Biotech 101 Lecture 1: Intro To Biotechnology Investing

Summary

  • Investing in the biotech industry is an art, not a science.
  • While the potential for gains from groundbreaking therapies exists, the majority fail.
  • By utilizing statistics, careful selection, and net present value calculations, it is quite easy to find a basket that fulfills your preferable risk tolerance.
  • By taking the gambling out of biotech investing, one can find peace in stable returns and support of a wide range of potentially life saving innovations.

Laboratory research medical and scientific chemical glass flasks for Background.

ipopba/iStock via Getty Images

Introduction to Biotech 101

In this course, we will learn about the principles of Biotechnology, discuss example companies, and cover theories and investment strategies that are useful for investors wanting exposure to the sector. Biotechnology companies, and to a greater extent the entire healthcare industry, are some of the most impactful investments one can make, whether for the advancement of healing technologies or personal financial success. However, risk abounds, and one must be careful.

Nature is nowhere accustomed more openly to display her secret mysteries than in cases where she shows tracings of her workings apart from the beaten paths; nor is there any better way to advance the proper practice of medicine than to give our minds to the discovery of the usual law of nature, by careful investigation of cases of rarer forms of disease.

-William Harvey, 1657

Biotechnology has been the basis for human health ever since microorganisms were beginning to be understood at the turn of the 19th century. However, it was not until penicillin was studied and developed for use by Alexander Fleming in 1928 that any full-scale biotechnology applications existed. Further, the industry remained focused on chemical therapies, and this led to a pharmaceutical industry that was born amidst the industrial revolution. Names like Merck (MRK) and GlaxoSmithKline (GSK) have roots that stretch back to the 18th or even 17th centuries.

Many have the misconception that the modern techniques relating to DNA or RNA were thanks to Watson and Crick, but genome focused research has been a part of our world since the discovery of nucleic acids by Swiss Chemist Friedrich Miescher in 1869.

More than 50 years passed before the significance of Miescher's discovery of nucleic acids was widely appreciated by the scientific community. For instance, in a 1971 essay on the history of nucleic acid research, Erwin Chargaff noted that in a 1961 historical account of nineteenth-century science, Charles Darwin was mentioned 31 times, Thomas Huxley 14 times, but Miescher not even once. This omission is all the more remarkable given that, as Chargaff also noted, Miescher's discovery of nucleic acids was unique among the discoveries of the four major cellular components (i.e., proteins, lipids, polysaccharides, and nucleic acids) in that it could be "dated precisely... [to] one man, one place, one date."

Discovery of DNA Double Helix

Modern techniques have shifted towards utilizing our unicellular and viral friends, with applications such as CRISPR, viral vectors, and monoclonal antibodies all based on natural processes. For example, CRISPR gene editing techniques are based on the natural process of viral DNA being incorporated as a bacteria’s own immune defense, as a way to protect against future infection. While you can spend a lifetime, or an expensive degree, learning about all the tiny details, as an investor from outside the industry, one need not shy away, and many reports, presentations, and articles are created to express the complex information for the masses.

The range of molecular therapies, ranging from small molecules to microbiome.

The range of possibilities is huge with our current understanding of life. (Revers & Furczon)

Revers & Furczon

Revers, L.; Furczon, E. (2010). An introduction to biologics and biosimilars. Part I: Biologics: What are they and where do they come from? Canadian Pharmacists Journal/Revue des Pharmaciens du Canada, 143(3), 134–139

Biotech Company Breakdown

Much can be said about the difference between a pharmaceutical and biotechnology company, but the two fields have been intrinsically intertwined in the modern era. Nowadays, most small-scale companies that attempt to develop novel therapeutics, regardless of the type, are thrown into the biotech basket. For simplicity’s sake, it is easier to account for companies this way, and from now on, any group developing a novel therapy, whether small molecule or stem cells, will be referred to as a biotech company. Only those giant companies already referred to as pharmaceuticals shall retain this distinction: Pfizer (PFE), Johnson & Johnson (JNJ), Roche (OTCQX:RHHBY), etc.

