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Efficient market? Not in Biotech.

Recs

21

February 17, 2009 – Comments (6) | RELATED TICKERS: PGNX , LJPC

The central purpose of my concentration on the small-cap biotech sector is to disprove the hypothesis that the market cannot be beaten, i.e. that at any given moment the price of a stock closely reflects the weighted average of all possible outcomes for the company given all information publicly available. Needless to say, to accept this efficient market hypothesis is to render retail investing useless, as the laws of probability dictate an eventual zero sum game minus the costs of trading.

 

I know I won’t ever be able to prove or disprove this in CAPS, since my own performance may deviate from the probabilistic mean and also because CAPS scores my picks against the S&P, a completely artificial metric. However, after two years of following the sector I am confident that in occasional circumstances the collective intelligence of all investors displays a marked disparity to a reasonable appraisal of value that would be apparent to an intelligent investor who follows the company closely.

 

Probably the best example I have encountered of a stock being undervalued in this manner is Progenix in March of 2008. The share price dropped 60% to about 5 on news that a phase III trial of IV methylnaltrexone in post-operative ileus had negative results. Here is an excerpt from the pitch on my subsequent green thumb:

 

“Progenix stock has tanked on what seems to be a wild overreaction to bad news of limited short-term relevance. I reviewed this company fairly closely and I didn't even know there was a phase III trial of INTRAVENOUS methylnaltrexone for post-operative ileus in progress. The short-term story for this stock is SUBCUTANEOUS methynaltrexone for opioid-induced constipation, not post-operative ileus. The whole IV methylnaltrexone for POI thing was basically a side project, not the justification for the whole enterprise value of the stock. The company is now trading at cash value, possibly below. Zero valuation of subcutaneous methylnaltrexone, zero valuation of pro140 (now in phase II). If I suck wind on this outperform, I will suck it strongly and proudly.”

 

At that time, Progenix was already awaiting European and FDA approval for subcutaneous methylnaltrexone, a compound which had already achieved phase III success for opioid-induced constipation. Within a month both approvals were granted and the stock was over 14. My green thumb paid off 158 points, my best score to date. While those approvals were far from guaranteed, the drop in an already low-priced stock after negative phase III results in a virtually unrelated trial made no logical sense. The only conclusion I could come to was that retail investors and likely even institutions who did not understand the stock created a chain reaction of selling after somehow misinterpreting the trial results as having negative implications for FDA approval of subcutaneous methylnaltrexone.

 

A similar event recently happened in the opposite direction. One of my earliest CAPS picks was a red thumb on a company called La Jolla Pharmaceuticals, a small company with a pipeline consisting of a single drug, Riquent for lupus. La Jolla was flying high the first half of 2007 after reporting encouraging preliminary data in their ASPEN phase III trial of Riquent. Unfortunately, this wasn’t the first time Riquent went through phase III. Years earlier, a lower dose of Riquent failed a phase III trial yet the company proceeded with an NDA anyway, which the FDA predictably rejected. Furthermore, the encouraging preliminary data from the new phase III trial was not true interim data on clinical response, but related to analysis of a surrogate marker that was not well-correlated to outcome. I felt that the company was being disingenuous both in simply repeating the long phase III trial simply with a higher dose of a failed drug, and in exaggerating the importance of an early subclinical result. After researching the history of Riquent, I came to the following conclusion in July 2007 with LJPC at 4.45:

 

“The clock is ticking on Riquent which will fail this phase III as it did in previous trials. This is a classic example of a company clinging to a single doomed product in order to extend the careers of the board and top management. I expect "shock and disappointment" when the negative interim results are released in 2008.”

 

In October 2008 I gave up on the pick when the share price had dropped to 1.13, writing:

 

“Riquent and La Jolla will die in 2009, but I don't feel like waiting. If the market pops up by then I'll be leaving points on the table, but I think we could be looking at a long period of stagnation. I'm picking a nice up day, over 40 points on the red thumb. Point made.”

 

The falling S&P had degraded the value of my successful underperform, and frankly I was just sick of looking at it on my CAPS profile. But the economy and small cap malaise continued to weigh on the share price, which eventually bottomed at 0.44 in December 2008 without any significant negative catalysts. I still updated my database on the stock, but didn’t watch the company particularly closely.

