Biotech and the Fallacy of Analyst Ratings

The health-care sector can be volatile, and it's oftentimes not for the faint of heart.

While there are tried-and-true conglomerates such as Johnson & Johnson, and big pharmaceutical companies like Pfizer can deliver somewhat predictable cash flow that allows shareholders to sleep at night, the more expansive but riskier biotech sector is based more on future expectations for projected sales and profits than any other sector in the market. For investors this means plenty of volatility, boatloads of potential, and a big helping of risk.

The good news is that there are a number of simple things people can do to greatly increase their chances of success when investing in biotech stocks. Purchasing established companies, companies with deep pipelines, or companies that are healthfully profitable are easy ways of moving the needle in your favor for long-term success.

What absolutely do not help biotech investors, though, are analyst ratings. These are not worth considering when it comes to a sector so inherently tied to future clinical studies, outcomes, and insurance actions. Allow me to elaborate a bit.


Source: snowlepard, Flickr.

Analysts overreact to short-term events
The first problem with analyst ratings is they're often focused on the extreme short-term future of stocks, or even their past, rather than the long-term potential of a company. The end result can be an almost comical micromanagement of their ratings, as we witnessed yesterday with small-cap biopharmaceutical company XOMA (NASDAQ: XOMA  ) .

Research firm MLV upgraded XOMA to buy from hold with a reiterated price target of $7 on the basis of valuation and high hopes for positive data from its phase 3 EYEGUARD-B trial involving gevokizumab. MLV's report specifically notes the potential for approximately "15%-20% of upside to the stock, with potential for additional upside in the form of two other phase 3 readouts for [gevokizumab] expected by year-end."

On the surface this analysis appears pretty straightforward and bullish. However, roll the clock back just a few weeks to March 11 and you'll find the very same firm, MLV, downgraded XOMA to hold from buy and cut its price target 12.5% to $7. The reasoning behind the move was the discontinuation of gevokizumab as a treatment option for erosive osteoarthritis of the hand in midstage studies, as well as weaker than expected fourth-quarter results. As the March report states, "We'd been pretty [positive] on XOMA since assuming coverage last August; that said, in the time since, we've seen one too many disappointments. Thus, while also finding the stock fully valued at current levels, we'd like to see more concrete progress with [gevokizumab] before regaining full confidence in XOMA again." 

So what exactly changed over the past seven weeks? Not a darn thing other than a solitary press release from XOMA on Monday that it had finalized a phase 3 study for gevokizumab as a treatment for pyoderma gangrenosum. That was the extent of the company's interaction with investors since the midstage update on gevokizumab as an EOA treatment in early March, yet MLV's opinion has reactively swung in both directions.

Could XOMA have long-term potential? Absolutely. Excluding its discontinued EOA trial, gevokizumab is being studied in 10 separate indications, giving the experimental drug plenty of chances to hit a home run for XOMA. Unfortunately, most Wall Street analysts do a very poor job of conveying this long-term perspective to true investors.

One of us, one of us!
Wall Street analyst ratings also often present a utopian view of the stock market without any context for potential downside or risk. A biotech investor understands very well that there are risks involved in this sector, from clinical studies to macro program shifts such as Obamacare, yet Wall Street ratings are almost always skewed toward the buy-side.

NerdWallet last year examined the ratings of Wall Street firms on the Dow Jones Industrial Average's 30 stocks, NerdWallet found that a whopping 96% of ratings were the equivalent of either a buy or hold. This means just 4% of all ratings were the equivalent of a sell despite the fact that historically just as many stocks will fall as will rise. NerdWallet's research shows Wall Street was considerably more accurate in picking buy-rated stocks than sell-side stocks in 2012, but it's also easier when buy ratings outnumber sell ratings by a ratio of more than 15-to-1. What this ratings skew implies to investors is that biotech stocks offer little to no downside risk, which is just plain wrong.

The primary reason this is a pervasive problem is twofold. First, historically speaking, taking a sell-side view on any stock is considered to be a bit of a faux pas. It's precisely why only 38 of 883 ratings were sells, according to NerdWallet's figures. More important, though, one analyst or a group of analysts speaks for an entire firm. In other words, if a research firm proclaims fictitious stock XYZ a buy, there can be no dissenting opinion throughout the rest of the organization. Failing to offer a counter perspective proves a disservice to investors. It's also a big reason why The Motley Fool encourages a bevy of opinions on all walks of finance to better understand a company, sector, or macroeconomic force from all angles.

There's zero accountability
Lastly, and this is a big problem that Fool co-founder David Gardner has addressed on a number of occasions, Wall Street analysts hold no accountability to the individual investor whatsoever. They have the potential to move a stock or a sector by simply releasing a research report or issuing a stock rating, but if that rating proves wrong only shareholders wind up in the loser's column.

Not to purposely pick on MLV again, but it was recently guilty of this with Prana Biotechnology (NASDAQ: PRAN  ) . If the name sounds familiar it's because shares of Prana were eviscerated in late March after the company reported that reporting that Alzheimer's disease drug PBT2 had failed to meet its primary endpoint in a midstage study. MLV had maintained a buy rating on Prana since 2011, and actually raised its price target from $6 to $11 just weeks before the company announced its PBT2 results. Afterward, MLV cut Prana to a hold and slashed its price target from $11 to $3. MLV simply reacted to the news, but shareholders face the brunt of the pain.

This zero accountability approach is bad news for biotech investors who can use a dose of long-term thinking from time to time.

The simple solution
But I have good news. There's one simple solution that can remedy this fallacy in analyst ratings: ignore them!

Feel free to bask in a one-day move that corresponds with your investing thesis from time to time, but consider that analyst ratings rarely have any lasting impact on a company's share price or business model. Once you realize that you're in charge of your financial well-being, not some Wall Street analyst who doesn't have your interests in mind, you'll be taking your best step toward financial freedom and success in the biotech sector.

One easy way you could take charge of your financial future is by learning about this ongoing TRILLION dollar health-care revolution
The Economist compares this disruptive invention to the steam engine and the printing press. Business Insider says it's "the next trillion dollar industry." And the technology behind is poised to set off one of the most remarkable health care revolutions in decades. The Motley Fool's exclusive research presentation dives into this technology's true potential, and its ability to make life-changing medical solutions never thought possible. To learn how you can invest in this unbelievable new technology, click here now to see our free report.


Read/Post Comments (0) | Recommend This Article (3)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 2936052, ~/Articles/ArticleHandler.aspx, 10/21/2014 12:52:00 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement