Benjamin Graham preached that, if one is to take an active (rather than passive) approach to investing, one must treat it as a business. As someone who has started and helped to run multiple businesses, I understand the commitment this entails. It means spending your time researching as if it were your full-time job. It means approaching investment decisions with the same analytical rigor of a strategic business decision. Most importantly, it means being intensely objective about your own performance.
2017 was a good year for equities overall and was particularly rewarding for biopharmaceutical stocks. The S&P 500 gained 19% and the NASDAQ Biotechnology Index (NBI) added 21%. A rising tide lifts all boats, so a random, long-only portfolio of biopharma stocks would likely have done well.
However, I've designed an approach to investing that is agnostic to market conditions. I look for informational or interpretational asymmetries that lead to a company's clinical-stage asset being mispriced. In a frothy market, there tend to be more near- to medium-term opportunities to profit from stocks that are undervalued, with select opportunities to short stocks that are exceedingly overpriced if there is a near-term catalyst. At first, this may seem counterintuitive - why would undervalued companies be more common in overvalued markets? They're not: in fact, they're less common. However, they have greater upside behind catalysts, as investors are more likely to deploy capital to clinical-stage companies when they perceive them as being de-risked. In practice, undervalued companies in bull markets are generally overlooked by investors when they've suffered a recent negative catalyst, they're trailing a competitor in clinical development, or they focus on therapeutic areas not perceived as "in vogue" (e.g. oncology, ultra-rare diseases, or large market indications). That's not to say that all companies fitting these criteria are undervalued, they just happen to be promising areas to start searching.
Conversely, in bear markets, there are more opportunities to profit in the near- to medium-term from shorting stocks that are overvalued, as skittish investors aggressively sell off companies that miss on catalysts. Of course, opportunities abound to purchase undervalued stock given that prices are generally depressed, but these tend to play out in the longer term. The intelligent investor will be careful not to overallocate capital to longer term assets when higher rates of return can be realized from shorter term bets.
How do I determine when a biopharma stock is mispriced?
Let's consider, as an example, a public biopharmaceutical company with a single asset: a drug candidate in Phase 3 clinical trials. FDA approval hinges on positive results in the trial, where top-line data are expected any day now. The drug, if approved, will ramp up to peak sales of $1 billion per year before succumbing to generic competition 15 years post-approval. Assuming net profit margins of about 40%, and a discount rate of 10%, the net present value of free cash flows is approximately $2 billion. Given what we know about the drug candidate - after 100+ hours of research into the pathogenesis of the disease, the drug's mechanism of action, and the existing clinical and preclinical data - we believe with 70% certainty that the drug will show a statistically significant and clinically meaningful improvement over placebo in this pivotal study. If the drug fails, though, the company is worthless.
The valuation of the company is then the risk-adjusted net present value of the asset, which is $1.4 billion ($2 billion × 70%). However, the company currently has a market cap of only $400 million, which instead implies a 20% likelihood of success. This company is undervalued, with a whopping $1 billion (250%) margin of safety.
Now that I know the company is undervalued, how much should I invest?
We use the Kelly criterion, which describes the optimal long-term betting strategy in order to maximize wealth. (In fact, the strategy maximizes the logarithm of wealth, which, given that money has diminishing marginal utility, actually optimizes for expected utility). The formula is simple: the only inputs are the probability of success and the net odds on the bet (how much you'd win for every $1 wagered, on top of your original $1 back). In our scenario above, our probability of success is 70%, and we're receiving 4:1 odds (we're investing at a $400 million market cap and the upside is $2 billion - $400 million = $1.6 billion). The Kelly criterion dictates that we should allocate about 60% of our bankroll to this investment. Of course, this calculation oversimplifies biotech investing as a binomial game and would be different if we were betting on a portfolio of equities in a continuous manner.
Forgive my detour into the realm of quantitative finance; now that I've comforted myself in explaining the merits of my investment style, let's take a look at my 2017 performance:
From a net asset value of $75,364 at the beginning of 2017 (including cash allocated to future positions), my portfolio returned 114%
Most of the gains were driven by the performances of Argenx (NASDAQ:ARGX) and Zogenix (NASDAQ:ZGNX). The former was a position from late 2016, when I first began investing based on the strategy outlined above. The gain in ARGX stock was driven by positive Phase 2 results of ARGX-113 in myasthenia gravis (MG), an autoimmune-driven neuromuscular disease. I believed the asset was undervalued given the impressive Phase 1 data in healthy volunteers and the strong therapeutic hypothesis in antibody-mediated autoimmune diseases. In particular, the drug acts by a very similar mechanism to immunoglobulin therapy, which is known to be effective in these indications. As a Dutch company trading on the Euronext exchange, they weren't able to access much of the American capital fueling the biotech bull market and were largely flying under the radar in Europe. Now, with proof-of-concept in hand for MG, ARGX-113 has significant potential in other antibody-mediated autoimmune diseases, such as immune thrombocytopenia and pemphigus vulgaris, for which trial results are expected this year.
I would be hard-pressed to find a clearer archetype of my target investment than Zogenix, the highest flyer of 2017. Zogenix's lead drug for Dravet syndrome was overlooked due to its spotted past as a weight loss therapy, as well as the retail exuberance for its rival GW Pharma (GWPH), whose CBD drug had already shown benefit in the same indication. Based on an investment thesis that I outlined in detail, I was confident that the drug would prove its efficacy and superiority to CBD in a Phase 3 trial. After the success of its first pivotal trial in Dravet syndrome, ZGNX continues to have upside ahead of results in its second Dravet trial, expected to read out in Q2 of 2018, as well as its trial in Lennox-Gastaux syndrome. Considering my level of confidence in the outcome, my biggest mistake of 2017 was not buying more ZGNX.
