I should mention up front that my knowledge of this sector comes from first hand experience. You could say that I paid for my education with biotechs, I'm glad I lost my money early and learned my lessons quickly.
The value mirage
What attracts investors to small biotechs is that often these companies sell for cash or less, and sometimes even below net cash. These companies fall within Graham's definition of a net-net, a company who's net current assets minus all liabilities exceeds the current market cap. The idea is a net-net is irrationally priced, there is no reason a business should sell for less than net working capital. In theory an investor could buy the entire business, liquidate it and receive an investment return. I've discussed this many times previously on the blog but I wanted to highlight it again because biotech net-nets are just a little bit different. The difference between the two is significant, and is the difference between a good investment and a value trap.
It's important to understand where these biotech companies come from. Often they start their existance as a spinoff from a larger biotech or pharmacutical company. The larger company might have some intellectual property that they believe has potential but it's so different from their main line of work that it doesn't make sense to invest. Other times a new idea might not get enough support inside a larger institution, whereas in a dedicated company the idea would be the sole focus. Lastly some of these companies come about when a doctor with an idea does an IPO to raise funds to develop their idea.
The key difference between a biotech net-net and a normal net-net is the purpose of the company. A biotech will be seeded with cash to spend down as they develop their invention (either a drug, or a device) that will eventually be submitted to the FDA for approval. A net-net is focused on delivering a product or service to customers and turn a profit while doing so. Very few net-nets state their purpose is to spend down their assets to zero in the hope of hitting a jackpot with a new product. The problem is this is exactly the mission of these little biotechs. It is fair to say that some net-net's do operate in this fashion, they are affectionatly called melting ice cubes.
But what about the revolutionary drug?
I think most investors understand the premise of these companies, spend down assets in search of gold. What I think most investors miss is how rare it is that one of these companies actually hits gold.
Biotech firms need to be complimented for their marketing hires. In every piece of literature I read I walk away with the thought that the company I'm looking at is on the verge of a breakthrough. Maybe it's my lack of biological understanding, or the companies really are convincing, either way it's easy to be sucked into the reality distortion field.
As I stated in the intro most of these companies have products in some stage of FDA testing, and as soon as the drug is approved the cash rolls in. The problem is what FDA approval actually consists of. There are three stages to FDA trials, stage I, stage II and stage III. After these three stages a drug is ready to be tested on humans. The problem with FDA approvals is that the FDA receives a large number of applications and few are approved. Out of every 5000 drug submissions for approval only 5 are progressed onto human trials. And of those five only one is actually approved for sale and distribution. So a drug has a 1 in 5000 chance of being approved, those odds are higher than the Powerball, but much lower than what company literature would have you believe.
Should anyone invest?
I'm not a big fan of the value investing cliche "circle of competence", but I can't think of a better way to describe investing in cash rich biotech firms. There are investors out there who understand the biology, the approval process, and are able to handicap the odds of a drug's approval. For investors who have that ability they will most likely be richly rewarded when a few of these companies have products that are approved. For the rest of us investing in cash rich, or net cash biotech firms is a way lose our money slowly as the company burns down their cash pile on salaries and research.
I'm sure some readers have biotech horror stories, I'd love to hear them, leave them in the comments.