The Worst Has Happened. Time to Sell?

Investors in Axonyx (Nasdaq: AXYX  ) would probably rather forget this week. After the company announced that it missed its primary endpoint in a pivotal study of the Alzheimer's drug Phenserine, the stock suffered a one-day, 63% smackdown.

As one of my colleagues noted earlier this week, Axonyx got a particularly nasty drubbing because it doesn't have much in the way of a pipeline to back up this drug. Thus, with a seeming failure on their hands, shareholders had little left to love about the company. He described an investment in Axonyx as "gambling, not investing" -- something that fails more often than it succeeds.

That's a fair enough description. Even when you're looking for aggressive growth stocks, you should seek out companies that offer more than a single toss at the dartboard. A biotech company can build a pretty decent empire out of a single product -- look at Icos Pharmaceuticals (Nasdaq: ICOS  ) and Cialis, for instance -- but with the high failure rate of even late-stage drugs, you should still look for companies that have the cash, management, and product portfolio to pull themselves out of the fire if the worst happens.

All that being said, many biotech investors like to pepper a portfolio of well-diversified companies with a few chances to swing for the fences. Even those who eschew the riskiest of biotechs still feel the pain of product failure -- witness, for instance, Motley Fool Rule Breakers pick BioSante (AMEX: BPA  ) . One-trick ponies like Axonyx, in which you should invest with only a small, speculative part of your portfolio, carry the highest risks -- but, if successful, they can also carry some of the highest short-term rewards.

Yet we all learned years ago from investment guru Kenny Rogers that the secret of success is knowing when to hold 'em and when to fold 'em. So what does history tell us about what investors in Axonyx should be doing right now?

Wait for the smoke to clear
It seems pretty clear to me that in most cases, investors will make more money if they simply ignore bad news. Even if you decide after calm, rational reflection that you want out of a stock, selling directly after the release of a clinical or regulatory setback is probably the wrong strategy.

Why? The reasons are as varied as the pitfalls that snare tiny biotechs, but a big part of it comes down to investor psychology. Biotech stocks trade not just on fundamentals but also on intangibles like hope, enthusiasm, fear, and panic. The day bad news is announced, fear and panic hold sway. More often than not, that panic sends stocks to extreme lows that don't hold. Or, put another way, the market has not yet digested any mitigating news that might make a seeming disaster not quite as bad as it first appeared. As a reason for hope emerges -- and there usually is one -- the stock tends to recover.

Consider a few examples of companies -- chosen pretty much at random -- that have suffered major failures in one or more clinical programs over the past several years. In every case, selling on the day that bad news was announced would have been one of the worst things you could have done.

Let's hop in the wayback machine and visit Alexion (Nasdaq: ALXN  ) , circa August 2003. Management had just announced that its complement inhibitor Pexelizumab, which was meant to improve survival in patients undergoing coronary artery bypass surgery, failed to reach its primary endpoint. The stock closed at $16 just before the announcement and opened the next day at $12.10, a 24% decline. The investors who rushed in to sell on that news (and they always do, in high volumes) missed the ride to $21 per share, which happened just two months later. Today, Alexion trades at more than $26, even though the company still hasn't proved that this product is effective or, indeed, gotten any product on the market.

You can find a similar example looking at Amylin Pharmaceuticals (Nasdaq: AMLN  ) , which has struggled for years with clinical and regulatory setbacks on its diabetes drug Pramlintide. Once described as "a typical cautionary tale from the biotech front" because of a seemingly devastatingly clinical failure with Pramlintide, the company now trades near all-time highs. Amazingly, neither Pramlintide nor any other Amylin drug has yet to reach the market -- although that may all change in a few months, if the Food and Drug Administration can be persuaded to give Pramlintide or another drug, called Exanatide, the green light.

For that matter, look at Dendreon. Or Pharmacyclics, Scios (now part of Johnson & Johnson), CV Therapeutics, Sepracor, ImClone, or any number of other companies that have faced product disasters.

