The Magic Formula for Biotech

If you're a busy investor with more than just stock-picking on your plate, you might want to consider a mechanical investing strategy. And if you're interested in stocks, one of the most intriguing of these strategies is Joel Greenblatt's Magic Formula.

Greenblatt details this approach in his enriching, funny The Little Book That Beats the Market. His strategy revolves around two factors:

• How cheap is the stock?
• How profitable is the company?

This simplified approach really boils down value investing to its essence. When you find a company whose price fails to reflect its high profits, you might have a winner.

A cheap business and a profitable company
To find cheap companies, the Magic Formula looks for a high earnings yield -- basically, a company's EBIT divided by its enterprise value. EBIT is earnings before interest and taxes, otherwise known as operating earnings. Enterprise value includes the company's market capitalization and then adds its net debt. In general, the higher the earnings yield, the better. The Magic Formula looks for a yield higher than 10%.

To find profitable companies, Greenblatt's Magic Formula seeks businesses that generate pre-tax returns on assets (ROA) greater than 25%. In other words, for every $100 in assets it holds, the company would produce at least $25 in net profit. In general, the higher the ROA, the better the business. Greenblatt looks for companies with an ROA higher than 25%.

So how do some of the biggest companies in the biotech sector fare?

Source: S&P Capital IQ.

Going by the Magic Formula criteria, none of these companies meets either standard, largely because biotech companies need to front a lot of capital in the beginning to make money in the long term. When investors buy shares, they are paying for the chance to cash in on gains from developmental drugs that have a chance to become blockbusters. In this case, the Magic Formula demonstrates the risk involved in biotech stocks and the fact that most biotech companies in the early stages of development will not stand up well against common methods for stock analysis.

The performance of Human Genome Sciences, like other small biotech and pharma companies, relies on the development of new drugs that treat unmet needs. The success or failure of these drugs can make or break these companies' profits. Fortunately for its shareholders, Human Genome Sciences gained FDA approval last year for its drug Benlysta to treat lupus, at which point its stock jumped several points. However, the shares have steadily fallen since then because of disappointing sales of the drug.

While Spectrum Pharmaceuticals is a small company, it has already pushed two cancer drugs through its pipeline. Zevalin treats non-Hodgkin's lymphoma, and Fusilev is used to treat some bone-cancer patients. Last year, the company also announced that it will produce a generic version of another lymphoma drug, Rituxan, which is produced by Biogen Idec. If Spectrum is able to gain FDA approval for its substitute and market it effectively, it could spell good news for shareholders.

The FDA's rejection of Cell Therapeutics' non-Hodgkin's lymphoma drug pixantrone in 2010 hit the company hard last year, and its shares lost nearly 50% of their value. The company spent much of 2011 fighting to reverse the decision on its leading drug candidate and gain approval, and it succeeded in getting the FDA to accept a resubmitted New Drug Application. An answer is expected from the FDA in February. While gaining FDA approval would be good news for Cell Therapeutics, in the meantime it has had to raise $50 million in dilutive offers.

In the past, Geron was best known for its research focused on developing stem-cell products. However, political controversy over stem-cell research has pushed down its share prices drastically. As a result, Geron announced in November that it's giving up on stem-cell research. While Geron will lose some short-term grant money as a result, it may be able to sell its stem-cell program to a bigger company. The move should also save the company money in the long term, which it can use to fund the clinical trials on drugs the drugs in its pipeline.

Keryx gained approval from an independent safety monitoring board for phase 3 of its clinical trials for its colorectal-cancer drug perifosine in August, which is good news for the so-far money-losing company. It is also in phase 3 trials for the use of perifosine on multiple myeloma, which is a type of blood cancer. In addition, Keryx is in the second stage of phase 3 of its trials for Zerenx, which treats end-stage renal disease. If any of these drugs pan out, the company may be able to become profitable.

While biotech and pharma stocks can be strong performers, they are not the types of investments that you can just buy and ignore. Their success relies on strong performance from year to year, and the rapidly changing nature of the industry does not allow any of these companies to rest on their laurels.

Foolish bottom line
The key advantage of the Magic Formula is speedy decision-making. You can run a screen and mechanically buy the stocks and then spend your free time doing the activities you love. However, such an approach means that you need to pick a lot of stocks (say, 25 or 30), since you haven't performed any strategic analysis of your investments. According to the formula, you should hold the stocks for one year to receive favorable tax treatment, sell all of them, and then run the screen again to find your new picks.

While this approach sounds easy, Greenblatt cautions that it can be tough to stick with during hard times. In some years, this mechanical strategy simply won't work. However, Greenblatt's extensive backtesting suggests that over the long haul, his Magic Formula can significantly outperform the market.

With high-risk propositions on sometimes unproven drugs, biotech investing is not for everyone. And that's ok. If you'd like to invest in lower-risk companies with more certainty of success, check out our special free report, "3 American Companies Set to Dominate the World." It's available free for a limited time. Get your copy.