Why Should Investors Consider An Allocation In Speculative Biotechnology: A Sector Analysis

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Includes: CYTR, IMMU
by: Strong Bio

Summary

Companies burn hundreds of millions of dollars with low chances of product development success.

Poor stock selection can cost an investor 99% of an investment.

Successful navigation of current trends in biotechnology can carry portfolios exponentially higher.

Many intriguing articles have been written about investing in biotechnology. Biotechnology investment has been referenced by many knowledgeable and respectable authors as controversial, out of favor, and even sexy (this article by Stephen Simpson, CFA, is must read). Surviving current trends in biotechnology stock price manipulation can be both stressful and disappointing. This leaves us all to wonder is it even worth it to try speculative biotechnology as an investment option?

StrongBio believes it is worth it, even if it results in losses that are hard to endure. In the end, contributions to healthcare from growing sources of capital are extremely important for improved patient care (termed supply-side capital). As these contributions have grown, however, so too has waste. With proper selection, timing, and diversification (three pillars of biotechnology investment), the common retail investor can eventually be financially rewarded as philanthropic goals of the population are met.

Simply put, biotechnology companies focus on drug development aiming to treat an unmet or under-met disease or medical condition. Companies that have succeeded have net sales in the tens of billions and total market values in the hundreds of billions of dollars. Speculative biotechnology companies, in contrast, differ from proven top biotechnology companies in that they often have no approved products or revenues.

Gary Pisano of Harvard Business School has done extensive modeling of biotechnology (and other technology) returns. Reports between 2006 and 2012 indicate that average biotechnology returns have been historically unimpressive; with 25-year returns of "market baskets" of biotech stocks yielding only about 10% per year. This means that much of the legendary "opportunity" in biotechnology stocks revolves around successful portfolio management of technological trend shifts and timing positions accordingly.

Much of the challenges lie in the fact that science experts tend to focus into niches instead of pursue interdisciplinary science. Scientists tend to lack fundamental economics or business expertise and vice-versa, with business leaders lacking science background.

So what if a speculative biotechnology company has shown positive data in a curative treatment for cancer? Many things can still go wrong for an investor. One should always have a plan for setbacks and delays. Sometimes clinical setbacks can occur requiring a company to delay a trial until regulatory requirements are met. Other delays are more business-oriented, with slated clinical trials held up due to lack of funding such as in poor economic times.

Even legal setbacks occur and can cost both time and money. And then we have the gatekeeper: FDA, and regulatory setbacks that can occur. The fact is most biotechnology projects fail. According to Pisano, the average biotechnology company is likely to fail 90% of the time, with companies that make it all the way to Phase 3 experiencing approximately 50% chance of success.

Multidisciplinary investment management increases the likelihood of a success, meaning, that many common retail investors are going to have to try to wear multiple hats when performing qualitative analyses. That's what StrongBio calls work. It's a lot of work. But knowing what to look for in each discipline can be of great service to the retail investor.

And if all of those pitfalls are not enough, going back to our legitimate cancer data success scenario, market manipulation and fake news from negative press can still make investors feel like their winners are losing investments for quite some time. Take for instance the 2016 situation with Celator Pharmaceuticals, which was driven down to $0.79 cents per share and rose 1600% when whatever market forces that were holding it down, along with negative press, finally gave up the fight to an obvious winner (having been bought out by Jazz Pharmaceuticals (NASDAQ:JAZZ).

The oppressive forces on the stock persisted right up until FDA review. Other company shareholders, like those of Northwest Biotherapeutics (OTCQB:NWBO), allege that negative press and stock manipulation are linked. Immunomedics's (NASDAQ:IMMU) stock see-sawed back and forth several times between $2 and $5 (and even drew a halt from the SEC), market cap between 180 million and 500 million respectfully, in 2016 with alternating negative legal press by no less than 20 law firms and positive research press and stock price volatility. Extreme patience is required while waiting for "fair value."