Learning from La Jolla
But to really bring the point home, look no further than La Jolla Pharmaceuticals (Nasdaq: LJPC  ) , a company that many investors might regard as a worst-case scenario in the flesh. La Jolla spent years developing a treatment for lupus called Riquent. This product flamed out not once but three times over a span of five years. Strike one came on May 12, 1999, when an interim analysis of a phase 2/3 trial showed that Riquent (then called LJP 394) did not show a benefit over a placebo. The stock closed at $3.31 before this announcement and opened the next day at $1.03. If you'd rushed to the exits on the basis of this 69% bludgeoning, you would have avoided having to see the stock drop as low as 21 cents per share. But you also missed that it was trading at over $12 less than a year after the announcement. (Yes, these were the glue-sniffin' days of genome mania.)

Strike two came on Feb. 18, 2003, when a phase 3 study essentially confirmed what investors learned back in 1999. Shares had opened at $8.02 the day of the announcement; they next opened at $1.49. Should you have sold then? If you did, you missed a ride back up to $5 by that September.

Just this past Oct. 14, La Jolla whiffed again on its third time at bat. The company submitted Riquent for FDA approval on the basis that the drug improved some surrogate markers (lab measurements that give an indication of progress in treating a disease) in lupus. The FDA issued La Jolla an "approvable" letter, meaning Riquent could potentially be marketed if the company could just answer some outstanding questions. involving a new, multiyear clinical trial requiring millions of dollars that the company no longer had. This, surely, was the final straw. La Jolla had no other active programs, very little cash, no clear means of completing the study that the FDA requested, and an uncertain market even if it could. Was there any conceivable reason to hang on after this announcement? Well, La Jolla went as low as $1.05 the day following the announcement, yet it was back above $2 a month later and still trades today higher than it did directly after that announcement.

None of this is to say that a savvy investor could have somehow played these turns of fortune for profit. It would have taken incredible dumb luck to have found the right entry and exit points. La Jolla was pretty much an unmitigated disaster for its shareholders. But the one thing that holds true for it, just as with many other biotech companies, is that leaving the stock directly after a major piece of bad news proved to be about the worst exit point. The three dates above were among the only times in the past decade when you shouldn't have sold La Jolla.

Are there exceptions to this rule? I expect that alert readers will remind me of some in the coming days. But one interesting potential example facing investors right now is Adolor (Nasdaq: ADLR  ) , which is waiting to hear an FDA decision on Entereg, its drug for post-operative treatment of ileus (a type of intestinal blockage). Last December, Entereg failed to reach its endpoint in a European phase 3 study. The drug was already pending FDA approval, based on a mixed bag of studies that were positive in aggregate. But the agency has since asked for more information, pushing out approval until at least this July. Following the December announcement, Adolor dropped from a close of $16.19 to an open of $8.99. Technically, that wasn't the best exit point -- the stock went over $10 per share within a couple of weeks -- but I don't want to split hairs here. Adolor has pretty much been flat since December, and if the FDA eventually shoots the drug down, the stock may not recover meaningfully from its December plunge for years, if ever. Remember that there are no hard and fast rules here!

Thus, it is probably more foolhardy than Foolish to actually load up on a biotech stock that has just been knocked down. After all, while I'm fairly confident that Axonyx will eventually trade at higher levels than it reached on Monday, that doesn't mean it might not subsequently get knocked back even further. Ultimately, you should be investing based on a fundamental belief in a company and its prospects. But the patterns I see among troubled biotech companies suggest two things: First, that long-term investors will, much more often than not, win out over the traders by buying and holding. (Plus, they get to hit the snooze alarm on ugly days.) Second, even when it comes time to sell, history shows that it is usually worth waiting for the smoke to clear after a disaster.

Karl Thiel does not own shares of any companies discussed above. He is almost always in favor of hitting the snooze. The Motley Fool has adisclosure policy.


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