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Ed Arce Of H.C. Wainwright On Minimizing Mistakes In Biotech Investing

Summary

Ed Arce of H.C. Wainwright & Co shared his insights in an interview last year, and picked 6 biotech stocks as likely winners for 2016.

I tracked, and present here the performance of these 6 stocks: a combined, annual return of 83.5%.

More pointers from Ed Arce, and I further discuss a very significant risk of biotech investing: trial failures.

I recently came across an article which deals with a subject matter which interests me greatly.  It’s an interview with Ed Arce, a managing director with H.C. Wainwright & Co. entitled ‘Minimizing Mistakes In A Volatile Biotech Market: H.C. Wainwright’s Ed Arce RLYP, AKBA, CBAY, ACRX, SCMP, CNAT’. 

His insights were poignant and instructive to all biotech investors.

However, before I discuss his insights in greater details, I would like to show the readers why I think his views are well worth considering. 

This article was published on Feb 24, 2016.  The interviewer, Gail Dutton of The Life Sciences Report, asked him to identify some likely winners for 2016, which he did.  He named six companies, which were Relpsa Inc, Akebia Therapeutic, AcelRx Pharmaceuticals, Sucampo Pharmaceuticals, Conatus Pharmaceuticals, and CymaBay Therapeutics.  In the interview, he commented on each of these six companies, and discussed in more details why he thought they were solid investments for 2016. 

I tracked the actual performance of these six stocks using historical data from Yahoo Finance.

If any investor had invested in Ed Arce’s picks last year on Feb 26, 2016 (a Friday, two days after the article was published online), then the table below gives their return on investment after 12 months (Feb 27, 2017) and after 22 months (on Nov 2, 2017).

Ticker

Buy price on
2016-02-26

Sell price after 12 months
(2017-02-27)

return

Sell price after 22 months
(2017-11-02)

return

RLYP

$14.60

$32*

119%

n/a

n/a

AKBA

$7.47

$10.15

36%

$17.52

134%

ACRX

$3.64

$3.20

-12%

$2.00

-45%

SCMP

$13.21

$12.25

-7%

$10.00

-24%

CNAT

$1.88

$5.50

192%

$4.26

126%

CBAY

$1.19

$3.26

173%

$8.62

624%


Source: Yahoo Finance

* Relypsa was acquired by Galencia for $1.53B, or $32 per share (July 21, 2016)

As shown above, two stocks (ACRX, SCMP) did not do as well as the rest,  showing a negative return.

After one year, the average loss from ACRX and SCMP was smaller than at 22 months:

9.5% (=(12+7)/2) vs. 34.5% (=(45+24)/2).

However, the total gain was also smaller after 12 months than 22 months.

In summary: If any investor who bought these 6 stocks with an equal position in each, they could have gained 83.5% of total return 
(= (119+36-12-7+192+173)/6), if they exited on Feb 27, 2017.

Or, if they held longer, their gain would have been 156% of total return 
(=(119+134-45-24+126+624)/6), if they exited on Nov 2, 2017.

I think that these numbers speak volumes for the success of Ed Arce’s picks!

This is why I think that biotech investors can benefit from hearing his ideas on how to minimize mistakes in biotech investing.

First, he talked about the biotech sector in general: [emphasis, mine]

The biotech industry is one of the most volatile in the stock market, so investors need to be prepared for that. If investors aren't prepared, they should consider investing in funds—either a biotech index fund or exchange-traded fund (ETF)—or select an experienced investment manager with a good track record in the space.

Biotech stocks may be affected by broad movements within the sector, but otherwise largely trade independently of other sectors and of the market in general. But biotech is sensitive to global risk factors. When investors move broadly to safe havens, including more stable industries, biotech is one of the first sectors affected, and the trades are more pronounced than those for most other industries.

He commented about what makes biotech different from other sectors; and how investors should look at biotech companies and make informed decisions:

Fundamentally, each biotech company has very specific risks. Many have to do with particular milestones around particular clinical development programs. Earnings are another example. They are a staple of larger companies, but in the small-cap biotech space, earnings are really not much of an issue. These companies generally don't have a drug approved yet, much less earnings or profitability.

