current times. One can speculate that foreign hostile takeovers and exploitation, negotiation of cheap buyouts, and shorts trying to cover inexpensively while begging companies to dilute are all reasons, but it doesn't matter what the reason for the fact is.

Chasing biotechnology stocks will almost always get you trapped, and it's not a good idea to do it even with a small initial position because it can create a bad habit with more significant money later. For any phase 2 candidate company that "gets away" by a massive run in stock price there will be many that get trapped in late phase 3 with awesome data at better bargains, and the runaway freight train scenario is just not realistic anymore, though they occurred in the 1980's and 1990's occasionally.

Due diligence is important. Knowing a stock on a personal level includes being aware of the total number of company shares, market cap, pipeline candidates, insider ownership, institutional ownership, and pipeline candidate total market size and realistic market target. It's also important to get information on how much cash a company has onboard, as they will periodically have to sell more shares (dilute) in order to make it to the next stage of clinical trial results. Refer to Table 1, the Simple Strategy of timing and weighting.

One should also be aware of treatment candidate updates, significant inflection points, and how these candidates are stacking up versus already approved therapies. I should mention dividend stocks here as an exception to the current rule of biotechnology. Though they are less common than prototypical cash hungry dilutive biotechnology machines, there are some dividend paying pharmas that develop drugs and it's a good habit to start holding dividend stocks because they are not manipulated as much. For these stocks it's advisable to use a 4% rule as they are safer and enable greater portfolio weighting.

When a speculative biotech runs and produces a positive outcome, it's important to lock in some dividend paying stocks to protect your gain as well as to milk any short that might lurk under your trading platform that might try to take their money back from you in subsequent positions while holding an open short. Dividend paying stocks will not be permitted as open shorts for such purposes. That is another reason to go in small and track companies with no position.

Hold dividend paying stocks over the long haul instead, and get paid for watch list tracking. Timing has become almost everything. So if you don't want to harness the negative pressure on stocks as an opportunity to maximize handsome profits and prefer a smooth steady ride, stay with a dividend paying stock and research those pipelines. These companies generally beat the Street because they have well connected and educated analysts making these purchases, and even if they fail the dividend will offset a lot of the losses over time. But lets face it, the real action is in pure money devouring, no dividend paying, treacherously diluting biotech.

After a biotechnology company has been followed for a period of time and there is some genuine inflection point for the company pipeline that appears to have been met in a positive way without a positive market response, it is time to take an additional $200 as "1st reinforcement" and invest again into what seems to be selling "pressure".

Note that we didn't reinforce into upcoming catalysts, we added after the catalyst was met positively without a proportionally positive market response. This is different than past characteristics of biotechnology stocks. Current trends in biotechnology support the contention that domestic and foreign pharma are pushing prices of biotechnology stocks down, sometimes dramatically, to try to accumulate shares inexpensively. Poor oversight by SEC, FTC, and political leadership for the past 15 years has catalyzed this development. There seems to be no consequence to manipulating stocks down, but this is not the case if a stock is manipulated upwards (see here). Under such conditions one might abandon "free market" as corrupt, but because the buyout event is based upon fair standards (if management is performing a fiduciary duty to shareholders) the end all creates value in these investments.

Meanwhile industry wide shorting firms take advantage of the fact that most biotechnology companies fail. So if a company appears to be succeeding, this is a critical time for these shorts to manipulate a stock lower so as to take advantage of traders, impatient longs, estate sales, or anything that leads to a successful cover of their short position (and their standard operating procedure is to force a stock lower and lower).

It only makes sense, pharma would manipulate prices to its own advantage as they do any other expenditure they can influence. Often one can deduce there cannot be legitimate selling pressure at these new lower stock levels following good data because a stock hasn't been at a low value long enough for any recovery volume to generate sellers. So this depression in stock price is a sign that deep pockets are beginning an accumulation or heavy shorting phase to help in the buyout, covering, institutional investing, or partnership phase of discussions.

Often negative press by sources that repeatedly bash biotechnology companies appear around these times to help frustrate retail investors. Sometimes institutions will sell during these downward pushes as well. So don't lose heart if the data is compelling. Hedge funds may well be taking advantage of put options by driving stock prices lower.

Stocks can remain low and gradually get pushed even lower through what is commonly known as a subsequent "starvation phase" (although not as dramatic as dips in the 1st reinforcement), providing an even better buying opportunity to buy before rapid recovery. If data would appear to be weak or adverse events arise, at least this approach only made small purchases fairly late in the game so risk and exposure was minimal.

Sometimes a stock will start to move up in a traditional ascension when a big player enters the market with ethical standards, usually an upstanding domestic entity. Trading patterns will be markedly different when this occurs and the stock will feel stable for long periods of time. But this is not the common current trend in biotechnology. The current trend would be a long plateau of perhaps 6 to 8 months while the price of the stock is slowly crushed further, weeding out retail longs, in absence of partnership announcements by a small pharma.

$300 more should be added here as a "2nd reinforcement" if indications point to good data, the company is properly reporting with the SEC, and doesn't appear to need to dilute to raise money, and the cost basis can be reduced by more than 20% in doing so. If the company falls below $25 million in cash one, would expect more dilution and shouldn't invest this $300 until potential dilution(s), reverse split, retail washout, negative press, and share price drop is completely developed. Thus the need for a starvation period, enabling those crushing the share price to kick the can long enough to generate some kind of selloff catalyst. Again, there is no hurry to reinforce. It always takes longer than one might think for a recovery.

