Biotechnology stocks continue to outperform this year.
While SPDR S&P Biotech ETF (XBI) and several other biotech ETFs have produced strong returns this year and for the past several years, investors are also attracted to individual companies in the biotechnology industry, since choosing an individual winner can be very rewarding. However, biotech, as we have often observed, is an industry where that potential reward is balanced by commensurate risk. Promising therapies fail, even in late stages of development, and an investment that would have produced a tenfold return in the event of success produces instead a “zero” in an investor’s portfolio. Frequently, failure is not a result simply of missteps in the underlying science; biotechnology is an industry where short sellers often work actively to undermine stocks, sometimes preventing companies from being able to raise the cash they need to bring their product to market.
Biotech is also an industry with a large number of players. In the U.S., there are about 375 publically traded companies categorized as biotechnology firms under the GICS (global industry classification standard). Globally, the total is almost 800. With this many companies in the industry, and more coming public at a rapid rate, an investor researching individual companies needs some quick tools to winnow the wheat from the chaff. Here are some of the tools we use to try to quickly spot the most attractive potential investments and bypass ones that will likely not be worth the time it takes to research them.
Look For Differentiation
We look for differentiation -- what sets a biotech company apart from its peers -- in a few key areas:
Discovery platform. If a biotech has a single asset, or a few assets, perhaps culled from the academic work of its founders, that can be rewarding. A proprietary library of proteins could be one step better. Best, though, is the presence of a proprietary platform for drug discovery that has generated promising molecules and is likely to continue generating promising molecules. We are most interested when the platform itself is unusual.
We recently researched a company whose investigational drugsare small-molecule; ordinarily we are most interested in large-molecule biologics. But the discovery platform was highly sophisticated, using x-ray crystallography and advanced computer modelling to design molecules from scratch to fit into particular cellular binding sites and block disease progression. This technology represents a leap beyond the screening processes that have characterized much drug discovery in the past, and caused us to set this company aside for deeper research.
Novel mechanism of action. Qualitative leaps in drug efficacy often occur when a new drug breaks with older therapies. Rather than seeking to refine and perfect the way older drugs work, these new drugs strike out on a different path, attacking disorders from an entirely new direction.
Several weeks ago we wrote about the rise of a new class of cancer drugs -- immunotherapies. Although new, these immunotherapies have the promise to take the baton from the last revolution in mechanism of action: monoclonal antibodies. When immunotherapy came to our attention, we immediately drew up a list of biotechs pursuing this new technology. Three weeks ago, we noted a new Alzheimer’s treatment being developed in Australia that uses ultrasound to break up amyloid plaque, and showed positive cognitive data in a mouse model. This is not a biopharmaceutical therapy, but it illustrates the principle that a new mechanism of action -- something outside the box of past treatments -- is worth investors’ attention.
Unusual business model. Another biotech that we recently examined is a synthetic biology company with a unique approach. Their scientific expertise is in genomics; but rather than use that expertise to create their own products, they license them to collaborators, often taking equity positions in these collaborators’ companies as part of the deal. The company thus acts as a kind of hybrid biotechnology firm and hedge fund, and has amassed valuable holdings in a number of promising biotech and genomic start-ups. Besides being an interesting investment option itself, such a company might also serve investors as a useful signal when it enters into a new agreement with an existing, publically traded company. We plan to watch for new deals it makes, and examine its collaborators closely as potential investments in their own right.
A similar, although less dramatic example is Celgene ($CELG), which recently acquired Receptos ($RCPT). The acquisition gives it a potential blockbuster to replace revenues from drugs soon to come off patent. This is hardly a unique strategy, but it is one that CELG has pursued with a good track record so far. CELG is, in a sense, a biotech ETF of its own… with managers who have executed its strategy successfully.
Other Items to Look For
A first scan of a biotech to determine whether it is worth the effort of further research can also ask a few other key questions:
Are there “multiple shots on goal”? Does the company have a single asset, or does it have multiple promising assets in its pipeline?
Is it an acquisition target? As we have observed in recent letters, much of the appreciation of XBI has been fueled by a nascent uptick in biotech mergers and acquisitions. The same characteristics that could make a small biotech company attractive to you as an investor may make it attractive to a big biotech or pharma incumbent looking to buy growth.
Does it have the cash to survive? Is the company burning cash at such a rate that it will be challenged to bring a drug to market? If so, when will it need to raise money?
Does it have any collaborators? Larger collaborators may indicate a vote of confidence in the smaller company’s technology, as well as suggest the possibility of an outright buyout in the future.
These represent some of the first thoughts and questions an investor can ask when evaluating a potential biotech investment.
Investment implications: Biotechs are legion, and with the industry having experienced years of strong growth and stock appreciation, more new issues are coming. Investors who want to pick individual biotechs need some criteria to screen potential investments and decide which companies are promising enough to merit deeper research. We suggest a few criteria -- differentiation in business model, platform technology, and their drugs’ mechanisms of action.
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