The University of Chicago oncologist Mark Ratain postulated that a company with a market cap of less than $300 million is unlikely to succeed. Commonly known in biotechnology investment circles, the Feuerstein-Ratain rule, was a solid predictor in the past. This year companies are defying the 300 million rule. StrongBio believes the rule used to hold water because there was a predictable method to the involvement of big pharma in purchasing speculative biotechnology cancer stocks.

So either big pharma is no longer able to identify useful technologies and many are slipping through the cracks, which is unlikely, or something in the markets is changing. It is also possible that it was getting predictable to pick biotechnology successes based upon the highly successful metric by the well-respected Feuerstein and Ratain, so market makers have changed it up a little. Past open market buyout periods of obtaining shares of speculative stocks drove prices up as a whole (or held them flat for long periods of time) to approximately 300 million market caps. Accumulation such as this no longer seems to be in effect.

Whatever the mechanism of value assignment by the market, it is clear there is a new market pattern emerging in biotechnology, with lower than normal market caps. StrongBio believes there may be several contributing reasons for this. One, investment levels are predicted to be the lowest that they have been since 1947. This is also true in the investment banking sector, a big source of biotechnology funding.

Simply put we have not had a great investment economy, and risky biotechnology may be regarded as an irresponsible investment during tough financial times. Because new patterns on speculative biotechnology company stocks show suppression over periods of months and years, it is possible there just is not as much retail and/or institutional support as in years past.

Two, is the SEC unconscious at the wheel or did someone outsource that job to Asia? This query addresses concern over foreign-based or hostile entities' ability to starve funding for cash hungry technology companies when they need to sell stock. In recent years, an increase in foreign companies cheaply acquiring U.S. biotechnologies developed at tax-payer-supported universities and other technologies funded by state and local governments has plagued markets.

New stock exchanges like IEX have even been set up in an attempt to thwart different kinds of financial manipulation utilizing delays in trade execution (read this book or a synopsis about it in Flash Boys; it's fascinating). However, the market is currently responding to new executive political leadership in a corrective way. One can always hope that a nation of laws will have proper enforcement.

Three, short sellers have influenced stock prices (being respectful of regulations) for a long time, but not to the extent that manipulation is occurring now. Foreign countries like those in Western Europe, Australia and Canada have entirely outlawed the practice of shorting on their own stock exchanges. This indicates these countries have identified that stocks were oversold and manipulated and regulations and laws limiting short sales were not able to control it.

It would appear pretty obvious to those following speculative biotechnology that the same is occurring in the U.S. For instance, one exploring and mining company presented evidence to the SEC of a naked short position in the hundreds of billions of shares. Regardless of mechanism there may be a way to estimate increases in short-selling using well established metrics in biotechnology.

StrongBio cites the 2016 failures (and likely more in 2017) of the long-established Feuerstein-Ratain rule as evidence NOT that the metric is somehow flawed, but rather that market conditions have changed. The 300 million "rule" is now as dated as 4-inch tile countertops for kitchens and bathrooms, and has likely been rendered obsolete by rampant stock price manipulation. But that does not mean that one should abandon biotechnology investments.

Eventually, a fair value is decided between a suitor and company management if something in the pipeline passes FDA and can be sold. Since Celator (NASDAQ:CPXX) rendered the Feuerstein-Ratain rule obsolete at a market cap of less than $100 million, and Immunomedics obtained FDA breakthrough therapy status in triple negative breast cancer at about $160 million, we know the static threshold value of 300 million is no longer even close to critical mass for the metric.

Out of fairness, the metric can be influenced by other factors such as a changing FDA landscape as well, but that wouldn't explain the difference in market cap as the FDA does not participate in stock pricing or market making per se. It follows that if market regulation returns to prior levels, the metric threshold would increase back to 300 million.

How much lower can the Feuerstein-Ratain critical threshold go? That may depend in part how many shares can be shorted in a given company. StrongBio cites here mention of a gnarly cancer drug company from a recent article by an author of the metric that has approvable Phase 3 data. According to a report by H.C. Wainright, this 40 million market cap company, CytRx (NASDAQ:CYTR), is likely to get some kind of approval pathway for aldoxorubicin on its statistically significant Phase 3 sarcoma data, where it outperformed all 5 other drugs in the study.