Pharma Companies

Yield and value seekers rejoice, your Pfizer, Roche, and AbbVie (ABBV) shares all contribute towards biotechnology research, manufacture, and distribution. These companies have grown to their current size thanks to both in-house and acquisition based FDA approvals, and an investment in these companies will support countless therapies to come. For those searching for safety and income within the industry, then these are the companies to look at. Other names include Bristol Myers (BMY), Novo Nordisk (NVO), Merck, Novartis (NVS), and AstraZeneca (AZN).

Company (Top 5 by Market Cap in Alphabetical Order)

P/E (TTM)

Div Yield (%)

5 Year EPS Growth (% CAGR)

5 Year Return (%)

AbbVie (ABBV)

32.6

3.88

2.55

181

Johnson & Johnson (JNJ)

22.1

2.43

5.65

73.6

Eli Lilly (LLY)

32.35

1.39

23.3

254

Pfizer (PFE)

15.3

2.98

27.9

113

Roche (OTCQX:RHHBY)

21.9

2.51

9.03

90.5

S&P 500 (SPY)(VOO)

-

1.27

-

116

As you can see, each company offers quite a different investment at the moment, and purely financial based analysis will allow you to choose the appropriate asset for your needs. However, expect performance averaging close to the S&P 500 as a whole, with minor variations due to blockbuster approvals and/or competition between peers. Many contributors on Seeking Alpha offer detailed analysis on these companies, so I will defer to them for additional detail.

The Mega-biotechs

If you find you would like slightly more in terms of capital appreciation, or do not require high yields, then there are a range of large and mid-cap companies who offer either specialization or diversification. Further, they have plenty of cash and significant pipelines to propel growth well into the future. While news in the market may cause volatility, they will tend to remain far less volatile than smaller biotechs with similar applications. Lastly, the five names I cover below offer weak correlation to each other, and would be strong pillars to add to any portfolio as a group. Other names include, Zoetis (ZTS) for pets and animals, Takeda Pharma (TAK), Biogen (BIIB) for neurological disorders, and the oncology-oriented BeiGene (BGNE).

Company

P/E (TTM)

Specialization

Approvals, Phase 3 Trials

Amgen (AMGN)

23.6

Pioneers in all end markets and therapy types. Latest major innovation for clinical pipeline is BiTE molecules.

20-25 major approvals, 20-25 Phase 3 trials.

Gilead (GILD)

11.72

HIV treatments, small molecules, remdesivir for COVID. Exploring mAbs for cancer treatment.

30+ Approvals. 15 Phase 3.

Moderna (MRNA)

10.35

Vaccines and other novel mRNA therapies. Full beneficiaries of COVID, allows for significant pipeline growth.

1 Approval (COVID vaccine), 1 Phase 3 CMV vaccine. Company remains mostly in Phase 1 and preclinical.

Regeneron (REGN)

9.81

Diversified, with major approvals in eye disease, and monoclonal antibody therapies.

9 Approvals, 10 Phase 3 trials.

Vertex (VRTX)

27.27

Cystic Fibrosis leaders, and gene editing (CRISPR).

4 Approvals, 3 Phase 3 trials.

An image of many cellular and molecular therapies that Amgen is developing in their pipeline. Includes antibodies, CarT cells, and RNAi therapies.

Amgen offers an incredibly diverse pipeline into all therapy types. (Amgen)

This image shows there is limited correlation between the five mega-biotechs.

Correlation matrix between mega-biotechs. (Portfolio Visualizer)

Mid-size

The mid-size companies listed below are often the opportune choices for high growth, but stable pillars of a biotech basket. The significant piles of cash, already approved drugs on the market, and high levels of profitability, all allow for significant cash flows to be reinvested into the pipelines. As I will discuss later in the article, this is an incredibly important factor for the longevity and success of a biotech company, and allows for the removal of risk. Also look to these companies to be frequent purchasers of smaller assets as a way to expand their pipeline, beyond in-house R&D. Feel free to check out my prior article on Horizon, here. Other names include Jazz Pharma (JAZZ), Incyte (INCY), and Grifols (GRFS).

Company

P/S (TTM)

Specialization

Pipeline

Cash as of Q3

Alnylam (ALNY)

22.7

RNAi therapies towards genetic diseases.

5 approvals, 4 late stage trials. 8 early stage trials.

