Binary Biotech Events And The Uselessness Of Analysts

Includes: ANTH, GSK, IBB, VVUS
by: NN Securities

The origins of this article date back to March of this year. I stumbled upon Human Genome Sciences (HGSI) while doing a scan for the most actively traded stocks over the past three months. It was at that time that I stumbled upon the world of biotech financial analysis.

Now, unlike most sectors (for example, consumer staples), there are many smaller biotech firms which focus on research and development. Many firms have 0 or 1 or 2 drugs on the market, but in those cases generally a larger firm (such as Roche (OTCQX:RHHBY) or Bristol-Myers Squibb (NYSE:BMY) or GlaxoSmithKline (NYSE:GSK)) steps in after getting relevant approvals.

In terms of investment, then, the research firms are essentially gambles on the outcome of drug studies and panel reviews and agency approvals (and on potential buyouts). It is all about speculating on what are essentially binary events, as there's never really any sort of middle-ground: either an agency approves a drug or it doesn't.

The Biotech sector as a whole is replete with armchair-scientists: financial analysts who talk about drugs as if they understand the intimate details of reaction mechanisms, catalyses, human and animal physiologies, and a slew of other subjects best left to scientists. People look at certain toxicology results (.005% of patients developed brain tumors) and authoritatively declare that drugs are successes or failures with nothing more than a scant understanding of the circumstances behind it.

So why are analysts useless? Analysts are dragged in to analyze research results and speculate on the agencies' reactions to findings. But at the end of the day, it's all speculation, and generally those research firms aren't required to disclose all of their positions (or if they are, it's by the "honor" code). No agency is going to turn to a Goldman Sachs report on the potential risks to a molecule and cite that as the reason why a drug should be rejected. No agency is going to turn to a Podunk analyst on a website pumping a drug and cite that as a reason why the drug should be approved. No one legally has inside information from any agency regarding approval or rejection. For any firm, I can cherry-pick facts that build a bullish or a bearish case.

So let's dispel all myths here: Assume everyone is talking up their book. Simple as that. Assume that no one is a disinterested party, and go from there.

We've all seen analysts essentially write pumps or hit pieces on some biotech names, sometimes even quoting the same facts and arriving at vastly different conclusions. Some analysts were wrong on some of the biggest movers of the year, yet no one bothers to hold them accountable. Many people opine that these analysts are talking up others' books.

Once you make those assumptions, we can delve into the facts. We see a sequence of events, and those events are facts, but we can twist those events to look like some firm was being aggressive or the same firm was trying to save investors. Once you take out that type of fluff, most research reports and articles essentially assert some strange aphorism like "Shareholders should not be greedy" or "A bird in the hand is worth two in the bush" or "I love this company because I will make loads of money if the stock price flies." It's a hard process to slough off the mess, because phrases are deceptively designed to look like facts. It's fairly crass to do a line-by-line analysis of an article, but if there is interest I am up to the task.

There are a few binary events next week. People are abuzz speculating wildly. Unfortunately, many such discussions (including some on Seeking Alpha) leave much to be desired. As a whole, with these binary events, forget the analysts. Forget everything you believe about "investing". When you stare at a binary event, you are gambling on an outcome. And once you accept that fact, analysts become useless.

As much as I would like to avoid giving advice, It's natural to ask how to play the next few events in the pipeline.

On Monday, we will hear from HGSI regarding the bidding process. I am long and believe there will be a higher buyout, but there's no good reason to go long or short unless you feel like gambling on the outcome. By this point, more than 300M shares have traded since the offer in April, more than 1.5x the entire float, so one would conclude that everyone who wanted to get out would have left.

By Tuesday we should hear more about Vivus (NASDAQ:VVUS) and Qnexa. There are many discussions, including some on this site, which conclude that it will get regulatory approval (many of which automatically assume that Arena Pharma's lorcaserin approval must bode well for Qnexa). However, many of these analyses don't address toxicology well. I shorted VVUS at the beginning of July after a large run-up (mostly due to ARNA approval) and have since closed the position.

For those who have the stomach and risk tolerance and wonder what positions to take, it would be antithetical for me to give a pick one way or the other. Do your own research. If you are looking for a trade to benefit from a view without potentially getting whipsawed by analysts etc, the biotechnology ETF (NASDAQ:IBB) is a reasonably robust play. It won't give 5x returns like some individual names but it also won't give -90% returns (see Anthera (NASDAQ:ANTH)).

"Action Items" as it were: long IBB, make your own judgments on individual names.

Disclosure: I am long HGSI, GSK.