Biotech Investing Tips For 2011

By Patrick Henderson
Sunday, February 13, 2011
Source: SFGate
Most investors understand the volatility associated with biotech stocks. Many avoid the sector altogether, horrified at stock charts that swing over 50% within a single trading day. Massive, sudden, and (seemingly) unpredictable price movements in the shares of biotech companies have given the sector a "high risk" classification in many investment circles. Although investors are attracted to the extraordinary gains - such as Clinical Data's (NASDAQ: CLDA) 80% gain in 2011 - they are also afraid of the associated risk of loss. Is biotech investing a hopeless gamble? Is there a way to control for risk, or are investors better off to enjoy their money in a casino, where at least they can get a few drinks out of the deal?

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The unfortunate reality is that many biotech companies are cash-starved businesses that are ultimately at the mercy of the Food and Drug Administration (FDA) approving their drug in order to have any hope for profitability. Although some companies have multiple business areas and several drugs in their pipeline, other biotech companies go "all in" on a single drug candidate and hope for the best. Factors such as economic volatility, healthcare reform, barriers to early-stage financing of innovation, and an increasingly hostile reimbursement environment all contribute to uncertainty in the biotech industry. Even formal FDA drug approvals do not always lead to improvement in biotech stock prices, as biotech companies will often use an FDA approval to dilute their shares for emergency financing and drug manufacturing expenses.

Without knowing the decisions of the FDA beforehand - as that would constitute insider trading - how can investors trade biotech stocks with a high probability of success? If the odds of the sector can be boiled down to essentially two possibilities - FDA approval or rejection - then why even bother with this sector? Would it not simply be wiser to look into businesses like Coca-Cola (NYSE: KO), where at least the odds of profitability are not a total crap shoot?

Actually, there are many ways to limit risk in biotech investing. For example, options create an interesting way to profit from FDA decisions, as the premium on options generally rises as companies approach their FDA decision date. Option premium is the extra price that investors must pay for the right to trade stock at a predetermined price at a predetermined future time. The luxury of having a fixed price and time for trading stock - the "luxury" of the option - has a cost: the premium. Therefore, a simple way to profit from FDA decisions is simply to sell high-priced options premium ahead of FDA decisions. There are many strategies for selling options premium, including many risk-limiting strategies.

Another way to limit risk in biotech investing is simply to trade the run-up in stock price prior to FDA decisions, exiting positions prior to the decision altogether. This relatively predictable behavior of pre-FDA-approval stock prices is called a "biorunup" and has inspired newsletter services like BuySellShort.net and BioRunUp.com to create entire trading methodologies based on only trading biorunups. Biorunup trading methodologies limit risk of investment loss by exiting positions prior to any FDA announcement. By doing this, investors buy the rumor, not the news. Investors can start an investment several weeks or months prior to a major FDA decision and exit in the days prior to the decision. By eliminating the risk of holding through any volatile FDA decision, the investor can potentially profit from the growing excitement - the rumor - but avoid the risk of the actual decision.

BioRunUp.com explains, "The Run-Up method involves locating and buying shares of these companies well before their decision date, riding the share price up, and selling BEFORE the FDA announces their decision. The concept can also be applied to clinical trials with data releases. The goal is simple: Minimize risk while maximizing consistent profits."

Another way to limit risk is to buy into companies that receive disappointing FDA decisions when the share price falls below the company's true value. This modified form of "value investing" has a simple premise: FDA rejections deliver crushing blows to companies, and disappointed investors will often be willing to sell their stock at irrationally discounted prices because of negative emotions. Biotech value investors will often watch stock prices fall after the FDA rejects a drug application. If the stock begins to sell for prices below the company's true value, then value investors will start to buy the stock, hoping to sell the stock at a later date for a price closer to that company's true value.

For example, over a year ago, Transcept Pharmaceuticals (NASDAQ: TSPT) received a Complete Response Letter from the FDA regarding its insomnia drug Intermezzo. The FDA expressed some concerns about packaging of the drug, potential dosing errors during sleepy times in the middle of the night, and possible next-day impairment of driving ability. In response to this disappointing FDA decision, shares of TSPT fell from over $10/share to below $4.50/share as depressed investors dumped their shares onto any willing bidders.

Astute biotech value investors, however, had already begun their due diligence and share price calculations. Some discovered that despite the disappointment, TSPT was actually worth well over $5.50/share. The company had no debt, a minimal cash burn rate, and a significant amount of cash and equipment. Value investors began to realize that even if the company were liquidated at "fire sale" prices, the shares would be...Read more on SFGate