$2.3

BioMarin (BMRN)

8.82

Genomic-based targeted therapies, but diversified.

7 approvals, 1 completed Phase 3 awaiting decision. The rest is Phase 1 or preclinical in nature.

$1.1 billion

BioNTech (BNTX)

2.74

Immunotherapy and vaccines.

1 approval: the COVID vaccine with Pfizer. Allows for significant growth and development of their early stage pipeline (0 phase 3 trials).

$2.7 billion

Horizon (HZNP)

7.14

Diversified into orphan and inflammatory diseases.

12 approvals. 3 Phase 3 trials. ~20 early stage trials. Serial acquires, which will bolster the pipeline with excess cash generated.

$1.07 billion

Seagen (SGEN)

14.29

Focused on monoclonal antibody and small molecule oncological (cancer) therapies.

4 approvals, 2 major late stage trials, both monoclonal antibodies. 10 early stage trials.

$2.4 billion

Royalty Companies

An interesting, and economically sustainable take on the biotech industry is from royalty companies. By buying the royalty rights from rights holders, these companies are able to earn a stream of revenues once a therapy is approved. Rights holders choose to sell their rights as they would rather have a lump sum cash flow to reinvest rather than waiting years for possible streams of revenue. In particular, organizations such as universities, individual researchers, and early stage companies are the most likely to sell out of their holdings or seek this form of financing. While most royalty acquirers are private equity firms, there are a select group of publicly listed companies to consider of varying quality and strategy.

Company

Summary

Royalty Pharma (RPRX)

A Warren Buffett-favorite, this is the pioneering royalty company in the industry. The diverse royalty base, long experience in this niche, and careful financial fundamentals offer the safest choice in the industry.

SWK Holdings (SWKH)

This small company has a niche in providing small cash boosts (under $25 million) to companies, whether credit or royalty agreements. This has led to quite significant growth in revenues of late, and is one of the top names to consider on this list. The current portfolio is over 25 agreements, and so there is plenty of diversification for the regulatory road ahead.

XOMA Corp (XOMA)

Invests in pre-commercial royalties, making the investment more risky, although they own over 65 separate assets to provide balance. While they have a more volatile revenue history over the past 2 decades, the shift to a high diversity of early stage assets may be favorable to long-term investors.

BioPharma Credit (OTC:BOPCF)

A closed ended investment trust, one of the first and largest in the industry. They return value to investors with a high yield at over 7%. Through 2020 this reached over 8%. One point to consider is that they are listed in London. However, as one of the largest and experienced companies, they offer one of the safest bets.

Innoviva (INVA)

One of the up-and-comers in the field (they used to do R&D until 2014), with a focus on reinvesting cash flows into new therapies, mostly in unmet need applications. However, they are not diversified much at the moment, with the three commercial royalty drugs all owned by GlaxoSmithKline. While they are currently seeing stable revenue growth, there is much work to be done for long-term success.

A slide discussing how royalty financing is good for early stage companies, far better than dilution or debt.

XOMA

Another similar situation, which is becoming quite common for all biotechs, is the collaboration for the 50/50 share of revenues of a particular therapy. One famous example of a company who exists for this purpose is Genmab (GMAB), who are one of the sole leaders in monoclonal antibody applications and have numerous 50/50 collaborations with other biotechs. Most large cap biotechs have several collaborative therapies, and small single platform companies are able to obtain important milestone payments for completing trials and support operations.

The Rest

While I have discussed only 20 of the largest, leading biotech companies and royalty seekers, there are thousands more to sift through. Not to mention the service providers, consumables/device developers, and manufacturing companies of the industry such as Thermo Fisher (TMO), Danaher (DHR), Repligen (RGEN), and Labcorp (LH) who offer safe investments much like the pharmaceuticals. However, the majority of biotech companies are taking big risks by betting on a single platform and offer little in terms of safety, but much in terms of reward.

There are some companies searching for the next Alzheimer’s Disease cure, such as Biogen, Cassava (SAVA), or Anavex (AVXL), or those famous next-gen CRISPR gene editing companies such as CRISPR Therapeutics (CRSP), Editas (EDIT), or Intellia (NTLA). The majority of biotechs are betting on a single platform and are in the early stages of development, so the probability of losing money if their trials fail is high. As such, I will now discuss tips and tricks on how to invest in the industry, so this hopefully allows you to see stable returns rather than risky gambles.

