How To Value Biotech Firms?

Summary

• Is it wise to invest in something you don't understand?
• Can you value a biotech firm without being an expert?
• Can an expert value a biotech firm?
• What are strategies to invest without deep knowledge?

A reader asked me how to learn more about doing valuations of biotech firms. Specifically, pre-revenue biotech firms. Thanks for the impossibly difficult question.

It’s so tough many investors - perhaps wisely - caution against it.

You may have heard the mantra of Buffett to stick to your circle of competence or Peter Lynch telling us to invest in what we know.

At the same time, these same investors famously don’t use extensive spreadsheets to model their investments. Peter Lynch invested in so many different companies he can’t have had time to do complex valuations and Warren Buffett prefers value to obvious.

And other investment legends also teach concepts like:

Heads I win; tails, I don’t lose much.

-Mohnish Pabrai

We do liquidation analysis and liquidation analysis only.

-Peter Cundill

Focus on the downside, and let the upside take care of itself.

-Peter Sellers

I always struggled to value firms like Nintendo (OTCPK:NTDOY), Dreamworks Animation - a big winner for The Black Swan Portfolio - or a net-net like Gravity (GRVY).

You can get a reasonable idea of the downside or liquidation value, which is the strategy suggested by some of the great investors mentioned above.

However, how do you value the upside of a firm that can produce a Shrek like franchise in any given year or a couple of total busts? How do you value a firm that one produced a very popular game in both Korea and China but with a declining user base. The gold standard for a success is something like Activison's (ATVI) World of Warcraft but it is only a matter of time before that success will be exceeded by another company. The market didn’t think much of Nintendo before Pokemon Go and then it surged 137.4%.

NTDOY data by YCharts

Not only you would need to model the financial performance of a hugely successful game but you’d also need to consider the potential for milking a new franchise for all its worth for the decade after. These questions are very similar to the problems analysts valuing biotech are facing. Basically these things are impossible to model.

Expert or outcast

You can invest successfully in many different ways but two important ways are:

1 Be an expert with incredible knowledge in a few areas.

2 Invest far outside the beaten path.

I’ve deliberately chosen to practice the latter. I’m not sure if it is the right decision but that’s my road so far. That means buying very unconventional securities and investing in obscure companies.

The reason both models can work is that experts are able to make more granular distinctions in value and investors venturing into the dark corners of the market find opportunities where valuations can be so out-of-whack is obvious to discerning non-experts.

Why are pre-revenue biotech firms - and other hit driven businesses - so difficult to value?

Until I discovered Nassim Taleb, I grasped “hit-driven” businesses were very hard to value but didn’t really understand why. One example is a game business like Zynga (ZNGA). The graph below, from Jeremy Liew, shows Facebook (FB) games by active users:

A typical market with many competitors where winners take all.

After studying Taleb’s work, I understood these sort of businesses, which includes biotech, fall in the bottom right square of the table below:

Source: Edge.org

In this instance, a Black Swan should be understood as a positive event. It could be a significant new cure or a release like Pokemon Go that is unexpectedly successful.

Biotech is a field full of unknowns. Researchers sometimes stumble onto things they did not expect that may or may not be related to what they are actually working on. Trials can yield unexpected results. Total addressable markets sometimes expand once a treatment becomes available. Unexpected viral outbreaks can expand a firm's value exponentially. Competition can emerge where a rival firm finds a better cure or something in society can change, which diminishes or expands the total addressable market. Not to mention the influence of regulators on pricing practices and competitive protection.

Probability of success is very hard to predict; success isn’t binary and the payoff is complex as well.

My takeaway from the wisdom of all the professionals mentioned above has been that extensive statistical work - which valuations often are - is fine but you shouldn’t take it too seriously.

Instead of trying to come up with a spreadsheet, see if you can derisk the thesis.

Examples

I bought Allergan (AGN) because of all the cash coming in after selling its generics division to Teva (TEVA) for $40.5 billion. This significantly derisked the remaining platform. Of course, Allergan then went on to make some acquisitions on which the jury is out.

Gilead (GILD) looked good to me because its profits are running off but probably not as fast as its market price implied. They were also in the process of returning money to shareholders. The result is you get exposure to the pipeline - full of positive Black Swans - at almost no cost or risk. Especially if you consider the firm had a history of taking its R&D dollar a long way. From the research I’ve read, firms that are efficient with R&D tend to continue to be efficient.

The pipeline of an established Biotech can be considered a portfolio of pre-revenue companies and you can occasionally get exposure to this upside at very low risk.

It is much harder to get exposure to a pre-revenue biotech without any supporting cash flow and be comfortable with the risk. There are two approaches that can work and I don’t use the first much.

Takeout multiple

A conventional method that has merit is to look for companies with a very similar pipeline that have been taken out. Recently, Gilead took out Kite Pharma, and since that date, a company working on something similar as Kite, called Juno Therapeutics (JUNO), went up 13%. In many industries, you could get a sense of the EV/EBITDA multiple informed sellers were willing to pay and use it as a benchmark.

In tech and biotech, the product, if it works, is often so well scalable other considerations may play a role. For example, the acquirer may be able to roll out the acquired party's product through its global distribution network or achieve economies of scale by selling the product alongside other products; it will be able to pay a very high multiple.

This is a go to method to keep in the back of your head because occasionally, it will be very easy to apply and you’ll instantly realize a buyout signals there’s a lot of value at a competing firm. It is much easier to execute on if you are an expert on the industry because you’ll be more adept at realizing which firms are working on similar applications.

Liquidation value

An alternative approach is to peruse through companies you can buy below liquidation value. Start searching among firms that trade at a discount to working capital. Pre-revenue biotechs often have a lot of cash on the balance sheet, which they are burning through at varying speeds.

Biotechs like Endocyte (ECYT), Adverum Biotechnologies (ADVM), OvaScience (OVA), Sierra Oncology (SRRA), Alpine Immune Sciences (ALPN), Chiasma (CHMA), Otonomy (OTC:OTIC) and Neothetics (NEOT) are all firms trading at least 25% below working capital minus liabilities.

As they are trading for such a deep discount to the dollar, these are very unpromising companies and I would suggest looking for other ways to ensure you are getting a good run for your money. Although most companies trading at a discount to liquidation value are probably a decent buy solely based on the metric, I don’t think it’s enough with Biotechs.

The problem with this category is that you can be virtually certain they are going to “invest” the cash that they have. There is never going to be a generous return of capital to a shareholders' event. Much more likely is that they will be raising money at some point in the future. You may be able to further differentiate within a group of Biotechs that you perceive to be cheap or undervalued if you look for:

1. Companies with significant insider ownership - they are burning their own money so you can be more certain they will spend it wisely.
2. Companies working on technology where they would have the market to themselves - these are treated favorably by the trial committees and regulators.
3. Biotechs with the lowest burn/employee - every additional researcher is one more person who may make an interesting discovery.
4. Biotechs with the most trials to market cap - more trials means more opportunities to get lucky.
5. Biotechs that took a lot of trials and burned cash without results are worth more all else being equal - failure doesn’t get much credit but knowing what doesn’t work is valuable too.
   

Conclusion

Pre-revenue biotech or similarly hit-driven business are among the hardest to value. It just isn’t real estate. It can be and there are different approaches. My way is to try and get as much access to upside that I’m not paying for and then patiently see the investment run its course. Buying cash (burning) boxes with what are metaphorically speaking “embedded deep out of the money options.” Or stable cash flow businesses at very low multiples that have similar metaphoric options attached. To sum it up: Value the easy-to-value-stuff and take the rest for free and cross your fingers.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Disclosure: I am/we are long AGN. 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.