The bear market is slamming biotech stocks as hard as any. Shares of the industry-tracking SPDR S&P Biotech ETF (XBI 0.18%) are down by more than 33% so far this year, and its five-year total return is just below breakeven thanks to its dramatic collapse in 2021.
With sentiment about biotech so persistently bad, bargain-hunting investors should be on the prowl, as there are bound to be a few diamonds in the rough out there. The trouble is, how do you find them? There's one technique in particular that's invaluable for identifying the cheapest of the cheap in the industry.
NYSEMKT: XBI
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What makes a biotech cheap?
Let's assume you're an investor who wants to buy shares of inexpensive biotech companies that have a chance of growing by 10x or even more. To find that kind of opportunity, you'll need to look at younger biotechs that don't yet have a product on the market, as companies that have succeeded in commercializing a drug or technology are rarely valued as attractively.
In practical terms, that means focusing your search on businesses with relatively small pipelines, perhaps with only three or four programs. And, those programs need to be somewhat early-stage, preferably in phase 1 or phase 2 of clinical trials as successes in later-stage trials tends to send share prices ballooning.
There's another challenge: How do you interpret the value of a company that's unlikely to have anything meaningful in the way of revenue or earnings? By using the price-to-book (P/B) ratio, of course. The P/B multiple is an invaluable screening tool for finding cheap biotechs, and it's also very easy to interpret.
In a nutshell, if a biotech's P/B multiple is lower than 1, there's a very high chance that its sum of cash on hand will be higher than its market cap. In turn, that means if the company were to somehow go bankrupt that day, common stock shareholders would get paid out for the value of their shares rather than being out of luck, thereby making their purchase a risk-free transaction (in theory). In practice, such a sequence of events never happens, and most investors will lose patience with a company and sell their shares long before it goes bankrupt.
Still, it's true that it's a lot more appealing for investors to pay $1 and get more than that in return since by definition a P/B multiple lower than 1 implies a price that's lower than the value of the company's holdings in liquidation. The key is to identify biotechs that are merely temporarily being valued for less than what's already on their books, rather than those which might be expected to permanently decline.
Finding bargains without diving in the dumpster
Consider Atea Pharmaceuticals (AVIR 2.19%) as an example. Its P/B multiple is a hair over 0.8, its market cap is around $557 million, and it has above $705 million in cash. Over the past year, its share price has fallen by more than 70%, because one of its phase 2 clinical trials for an antiviral drug for coronavirus infections failed to meet its primary endpoint.
Then, in May, a follow-up phase 3 trial for the same candidate reported disappointing results, but this time with a glimmer of hope for some of the trial's secondary endpoints, like reduction of hospitalizations. Atea says that it'll be working with regulators to see how it can continue to advance its therapy program, and it'll keep trying to get its candidate to work.
NASDAQ: AVIR
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So the company's stock is beaten down because of its clinical-stage failures, which explains its rock-bottom P/B ratio. But there's still at least some hope for Atea to eventually commercialize something approximating an antiviral for coronavirus infections. And that means it may be ripe for an inexpensive gamble for daring investors. After all, the market thinks so little of the biotech's chances that it's literally saying the money Atea has in the bank is less valuable than an equivalent amount of money held by another entity. That doesn't seem right, and so it could well correct back up to a more reasonable level eventually.
To be clear, there's no guarantee that Atea will ultimately succeed or that its shares will soon rise. But if you look for similar stocks with a P/B ratio under 1 and sift out the moribund companies from the merely wounded, you'll likely eventually get your hands on a biotech that later becomes a winner. And in today's market, opportunity is everywhere.