Finally after months and years of following a company in final stages patiently, waiting out delays and silence from management, watching the stock price get hammered and crushed, a "true position" can be taken if all still appears positive. Remember this is where risk and exposure increase, and just because one obtains a stock at a ~85% lower price than one would have by investing in phase 2, it's still possible that the candidate will fail to pass FDA. So it's nice if the company has a pipeline of trials and treatments so that some of this money can be regained if a fail results.

If one had taken the full position in phase 2, it would be hopeless to ever regain that capital. A true position is best taken late in the development of a pipeline candidate that shows a lot of promise on multiple levels. Maybe multiple studies are showing the candidate to be strong in different indications (combination therapies with other drugs show great promise, monotherapy superiority, positive phase 1 or 2 indications that are different than primary phase 3 pivotal trial nearing completion, etc.). There should be good academic publications referring to this emerging therapy that have passed peer review. Company presentations at symposiums should be strongly supportive of FDA approval. Industry leaders such as M.D.s and scientists should become increasingly involved, perhaps as additions to the board of directors or giving positive interviews of the clinical findings for FDA meeting expertise.

Importantly, do not take a large true position but rather lightly reinforce if management has positioned themselves suddenly with an abnormally large number of share options (millions), or if the CEO is replaced by someone that has not worked to develop the pipeline for a long time. These would indicate a cheap buyout is in the works, which can still be lucrative but would not warrant as much weight as those without such cautions.

Before taking a true position make sure the stock is clear of any recent pops or runs or recoveries, and is not bouncing off of support. Currently biotechnology company stocks are getting crushed back down in only a few days. So be patient for this bottom. Look for shake outs and slow falls, and watch message boards for people complaining of trouble filling buy orders. Social media bashing tends to pick up when support levels are artificially broken.

This is where one sinks its teeth in and takes advantage of the current biotechnology landscape of stock price crushing by putting in a bid slightly below the trading value. Be patient and it is likely it will fill. Remember retail orders are small and pose no threat to larger institutions making markets in biotechnology stocks. $1,900 is a reasonable amount of money for such a high risk and massive reward scenario even in large portfolios, but use this approach as a proportion guide if you have more or less to invest.

The true position is greater than 3-fold the sum of all prior investments and should increase market share nearly 10-fold of initial position cost basis of the modern crush and starve biotechnology stock motif. Positive momentum heading into an FDA verdict could mean the candidate is going to (or already has) failed so do not chase the stock up until an announcement is made, the data is good, and one still likes the price.

Counterintuitively, it's more likely a stock will dip suddenly coming into a gap up or spike prior to an FDA inflection point. Some investors call this clearing stop losses or shaking out weak hands. Whatever it is, it's clearly standard operating procedure. In contrast to the 1990s and early 2000s, it is now better to chase a stock after good FDA feedback than to buy on a run up prior to that feedback.

An "overweight position" should be a rare event if additions of shares are made patiently and well-timed, because a true position should be able to carry a nice entry point into an FDA approval, without a lot of down-side. But sometimes an unexpected (and even repeated) cooperation of a company management and a suitor can lead to even lower drops in price to expedite a purchase leverage for the suitor etc. Examples include dilution and washout events that make a buyout occur at a lower price per share in spite of a consistent total payout. But these buying opportunities can be a retail investors as well if funds are preserved as cash or dividend stocks and are used to overweight.

A primary consideration for overweighting a biotechnology stock in addition to multiple indications having yielded good efficacy is an independent clinical group validating the data and having a confident tone as they approach FDA for the treatment candidate. Overweight is best done when a drop in stock price seems almost comical. In such cases sources of fear are being exploited, such as lack of earnings (common in biotech) unnecessary dilution, addition of free warrants, reverse split, risks of delisting, and similar negatively perceived company events can drag the stock price of a well performing science.

Since the science and the company are somewhat independent, and one is able to leverage a significantly lower cost basis by overweighting, another $2500 can be added very late in the game, perhaps on a shake out or other unexplainable market dip. Such dips are common before good press releases or results just prior to announcement in the current landscape. This is especially true if it has bounced off of nearby support a few times over a couple of months, and finally breaks down rapidly. It is preferential to see management taking pay increases rather than increasing their own stock options during these considerations.

Also remember that the landscape can change once the entities that make the market are best served by a change in direction of the stock, or if acting entities are exiting and entering the fray. It's important to remember that at some point one must be satisfied with a position and ride it out. Continuous hasty repositioning is usually not profitable and the absolute bottom can elude even the most patient and savvy investor.

Table 1: Simple Timing Strategy for Current Trends in Biotechnology Investment, 1% Total Rule

Initial Position

$100.00

Begin Tracking Impressive Pipeline

Promotion phase has worn off

1st Reinforcement

$200.00

Data is impressing in phase 2, interim phase 3

Lower price exists due to dilution or manipulation

2nd Reinforcement

$300.00

Data impressing in publications or symposiums, deep phase 3

Lower prices due to dilution(s), negative press, social media bashing

True Position

$1900.00

Data hitting marks, BOD expert additions, company confident

Market of successful drug exceeds market cap by illogical amount

Overweight

$2500.00

Approval Imminent, management very confident, 3rd party validation

Signs of technical reversal, Stock still trading below cash value, rapid dip in price

Since StrongBio covers a lot of different stocks, it was decided to publish this general strategy in lieu of the current biotechnology stock landscape as it will be referenced in a multitude of articles that will be released soon as a reference. Table 1 will be important to understand as the current biotechnology landscape is exploited by small long investors for improved retail profits.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.