Investing in the Biotech Industry

Biotechnology is a sector of the market that is often speculative and conducive to either significant gains or sharp losses. It is important to take a thoughtful and unbiased approach to the industry, and one of the easiest ways to do that is with diversification. Further, breaking the industry down into segments allows for different risk profiles, and the dominant names with a large pipeline I discussed earlier cater to those with little risk tolerance. However, first one must understand some financial headwinds that all companies face.

The Dire Need for Funding

One may at first wonder why there are so many biotechs on the market just as they reach an early stage of clinical trials, whether Phase 1 or 2. This is due to the issue of funding research as a private corporation. While one can have many elevator pitches and flashy presentations, most investors will remain hesitant to put significant investments into a single company. If a company is unable to support operations, the therapy, no matter how groundbreaking it may be, will fail. This effect is known as the Valley of Death, and is a significant driver for why biotechs enter the open market.

[At] the same time [as] biomedical science is producing these lifesaving breakthroughs, the funding for research is dwindling. This is a frustrating conundrum for financial economist Andrew Lo of Massachusetts Institute of Technology’s Sloan School of Management. “Why, at the very cusp of being able to cure some of the most devastating diseases known to society, are we pulling back?” he asks.

A large part of the problem boils down to the basic calculus of risk and reward, Lo said. Developing a single drug can cost up to $2.6 billion over a 10- to 15-year horizon—and 95 percent of tested therapies fail to reach the market. Few investors have the appetite for that level of risk.

“Financial engineering can help,” Lo argued in a talk called “Buying Cures vs. Renting Health.” He made the case for using tested tools from the financial sector to increase funding while reducing risks. As an example, he showed that pooling a large number of independent drug trials diversified the risks involved, making it feasible to issue bonds to finance this crucial research, with manageable default rates and promising returns.

Failing to tap into investment dollars to finance biomedical research, improve health, and extend lives strikes Lo as a waste. “Being at MIT, I see incredibly talented graduate students and researchers in the biomedical field. They are struggling and many are leaving the field because they can’t get grants. They are coming to my MBA class looking for jobs because they can’t follow their dream of curing cancer.”

Diversifying the Risky Biomedical Business | BFI

As you can see, diversification is already playing a role in modern financial loan and bond strategies, and this further leads to persistent IPOs, and unfortunately, shareholder dilution. It is sad, as no one wants to see a clinical trial fail, or a company fold, as their therapies may one day save you or someone you care for. IPOs are a relatively easy way to gain a large cash influx, and often, this will be one of the last chances for a company to earn funding. As such, it is oftentimes the case that the majority of investors are individuals, and they will suffer the consequences of failure or from excess dilution. This leads to the negative stigma towards the industry, but there are a few ways to work around this risk. If making speculative bets, make sure to have multiple, and the more, the safer.

Factors Beyond Diversification

There are three main factors to look for when making an investment into an early stage biotech company. Most of these are in regards to the quality of the company in question, and may offer reduced risk compared to those who are evaluated poorly. To find the information required, one must merely look at either financial reports, company presentations, or website. Further, most technical jargon can be skimmed over, and the key points will be made clearly visible for those with little biological experience. In my next article, I will be assessing a portfolio of 5 assets in a hands-on way with detailed research examples.

An image of SA stock selection metrics with a list of 12 stocks.

In my next article, I will go through more detailed examples of assessing biotech companies, utilizing SA filters and other methods. (Seeking Alpha)

Operating Costs and Cash on Hand

As typically no revenues are being seen by early stage biotech companies, cash is the only source of money to operate and run the trials. Therefore, it is important to see how long the current cash levels will allow for operation. As an example, if a company has $100 million in cash and spends $25 million per year on operating costs, it will require an influx of cash within four years. This is why dilution is common, and why milestone collaborations are favorable for success. Therefore, I recommend only investing in companies with either: enough cash to sustain all trials for the necessary time period or collaborations with larger companies that provide cash upon fulfillment of milestones. This is also important if trials fail and the development of a new pipeline is necessary, protecting some value for investors.