One might approximate that if short selling is the cause for lower market cap FDA approvals in cancer, estimates based upon how much additional share supply exists now versus when the rule was working can be made. 300 million, the past metric threshold, divided by 40 million, the current potential low, gives a WHOPPING 7.5-fold more potential share supply (provided to the market by short selling). This assumes that the relationship between stock price and shorting of shares has some kind of linear and direct relationship, such as common economic supply and demand curves.

This implies the Feuerstein-Ratain metric tool is a dynamic sliding-threshold subject to changing market factors. One might argue that a linear relationship would be less representative for a "real world" sigmoidal supply and demand model, such as that proposed by Alfred Marshall. These curves break from a linear path to form a smooth parabolic curve with sigmoid limits because of factors such as wear and tear of production equipment, transportation limits, and other practical factors in supply-side analysis. In an electronic market system of a thinly traded biotechnology stock, it is unlikely these factors are relevant.

This emerging scenario creates an even greater margin for profit if one can properly select stocks that are at a record low market cap threshold for FDA approval in cancer, sometimes called short squeeze. At some point, speculative biotechnology companies get a fair value assigned if management is honest enough to serve their fiduciary duty to shareholders. It is at the point of buyout that fair value was reached for CPXX. Fair value soon will be reached for IMMU based upon significant partnership (Seattle Genetics, SGEN) and possibly even CYTR.

StrongBio cautions the reader that CytRx has been accused of hiring stock promotion media in the past, and its pillar of honor might have been "pierced." Nonetheless it appears that after a substantial period of risk everything that was promoted is likely to be true. In addition, remember that biotechnology investment in a "market basket" of companies typically returns about 10%. StrongBio does not recommend deviating from this basket approach, but rather by changing weighting late into development and after dilutions, obtain higher than 10% returns when possible.

The primary pillar of biotechnology stock investing, selection, is obviously a critical factor, standing tall in front of the pillar of timing. How can we avoid picking a loser? The second pillar of timing comes down to choosing a company with favorable Phase 3 data as they meet with FDA in a type B meeting (where FDA reviews the data outcomes of a clinical study) and an abnormally low stock price compared to the annual market its product will serve.

These two pillars stand in synergism, as one doesn't have a favorable investment with only one solid pillar supporting a portfolio candidate under current market conditions. It is important to invest lightly at first so that lower prices do not cause harm to a portfolio. If the stock runs up just be happy you had a little.

The pitfall of regulatory hurdles is always a major concern, but there is circumstantial evidence that the FDA will be easing some burdens. Cancer drug shortages (such as existed for doxorubicin in December 2016) can be thwarted by increasing the number of suppliers and approving safer more effective derivatives. The FDA may favor competition to lower prices of potentially egregious monopolies. Cancer treatment in the hospital environment is currently trending towards increasing physician options and information as well as for patient-physician interaction as well.

For instance, some drugs may be hard on the liver and not be good for alcoholics, whereas other drugs may be rough on the heart, and be contra-indicated for heart attack sufferers. So demonstration of comparable efficacy may be acceptable if safety is improved for subsets of patients. Whether the desire for increased options will spread from cancer to other indications remains to be seen.

However it is no secret that Trump intends to "slash restraints" artificially put on drug makers by the FDA. If these trends come to fruition, StrongBio expects the chance of success of biotechnology companies to increase, but the markets for some drugs may sink into smaller niches of sales with greater total options available.

So there are certainly the same past investment risks that the FDA will not view data as favorable or that companies will have a hard time proving they can meet production standards for NDA approval, including lot to lot consistency. Oftentimes a speculative biotechnology company can partner this production with a number of firms.

But the reward to risk ratio can at least be dynamically tuned for investment success. With proper selection, timing, and diversification, StrongBio estimates that new regulatory policies and market conditions will make biotechnology investment potentially more common and successful as the outdated thresholds of the past are readjusted to guide investors.

Disclosure: I am/we are long IMMU CYTR.

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.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.