The biotechnology industry is one of the hardest spaces to consistently identify stocks that will outperform. Many companies seem to offer all the potential in the world, but very few seem to be able to capitalize on that promise. Before risking one’s hard earned money, every investor should have a checklist and game plan for adding a biotechnology company to their portfolio. Below are seven things that investors should look at before investing.
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- Pipeline Of Products. Diversified biotechnology companies (meaning multiple drug candidates) have a much better chance of sustained success over the long-term. Additionally, there is built in diversification for investors if the company has multiple avenues for success. Dendreon (NASDAQ:DNDN) is a classic example of what can happen to a company that relies on one product. Dendreon was fortunate enough to receive FDA approval on their prostate cancer drug called Provenge. Unfortunately, the company has had a great deal of trouble navigating the commercial world. With several other treatments on the market now for this particular indication, Dendreon appears to be toast.
- Market Potential. There are many potential indications that a biotechnology company can develop a treatment for. But in order to determine the risk/reward potential, investors need to look at the market size for the indication and the revenue that may follow. Biotechnology companies that are able to grow from a hundred million dollar company to a multi-billion dollar company typically developed a platform that ended up being applicable to many indications. Pharmacyclics (NASDAQ:PCYC) is an example of what can happen when a biotechnology is successful with multiple indications. Pharmacyclics has soared in value over the past two years and is now valued at more than $7.5 billion. The company’s pipeline now includes multiple forms of cancer and autoimmune disorders which should lead to sustained growth (the dream of every small-cap biotechnology investor).
- Competition. Investors need to investigate whether a company is developing a breakthrough treatment in an area of unmet need, or it simply developing a better product than its competitors. This can be difficult to research and will involve significant energy but it will be worth it. When a company is developing a completely new and revolutionary treatment, the world is its oyster. An example is Sarepta Therapeutics (NASDAQ:SRPT). Sarepta Therapeutics is developing a drug for Duchenne muscular dystrophy called eteplirsen. It is a breakthrough treatment which will likely dominate the market upon approval (should Sarepta be so lucky). The potential revenue generating abilities caused shares of Sarepta to trade as high as $55.61 this year, more than a $2 billion valuation. Unfortunately, shares of the company collapsed after the FDA decided it would need further Phase 3 data before approving. However, should eteplirsen survive Phase 3 and be approved, the company’s value will likely surge to $2 billion and above just on potential.
- Cash On Hand. Looking at a development-stage biotech’s available cash is mandatory. One of the biggest risks facing investors in this industry, besides trial failure, is dilution. A company can burn millions of dollars while conducting trials. The funds for those trials need to come from somewhere (the investors). Companies will typically conduct multiple secondary offerings in order to raise the cash necessary to get enough data to square off with the FDA. Each secondary will cause a drop in significant drop in share price. An example is Celsion Corporation (NASDAQ:CLSN). Celsion was a promising cancer biotechnology company before they announced a Phase 3 failure in January 2013. Unfortunately, the company has continued to dilute its shareholders, even after the poor data. A look at the company’s annual statements will reveal how much dilution has taken place over the years and what an initial investor’s contribution is now worth. It’s not a pretty picture and is a cautionary tale for investors.
- Institutional Holdings. Before taking a position, one of my favorite weapons is to look at institutional activity. This activity can be seen by going to the Nasdaq website and searching for a particular symbol. Investors will be able to see all the institutions that hold a position in the company as well what activity occurred during the last quarter (position increases, decreases, new positions, and closed positions). If the trend is up, it can be a sign that the “smart money” thinks a move up is coming in the company. Pharmacyclics is a perfect example of how successful investors can be by utilizing this strategy. A few years ago when shares of Pharmacyclics were in the single digits, the Baker Brothers, a renowned hedge fund, acquired a substantial stake in the company. Since then, the fund has continued to add to their position. Currently, the Baker Brothers own more than 9 million shares of Pharmacyclics, a stake now worth nearly $950 million.
- Leadership. It’s a good idea to always look at who is running the company you are about to invest your hard earned money in. Does the CEO have lots of experience in biotechnology/healthcare? Have they built other successful companies? Do they have a history of investing in their own companies? These are just a few of the questions that investors should ask.
- Number Of Shares Outstanding. As a general rule of thumb, I tend to stay away from companies that have shares outstanding of more than 150 million. The reason is that biotechnology companies with a large OS tend to declare reverse splits. While mathematically that doesn’t impact shareholder value, psychologically it does. After the shares reverse, the tendency is for shares to trade back down. A reverse split can result in substantial investor losses.
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