In the biotech space, investors choosing individual stocks must look at the individual risk components for that particular company. Other industries typically have a few companies investors can use as comparisons, but in biotech there are few such companies. Often the programs in development are one-of-a-kind for a particular indication, so it behooves the investor to look closely at the particular market for that drug, and the patients that it will serve.

I find his comments to biotech investors who are generalist, not specialists, helpful.  This is what he said:

try your best to understand the underlying science. If the product is novel, do your own due diligence to see what can be learned about that particular pathway, or what is understood molecularly about the science. At the end of the day, if the science is weak, there's really nothing that can correct for that. That particular point is hard for generalist investors to ascertain. It will always be a point of weakness from their perspective….When a company pioneers a new area, it may undertake several exploratory trials in different, but related, indications. Although these trials may produce positive results, the registration pathway often is unclear. Positive results, then, set up poor expectations for investors who don't really understand how that data will help the company get closer to market.

There's often some degree of impatience, especially among investors who are more concerned about achieving a near-term catalyst than about developing a drug for an indication in which it is supremely suited.

At this point I will leave the article and invite all readers to read the interview in its entirety for themselves.

Risk

Besides the high volatility associated with the biotech sector, there is one very significant reality that must be duly noted and understood by all investors, especially those who are interested in small clinical stage biotech.

In their paper on phase 3 trial failures, the authors report that approximately 70% of phase 2 trials are unsuccessful and 50% of phase 3 trials fail. They also pointed out that oncology and cardiovascular trials had the highest failure rates, and that trials of small molecules have a lower probability of success than for trials of large molecules.

These phase 2 and 3 trial failures, while not affecting to a great extent the established big pharma, which have solid, consistent revenues, usually have a devastating impact on small clinical stage companies, and can result in a 70% to 85% loss of their stock price.  Such a loss can take months to years to fully recover from, if ever.  Some companies have suffered more than one trial failure.  While this kind of loss is hard on anybody, it can potentially unhinge investors, who for some reason are not fully prepared for this rather common occurrence in this sector.  In online forums such as StockHouse, StockTwits or Seeking Alpha where investors interact, I often encounter individuals who seem very adversely affected by their significant investment losses resulting from failed trials.  In their anger and bitterness, they blame the company, the FDA, the market analysts, or even other investors.  According to them, the company whose trial had failed, was nothing more than a scam to rob the investors of their hard-earned money with false promises of great returns; and all the analysts are frauds, and paid promoters.

It is possible that there are some biotech companies that overemphasize their chances of success, and which fail to disclose the potential risks involved.  It is also possible that some analysts' reports are of questionable quality and intent.  However, I think that the responsibility to discern and screen out the bad apples, be it companies or analyst reports, lies entirely on each investor's shoulders.  This is what due diligence is all about. 

It really is a high risk, high reward space.  Even with the best drug candidate, and the best team, the high failure rates are still a very present reality.  Investors who are not prepared for the possibility of a great loss should really rethink carefully, and evaluate realistically their core competence and limitations as biotech investors.

Among Seeking Alpha biotech authors, I find Terry Chrisomalis and Bhavneesh Sharma's articles easy to follow and helpful to my DD. Jonathan Faison, a prolific author, has a system called ROTY (Runners of the Year) where he picks and follows 10 biotech stocks closely; besides articles on many other biotechs.

Bret Jensen recently published an article entitled ‘The 2 Cardinal Rules for Successful Biotech Investing’ in which he shared his wisdom gained from decades of experience.  I recommend his article, especially for anybody who is new at this.

In conclusion

I hope that readers will check out the two articles mentioned here.  Please note that those 6 companies are Ed Arce picks for 2016, and therefore are probably not applicable for 2017.  This article is not a recommendation to invest in any of these companies.  For anybody interested, you can find Ed Arce's current picks on the TipRanks site.   As always, you must conduct your own DD, and take responsibility for your investment decisions.  For anybody who feel that the risks and volatility are too much for them, they should definitely consider a different venue or as Ed Arce suggested: investing in funds (index or ETF), or seeking out seasoned managers with good track records.

Disclosure: I am/we are long PFSCF, PLX.

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: I/we have no positions in any stocks mentioned, but will initiate a long position in ATBPF, TSTIF, AXON, CAPR, CATB, PSTI, RDUS, TNXP within the next 6 to 12 months.