Strong Investor Base

One important factor to screen companies for is their ability to draw in financing, whether through marketing or relationships with institutional investors. This allows for the company to build up their cash base, and ties into point one above. While there are many ways to screen for this, Seeking Alpha provides some strong selecting tools that help make the process faster. First, go to any biotech stock, and click on the biotechnology sector heading. This will take you to a list of all biotechnology stocks in the market. By using the filtering tools, you can easily weed out poor names, either those rated poorly by quant metrics, SA Contributors, Wall St, Total Cash, or institutional ownership.

In the biotech industry, high institutional ownership signifies that the company has accrued a following who are willing to bet on their platform. Additionally, one can look at Biotech-focused Venture Capital funds such as Bain Capital Life Sciences, New Enterprise Associates, Polaris Partners, and Third Rock Ventures. In a future article, I will discuss how their holdings can be utilized by individual investors as well.

Rare Diseases and Unmet Need

If you have looked at the MIT PoS page, you will notice that the subgroup of rare diseases sees a higher likelihood of succeeding. This is because these groups often have no treatments at the moment, and they are diseases that favor any increase in safety or quality of life. Laws in place allow for faster development periods, with tactics that include lumping Phase 1 and 2 together, and a faster FDA approval time. As such, operating costs are reduced over time, the PoS is higher, and the time to market is far sooner. Not to mention the fact that due to the small population sizes, biotechs are able to charge insurance companies higher fees for treatment, allowing for peak cash flows on par with therapies for high population diseases. This also applies for diseases where there are no current treatments, and an expedited clinical phase is allowed (i.e. Operation Warp Speed)

Finding Present Value Based On Statistics

One of the most important tools to determine a company you are investing in is the potential peak cash flows from their investigational medicine. The strongest biotech companies will have highly detailed cash flow expectations laid out in their presentations, but determine which you think are viable. By taking the expected peak cash flow of a drug, and discounting it across the time it will take to commercialize the drug, you can find a suitable present value. The appropriate discount rate should be quite high due to the risks associated with clinical trials, as shown in the various images below, and make sure to incorporate operational costs at the end. To determine the likelihood of success by phase or therapeutic area, I use the data provided by MIT at the link here.

Estimates of clinical trial probabilities of success PoS as of 2021Q4

MIT Project Alpha

As you can see, based on real historical trials, the probability of going from Phase 1 to Approval averages at 10.5%, 16.5% if you do not include the outlier Oncology group. Using this data, we can approximate the likelihood of success of a company’s trials in varying therapeutic areas. Further, with the data for all trial levels and therapeutic areas, you can determine the success no matter which phase the trial is in and what disease the therapy is targeting. Lastly, it takes on average 8-9 years for a drug to go through the three phases, and then become FDA approved, with commercialization typically commencing in the 10th year. Using the chart provided by FDA Review below, you can determine how long you should discount the trial period by.

The typical timespan of the drug approval pipeline. Discovery phase is around 6.5 years, phase 1 is 1.5, phase 2 is 2, phase 3 is 3.5 and FDA approval is another 1.5 years.

The typical time span of the drug approval pipeline. (FDA Review)

Do not forget to consider adding a few years to consider the early period of growth into the full patient population. Also, it is okay to be extra conservative with your data, as the extra discount, reduced probability of success, or longer timeframe lead to a lower present value, but this allows you to make safer decisions about your purchases. Further, you can make the calculations more complicated by incorporating operating costs into each year or phase. However, watching the current cash balance and yearly losses of a company in the early stage will remain important. There is no right answer, and the calculations should be adjusted to your personal wants and needs.

A chart showing average discount rate for various clinical phases.

Average NPV discount rates for a variety of phases. (Alacrita)

NPV of a JNJ acquisition in 2016. Highlights the wide range of discount rates.

Discount rates are highly variable, but large companies are able to have lower rates due to having plenty of cash. (Alacrita)

Valuing Pharmaceutical Assets: When to Use NPV vs rNPV.

