Searching for Cheap Biotechs

The index fund investors sure have it easy. Their investment effort consists of spending maybe an hour or two finding a low-cost fund that will match the performance of the S&P 500 or Wilshire 5000. Once that is set up they can forget about investing and worry about more important things like finding out when Dude, Where's My Car? is going to run on cable.

That's not a jab at the indexers. In a lot of ways they're the smart ones. You could certainly do a lot worse than indexing and matching the performance of the overall equity market over the long haul. In fact, such an approach could be considered a core foundation of a Foolish portfolio, along with an allocation for Rule Breaker investments like biotech.

But once we take that step of investing in individual companies, we are left with the daunting task of trying to find the best investments out of an extremely broad array of choices. There are more than 9,000 publicly traded companies in the U.S. alone. No one person can tackle all of them to find a select few in which to place hard-earned investment dollars.

Within the biotech sector the undertaking isn't quite that extensive, though it still requires considerable effort, as there are several hundred public companies to review. Trying to look through all of them to find a few good investment ideas is an incredibly intimidating task. I don't even think it's possible to follow more than a few dozen companies adequately, let alone a few hundred, before getting spread too thin.

So some method is needed to condense this assortment of options into bite-sized pieces. One approach to make the investment process more manageable is to use stock screens. A good stock screen works just like those pans that 19th century gold prospectors dipped in the rivers out West. When the prospector pulled the pan up out of the river, the screen let all the water and mud fall through, leaving some rocks and, hopefully, something valuable. The same idea is at work with stock screens. A stock screen will automatically eliminate all companies that do not fit predetermined criteria and will leave you with a manageable group to examine more closely. Just like with the prospectors, some of what you pull up will be junk, but maybe you'll also come up with a good company that has been overlooked.

The vast majority of stock screens are financially based. Common metrics used are earnings growth rates, P/E ratios, price-to-book ratios, dividend yield, and so on. These different measures of a company's performance can even be combined to find companies with a certain dividend yield that are growing earnings at a certain rate, for example. These financial screens can be useful when looking at the overall market.

For the most part, however, biotech investors are out of luck. Not even the big biotechs like Amgen or Genentech pay a dividend. On top of that, the vast majority of the sector consists of unprofitable companies, making all of the earnings-based stock screens irrelevant. (Though I suppose I could run an earnings screen and find out which biotechs are losing the most money. I could call it my Dirty Dozen screen. But that's not all that helpful for finding good ideas, even though it may point out some bad ones.)

But there is one financially based screen that can be used with biotech companies, and this one comes from looking at the balance sheet instead of the income statement. In this screen I looked for biotech companies that had a low enterprise value (EV). EV, as you may remember from Fool's School, is equal to market cap + debt + preferred stock - cash.

The EV calculation strips away all of a company's financial assets and obligations. It therefore tells us what the company's ongoing operations are worth. With small-cap biotechs that do not have current earnings, that worth is tied up in the drug pipeline. or more accurately, in the potential of the drug pipeline to be worth something more than zero.

We can think of EV, as related to biotech, as equal to the net present value of a company's pipeline drugs. As investors, we want to buy companies as cheaply as possible. Thus, the lower the EV the better. If we can find a company with an EV close to zero, then we are getting the company's technology almost free.

Using the most recently available financial statements, I ran 180 unprofitable small-cap biotech companies through this screen for the lowest EV. I set a minimum market cap of $70 million so that I could ignore many of the bottom-of-the-barrel penny stocks. I found seven biotech companies with a market cap over $70 million and an EV lower than $50 million. They are listed in the table below.

Up at the top of the list with an EV of a measly $8.3 million is Axonyx. This company has run into problems lately because its drug for Alzheimer's disease, Phenserine, failed in a phase 3 trial. For more on that story see articles by my colleagues Stephen Simpson and Karl Thiel.

I'm kind of glad that Axonyx came up in these results -- simply because it helps underscore the point that a low EV alone does not indicate whether or not a company is a good investment, just like a company with a P/E ratio of 7 may not be a better investment than a company with a P/E ratio of 15. Sometimes a company is cheap because the market has misunderstood its value. Other times a company is cheap because it is lousy. That's where the investor's decision making has to come in to play to make that distinction.

Given that caveat, the results in the table above have to be taken within the overall context of the company's situation. With Axonyx, and all other biotechs, investors need to be focused on the company's prospects as well as the low EV. If there are drug programs of value in the list of companies above, the current EV could present an attractive buying opportunity.

The final point that I'd like to make is that stock screens like this one are a starting point, not the finish line. The screen just gives a short list of potential ideas and some guidance as to where a good place to look may be. But it is not a replacement for doing research on a company's drug programs and management team. Don't want to do all that work on your own? Take a free 30-day, no-obligation trial to Motley Fool Rule Breakers, where we do much of that work for you. And for additional articles on the biotech industry, see:

• Investing in a Cure
• Grading Old-School Biotech
• Biotech Class of 2004
• The Future of Cancer Vaccines

Motley Fool Rule Breakers biotech analyst Charly Travers does not own shares of any company mentioned in this article. The Motley Fool has a disclosure policy.