FOMX has also appreciated nicely in the latter half of the year. The chief catalyst continues to be the results of their ongoing Phase 3 trial in acne, which should read out in the mid-2018. However, as I mentioned in my analysis, I believed the price would be higher in the months leading up to the results than it was when I invested.
Just before year-end, OCRX was acquired by Mallinckrodt (MNK) for $42M in cash, plus up to $75M in Contingent Value Rights (CVR) tied to achieving development and sales milestones. I thought this was highway robbery for MNK given the market opportunity for OCR-002 and the relative strength of its data package. OCRX could easily have been a 5-10x on the basis of a successful Phase 3 trial of OCR-002.
Just before the close of the acquisition, the market value of the CVR (OCRX.CVR) was $0.27/share, which is the price at which I'm holding it in my portfolio. The CVR could be worth up to $2.58/share based on the following three milestones:
- $0.34/share if the first patient is enrolled in a Phase 3 trial for an intravenous formulation of OCR-002 (before 2029)
- $0.52/share if the first patient is enrolled in a Phase 3 trial for an oral formulation of OCR-002 (also before 2029)
- $1.72/share if cumulative sales of OCR-002 worldwide exceed $500 million before 2029
I believe that the first earn-out of the CVR is extremely likely to occur in the next year (~80%) and that the other two milestones have a 25% chance of hitting, although they would occur in the longer term. As a patient investor, the prospect of 200% upside on my initial investment, with essentially no downside, was too good to pass up, so I chose to hold the CVR.
My experience with Sage Therapeutics (NASDAQ:SAGE) is characteristic of why shorts are so difficult. When I first shorted the stock, results from its trial in super-refractory status epilepticus (SRSE) - which I was betting would fail - were expected sometime in the first half of 2017. However, the results were eventually delayed to the end of Q3. In the intervening time, due to some good marketing on the part of the company to shift the spotlight from SRSE to post-partum depression (PPD), the stock rose 33%. SAGE was expected to release results in PPD anytime in the second half of 2017, and I knew that a successful outcome in PPD was quite possible and would catapult the stock. Facing unlimited downside, I repeatedly considered cutting my losses by covering. My decision to stay short ultimately came down to my belief that the PPD results would hit in Q4. I thought the company was creating the specter of imminent results in PPD in order to squeeze out the 15% short interest in its stock.
When the SRSE results were finally announced, I was proven right. However, the stock price had risen so much, and exuberance in PPD was so high, that I barely edged out ahead on my position. In this game, getting the timing right on shorts is crucial.
My only write-off for the year was Xenon Pharmaceuticals (NASDAQ:XENE). I believed that its acne drug, XEN801, had a compelling preclinical dataset and a strong scientific rationale. As a topical drug to treating a skin condition, I thought the preclinical models would be predictive. Alas, XEN801 turned out to be a complete dud, as it was no different from placebo on any of the Phase 2 endpoints. This outcome highlights a fundamental principle of biopharma: no amount of preclinical data can substitute for clinical data in informing what a drug is going to do in humans.
Finally, just before the end of the year, I opened a new position in Achillion Pharmaceuticals (NASDAQ:ACHN). ACHN is developing a pipeline of factor D inhibitors for a variety of complement-mediated diseases. In 2016, the company's share price was crushed by concerns over potential liver toxicity of its lead factor D inhibitor, ACH-4471. These findings didn't kill the program but effectively limited the dosing schedule to three times per day (oral). I believe the drug has a high likelihood of success in C3 glomerulopathy (C3G) given the preliminary clinical data. Trading at just above its book value, ACHN also has substantial upside ahead of its impending results in paroxysmal nocturnal hemoglobinuria (a multi-billion dollar market), offering investors a free roll of the dice. Although results in C3G won't read out until 2019, the price leading up to those results will most certainly be higher than it is now.
I'll wrap up my year-end review with answers to some frequently asked questions on my investment strategy.
Why isn't your portfolio more diversified?
Outperforming the market requires you to be highly selective in allocating your capital. When you have a high degree of confidence in your investments, diversification only dilutes the impact of your successes. You will be less certain about the 20th company you load into your portfolio than your top 5, and needing to load up on 20 companies signifies that you're perhaps not as confident in your top 5 as you should be. As Warren Buffett says, "diversification is protection against ignorance. It makes little sense if you know what you are doing." Stick to your best ideas, and size them up big.
OK, but wouldn't you have done better by just buying bitcoin (BTC)?
The value of Bitcoin soared over 1,000% over the last year, and I'm sure many people made a lot of money by holding the cryptocurrency. Some of these people may have even realized their gains. Can any of them actually tell you the intrinsic value of a bitcoin today? If they can't (or they do, but can't explain how they arrived at their at their valuation), then you must assume they are speculating. I'm not aware of any form of speculation that consistently and reproducibly outperforms the market over an extended period of time.
On the other hand, if you know of someone who can rationally value cryptos, I would love to speak with them!
I don't have technical knowledge of biotech. How do I replicate your strategy?
Value investing is a proven framework for achieving superior long-term returns. The amount of knowledge you need to accumulate about a company in order to invest entails focusing on a small subset of industries - a circle of competence. Anyone can develop a circle of competence that is relevant to investing, based on their educational and professional background; mine happens to be in the life sciences. To apply the framework of value investing to one's circle of competence requires some insight. You need to determine how to accurately value a company in a given industry and develop a strategy for allocating capital to companies you believe are investment-grade (portfolio management). Once your strategy is in place, the only factors within your control that govern whether you will be successful are your temperament and your work capacity. In a future article, I'll describe how I've developed these two skills.
Disclosure: I am/we are long ZGNX, ARGX, FOMX, ACHN.