Friday, October 5, 2012

Biotech net-nets, a value mirage

What looks like a net-net, walks like a net-net, yet quacks like a speculative penny stock. It's a net cash biotech stock. Deep value screeners are littered with these companies. They're small, selling for cash or less, have an incomprehensible annual report to all non-doctors, and are usually in possession of a drug patent or a "game changing" invention. The story in all these stocks is the same, all that stands between them and untold billions of dollars is FDA approval.

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.

6 comments:

  1. Two points: (1) This is why a company like Valeant makes sense from the perspective of the (relative to doctors, researchers, etc) layman investor - you've essentially very hired knowledgeable pros to do this research and pick how they'll deploy the cash. (2) Nitpicking I know, but FDA trials start with humans - the only stage that doesn't involve giving novel molecules/treatments/devices to live humans is preclinical - in fact "give this to humans and see what it does" is exactly what "clinical" means.

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  2. Henry,

    Thanks for the comment. I appreciate the nitpick, you're right, FDA trials are all on humans.

    I'm not very familiar with Valeant, but it appears they make acquisitions of the most promising biotechs then carry the drugs to completion. A company like Valeant has the knowledge and expertise to diversify their prospects, and know which ones will most likely work the best. Most investors don't have this set of skills.

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  3. I only really know of VRX through Sequoia (guess I should disclose that client accounts hold SEQUX). This excerpt from their annual goes to the issues you brought up in RE: layman investors buying into heavily marketed net cash biotechs:

    "As we discussed in last year’s report, we like Valeant’s approach to the pharmaceutical business. In an industry marked by heavy spending on unproductive research and development, Valeant over a period of years has acquired a stable of older branded drugs, generic and OTC drugs. Many of its drugs are steady sellers in niche categories of dermatology or neurology. In our view, Valeant is essentially a value investor in pharmaceutical products."

    To wit, Ruane and Co. know probably zero about buying the correct drugs rights etc. They just know how to hire people that can shift the scratch ticket-like odds in their favor.

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  4. CBMX was a really neat company. Really neat product too. Total failure as a stock though...

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  5. Interesting is also the way biotech start-ups resemble explorative mining company of which there is an abandunce on Canadian and Australian stock exchanges.

    Biotechs are in my view not so suitable for net-nets-stategy not only because so view make it far in the trails. A net-nets-strategy brings about selling almost automaticly when a stock hits his net-nets value. In the case of biotechs (and explorative miningcompany) that leaves to much money on the table.

    I can tell after my experiences with Inhibitex: I sold disiplined at ncav after waiting patiently for two years. Couple of month later the company was taken over for a stockprice ten times my disciplened selling price.

    I've been engaged with a women who worked near the board of such a start-up. It was interesting to see how highly educated employees where so overestimating the chances of approval for their main product. Although their carreers were already attached to a certain extent to succes of this company and the product pipeline. And although each employee had a optionplan. Still some bought additional shares on their private account because they thought they knew more then the market.

    They bought at 8 or 9 times bookvalue and after FDA disapproval or mice who died, I forgot, but what I do know was that the share went down 95%! How do we call that bias of which this is an example: familiarity-bias.

    These employees option-plans are also quit funny. Some employee got filty rich, just out of luck. We know those stories.

    But there is some risk for the individual employee in the short time frame between execising the option and selling the shares. And everybody on the paylist got an optionplan also the less highly educated, fainthearted, financial problematic, lab nurd.

    Anyway, there was one who on the day he let his options be exercised and his volatile shares be sold, he was so nervous of becoming into debt because all of this that he had to be driven home 'cause it was unresponsible to let him drive himself.

    Oeps, I intended to give some short notes.

    Maarten
    Netherlands

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  6. I think investors can also sometimes fall into the trap of assigning significant economic value to the NOLs generated by a biotech firm that trades at net-net levels. Their thinking is further supported by the hope that these NOLs would be desirable (and fairly priced) by an acquirer if the firm is unable to make a profitable go of it on its own. The most deceptive implication of such assumptions is that the NOLs cause the margin of safety to appear much larger than it truly is.

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