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An Inside Look at Biotech Investing, Part 2

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In this second article in a two-part series, Fool Community member zzlangerhans shares more of his approach to biotech investing and tells us which companies that he thinks are best buys now. ZZ is an emergency room physician and Harvard magna cum laude in biochemistry. He has been a Howard Hughes research fellow in transgenic mouse models and an NRSA fellow in xenotransplantation. He currently maintains a high rating on CAPS while focusing exclusively on biotechnology companies.

John Keeling: How do you calculate the fair market value for biotech buying opportunities?

zzlangerhans: I don't use mathematical models to calculate an appropriate market capitalization based on long-term potential. To do this, one would have to calculate the likelihood of success of a drug in clinical trials, probability of FDA approval, and commercial potential. I've seen many attempts to do this, and usually they underestimate risk and wildly overestimate the value of the stock. I tend to focus on whether I think the share price will be higher or lower within six months to a year. It's unrealistic to expect consistent accuracy within a window of less than six months, and a waste of capital to hold a biotech more than a year waiting for the pop. Looking ahead more than one catalyst into the future tends to introduce excessive error into the equation.

Keeling: How do you evaluate a biotech's pipeline versus its existing drug portfolio within your strategy?

zzlangerhans: I'm very poor at modeling the value of drugs that are already on the market, and I usually look to analysts for this information if I need it. That's why I have a preference for companies where marketed drugs make a minimal contribution to their long-term potential. I'm much more comfortable evaluating a pipeline than trying to guess how much sales of an approved drug might grow over the next 10 years. On the other hand, I do take advantage of the fact that the Street tends to overestimate the value of drugs up until the moment they are approved. The large majority of companies with drug approvals over the last few years have seen heavy share-price declines in the months or even years after their approval. This is mainly due to oversaturation of the market for pain medications, but drugs for gastrointestinal motility and antibiotics have also been notable failures.

Keeling: Which biotechs now look like best buys? Who should we avoid?

zzlangerhans: This is of course the most difficult and dangerous question. Part of my motivation to write CAPS pitches and blogs is to provide a counterpoint to one-sided pump pieces that misrepresent the truth. When I write about a stock, I try to be as objective as possible and include the negatives and risks, along with the positives. Baby biotechs are often undervalued or overvalued, but there's always an element of justification to every downdraft and updraft.

Two stocks which I've recently bought after precipitous drops on negative catalysts are Vical (Nasdaq: VICL  ) and Alnylam (Nasdaq: ALNY  ) . Vical dropped from $3.80 to as low as $1.80 after negative phase III results for its angiogenesis factor Temusi in peripheral vascular disease, which it followed with a large below-market dilutive financing. That puts a big hurt on Vical investors, who didn't account for the fact that angiogenesis therapies have a very poor track record so far in peripheral vascular disease -- which is generally a problem of obstruction of large arteries -- and also didn't pay attention to a shrinking cash hoard. But for those who stayed on the sidelines, it presents an opportunity to buy in with at least two years of cash runway and a lightning-rod catalyst of phase III trial data for Allovectin-7 for melanoma in mid-2011. Do I really think Allovectin-7 will work? Heck no. But as top-line data approaches, a lot of speculators are going to see Vical at $1.80 as significantly undervalued for even an outside chance at success.

I feel Alnylam is primed for a rebound, now that it is trading barely above cash after its partnerships with Roche and Novartis were terminated and some prominent analysts registered negative opinions about the future of RNA interference. A year ago, Alnylam was trading in the 30's because RNAi was the next big thing. This year, everyone hates it. With the nearly $400 million of cash Alnylam has in the bank I'm willing to bet that some time in 2011, people will start loving RNAi again.

There are two major types of stocks to avoid: legitimate companies that could potentially lose 50% or more of their value on negative catalysts in the near future, and companies of questionable legitimacy. In the first category, I would place Viropharma (Nasdaq: VPHM  ) , because generic oral vancomycin could appear at any moment; Aveo (Nasdaq: AVEO  ) , flying very high ahead of phase III cancer data in mid-2011; and Sangamo (Nasdaq: SGMO  ) which has recently risen dramatically, but whose future depends on a phase III trial that will be resulted later this year. In the second category, I'd put Hemispherx, Antigenics, Osiris (Nasdaq: OSIR  ) , Cel-Sci (AMEX: CVM  ) , and Oculus, although I wouldn't consider a company legitimate just because I didn't list it here.

Keeling: What are the biggest mistakes to avoid in small-cap biotech investing?

zzlangerhans: Almost everyone buys into stories when they begin investing in these companies. There's so much positive coverage and so little objective criticism that it's very easy to be snookered into thinking that biotechs will deliver on their promises. What differentiates long-term successful investors from what I call the Kool-Aid drinkers is that the former make an attempt to learn from their mistakes, rather than digging in their heels when developments aren't in line with their expectations. Although there are fairy tales with happy endings in biotech, more often than not, the dragon eats the prince. Baby biotech investing is for the most part a zero-sum game, so unless you're being smarter than other traders, you're going to end up losing money.

Novartis is a Motley Fool Global Gains recommendation. Try any of our Foolish newsletter services free for 30 days

ZZlangerhans owns shares of Vical and Alnylam. Head over to CAPS and check out ZZlangerhans's latest outperform and underperform picks. You can check out ZZlangerhan's Motley Fool CAPS blog here. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy has a junior chemistry kit.

Read/Post Comments (3) | Recommend This Article (26)

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.

  • Report this Comment On February 18, 2011, at 7:07 PM, Option1307 wrote:

    Thanks for the second article, seriously great stuff here!

  • Report this Comment On February 22, 2011, at 10:35 AM, TMFHelical wrote:

    John, ZZ,

    Good interview and discussion on this investing minefield. Thanks for sharing.


    Home Coverage Fool

  • Report this Comment On March 08, 2011, at 11:59 AM, Rodex55 wrote:

    John, ZZ,

    Before you trash CVM you really need to look at the top institutional holders of this stock. Big names like Vanguard and BlackRock would not hold large portions this stock if it wasn't legitimate. I agree CVM is moving painfully slow in the Phase III release of real-time data, but the risk to reward payout could be exceptional for investors.

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