As you can see, it is quite straightforward to take a portfolio of assets, whether individual drugs or a company’s pipeline to determine the present value. Also, you can simplify the calculations by either adding all drugs into a single cash flow and probability of success, or take averages of each factor prior to calculation. Then, you can assess whether the company or your portfolio offers a discount at the purchase price. Of course, factors such as cash on hand, collaboration/milestone payments, and the therapy in question all play important parts to the value equation. For clarity I added a small excel table below of a sample portfolio and a value calculation you can perform.

Additionally, here is a link to my old article on Schrodinger (SDGR) from 2020, one of my best, which offers a detailed pipeline value analysis strategy (I also still stand by my thesis in that article and believe SDGR is still undervalued).

This image shows three drugs, and a NPV analysis for each. This highlights that both time and PoS are important factors towards overall success rather than total cash flows from a therapy.

An example drug portfolio and associated NPV analysis. (AMR Investing)

As you can see, time and PoS play the most important role rather than peak cash flows from the therapies. Considering that peak cash flows are the hardest to determine, this is good for us retail investors without a lot of market knowledge. In regards to this made up company, if the current market cap is $1 billion, an investor may end up not gaining much capital from this investment, even over 10 or 15 years. This is why these simple calculations are very important in sussing out overvalued names (i.e. ARK Genomic (ARKG) holdings in early 2021).

As an example, one can consider the stock Evofem Biosciences (EVFM). The company has been terribly destructive to shareholders over the past five or more years. This is even as the company earned FDA approval for their novel birth control gel. However, issues with low cash levels leading to dilution, the inability to bring their drug to market, and increasingly higher operating costs every quarter have wreaked havoc. Even though sales are increasing slowly and there has been a favorable change to Medicare in regards to birth control therapies, investors still believe the company to be essentially worthless. This is why I would typically avoid single therapy platforms. Although, some may be proponents of buying low, and selling on positive news as a way to adjust to the commercialization risks.

The price of Evofem has fallen over 90% from highs in 2015 due to dilution, even as their main drug has been approved.

Evofem Price Chart (Seeking Alpha)

Investing in biotechnology is an art, not a science. It will take practice and hours of research, and offers flexibility to use valuation formulas to your benefit. No matter how you perform your calculations, someone will likely perform the calculations differently. Especially when it comes to the incorporation of the share price valuation, or additional operating costs per year, as shown below. In the table above, I assumed a price to share of 5.0-7.5 as the company may continue to expand their pipeline with any cash they earn from an approved product. This highlights how companies with many shots on goals, and across multiple therapy types, will have the best chance of success.

Net Value Web for a therapy.

BioProcess International

Accounting for Portfolio Risk: Creating an Analytical Framework for Optimizing the Portfolio Mix - BioProcess International

Conclusion

While luck plays an important part, you can negate this risk by diversifying and selecting high-quality assets. In my next article, I will look at a few small biotech companies and put some of the techniques I discussed in this article to work. Beyond that, I will be covering VC fund holdings I have been following since August 2020 to determine whether individual investors can copy institutional investors. In the meantime, make sure to diversify your current biotech basket, and perform some present value calculations to determine your risk-adjusted outlook. Or, stick to those large companies which I covered at the beginning of the article, as all have a proven history of success over the past decade or two at the least. If you would also like in-depth looks at the technologies and top-contenders in each therapeutic area, whether cardiovascular diseases, oncology, etc., please let me know in the comments.

Thanks for reading, and feel free to share your own personal tips and tricks below!

This article was written by

Hello, I am an individual investor with an interest in bringing diversification of viewpoints to stock analysis and investing. This brings to point the Japanese proverb 他山之石 -ta-zan-no-ishi- which translates to "another-mountain's-rock" and denotes the importance of diversifying the sources of your knowledge in order to gain the advantage of multiple perspectives. Further, a rock represents the foundational aspects of the world a mountain supports, signifying the importance of understanding the simple fundamentals in order to succeed. As such, I cover a wide range of assets in order to find the best of every type of investing. Please consider following so we can continue down this path of knowledge together, and hopefully, I am able to provide some novel insights for you with every article. Thanks for reading.
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Disclosure: I/we have a beneficial long position in the shares of RGEN, HZNP, JAZZ, SWKH either through stock ownership, options, or other derivatives. 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.

Additional disclosure: Remember to do plenty of due diligence and consider your risk tolerance before investing. No need to gamble or go beyond your means.

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