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 with a price that 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, 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's Capital IQ.

Going by the Magic Formula criteria, only Myriad meets both standards, while all the other companies are hardly even close. This can largely be explained by the fact that drug 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.

Ariad (Nasdaq: ARIA) is smaller than many other drug makers in the industry, but it is in the process of developing two possible blockbuster cancer drugs. If successful, these drugs can go a long way to help the company grow. Ariad is currently partnering with Merck to develop Ridaforolimus. On June 6, the companies presented favorable results from phase 3 of its clinical trials and on October 5, they announced that the FDA accepted the New Drug Application filing for the drug. Ariad is also in the process of testing ponatinib, and is currently in phase 2 of its testing.

Dendreon (Nasdaq: DNDN) was looking pretty good in July of last year, at which point it was poised to enjoy the success of Provenge, a cancer drug that gained FDA approval in 2010. Despite Provenge's high price, several insurance providers agreed to fund its use for its clients, including those on Medicare. Unfortunately, doctors have not been prescribing the drug at the rates Dendreon was hoping for, which resulted in more modest growth prospects and a 65% reduction in the stock price one day last August. Shares continued to drop for the rest of the year, and only early this month have started to recover.

Exelixis (Nasdaq: EXEL) was quite volatile in 2011, dropping from a high of $12.82 in in early March to $3.94 by late November. Some of this volatility might be attributed to the fact that Exelixis does not yet have any approved products on the market, so the success of the company completely depends on the products in its pipeline. On a positive note, now that Bristol-Myers Squibb has pulled out of a partnership with Exelixis in developing the drug cabozantinib, Exelixis has gained exclusive rights to the drug, which was granted orphan-drug status by the FDA in January of last year. However, it faced a setback in November when the FDA refused to approve a quicker version of its phase 3 trials in treating prostate cancer, which would simply demonstrate pain reduction and would not demonstrate prolonged survival. However, the drug is currently in phase 3 of its clinical trials for medullary thyroid cancer and in phase 2 of its clinical trials for a wide range of other cancers. Success here could spell jackpot for investors willing to take the risk in an early-stage biotech like Exelixis.

Amylin (Nasdaq: AMLN) is in a slightly better position than Exelixis, as it already has already gained FDA approval for its diabetes drug Byetta. However, the drawback of Byetta is that patients need to inject it daily, which makes it difficult for the company to compete with oral medications offered by competitors. Amylin is attempting to address this issue by creating a drug called Bydureon, which patients would be able to inject once a week. The drug is expected to get an answer from the FDA by January 28, and already received approval in the EU.

Seattle Genetics (Nasdaq: SGEN) also has a promising drug in its pipeline, called brentuximab vedotin, which gained FDA approval for use on Hodgkin's lymphoma and anaplastic large cell lymphoma in August. The company also recently licensed its antibody-drug conjugate technology to several drugmakers, including GlaxoSmithKline, AstraZeneca, and Pfizer. This gives Seattle Genetics the potential to make a great deal of profits in milestone payments and royalties coming from drugs developed with this promising technology.

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, 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 in order 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. Just click here to get your copy.