 

In January of this year I was surprised to see news that the company had managed to license Riquent to Biomarin, a company I always thought of as being very sensibly managed. I was even more surprised to see La Jolla stock continue to spurt upward past the initial double after the partnership announcement, doubling a second time to reach a high of 2.8. Did well-informed investors really believe that the Biomarin pact changed the risk/reward ratio in the ASPEN trial so immensely as to justify a six-fold increase from recent lows? Or had an initial surge of excitement permitted a dam of pessimism to simply burst? I red thumbed as soon as I could given the 100 million market cap threshold for CAPS, stating as follows:

 

“La Jolla bounced back on a questionable decision by Biomarin to partner up on the Riquent program, a project that is by consensus almost certainly doomed to failure. Of course, at LJ's pitiful market cap is was enough for more than a double in share price. It's a nice opportunity to replant my red thumb and collect a decent chunk of CAPS points at the latest by the end of 2009, when the topline data for the phase III trial of Riquent will be released. And this time hopefully the S&P won't drop 50% to cut my score.”

 

I didn’t have to wait that long. The first true interim analysis of the ASPEN trial came back just a week later showing futility of trial continuation and the share price vaporized. La Jolla is finished, kaput, history. And it was the most predictable implosion I’ve seen so far. While I know this was devastating to the investors who bought at the peak at the beginning of this month, I have to wonder how many of them took advantage of the research tools easily available to them via the Internet. Clearly enough piled on for the sake of hype and momentum to degrade the collective intelligence far below that of a reasonable investor exerting due diligence. So much for efficient markets in the small cap biotech sector.

 

Interestingly, of all my red thumbs this was the one that the most highly ranked CAPS players chose to tag along with. It’s another way that I see how the top players are truly seeing stocks at a different level, using me to locate potential plays in an unfamiliar sector but evaluating them on their own terms and outperforming me at my own game.

 

Anyway, the point of all this post-hoc analysis is not to brag about my best calls, but to challenge myself to take advantage of those rare opportunities when a huge discrepancy between share price and true value presents itself. So far these occasions have come only about once a year, but I pledge that the next time I see one I’ll put my rep on the line for it. While plugging away at 55/45 percentages eventually wins in the long term, the only way to really beat the market is to keep some resources in reserve for those rare 90/10 opportunities and go in hard. Next time, no hesitation.

6 Comments – Post Your Own

#1) On February 18, 2009 at 4:20 PM, GorillaGorilla (< 20) wrote:

Thank you for the education.  What ya think of JAV? I've kicked it about a bit - it looks interesting.  Seems to be in hyper-growth in UK - was waiting to see what the next quarterly update brings..

 

rich

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#2) On February 18, 2009 at 8:17 PM, SuperPicks (29.03) wrote:

Keep up the great work ZZ.

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#3) On February 18, 2009 at 9:51 PM, goldminingXpert (29.47) wrote:

Totally agree with your thesis on an inefficient market. I never had a doubt that Repros was going to get slammed, and I usually question all of my investments over and over. I lost no sleep over RPRX however--it was clear that the company was priced entirely on hype.

Nice call on La Jolla, I only got 20 points off it as I closed it early, but I deeply appreciate the lead.

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#4) On February 19, 2009 at 12:08 AM, zzlangerhans (99.70) wrote:

Umm, Javelin. Wish I could take a mulligan on that green thumb. I'm having a hard time seeing a happy ending there. Dyloject has positive phase III data all over the place and no one cares. Is hyper-growth in the UK the bump from 180K to 360K in sales quarter to quarter? They're not playing with the right number of zeros to bump up the share price. Meanwhile Rylomine was last seen on the back of a milk carton. That leaves Ereska - better pray for positive phase III results. I've concluded that the pain pharmas are lousy bets - there's just too much generic competition that's pretty damn safe and effective. Stay away from Javelin, Pain, Acura, and BioDelivery Sciences. These guys are just not delivering.

GMX, I honestly don't share your confidence in the fall of Repros. They'll likely die eventually but for now they've got financing and positive momentum with Proellex. I closed my red thumb and I'm going to range-trade them. Don't be surprised to see me going green below 8. I don't see anything finishing them off in 2009. We're on opposite sides of Arena now also. Prepare for mortal combat.

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#5) On February 19, 2009 at 12:27 AM, goldminingXpert (29.47) wrote:

Proellex is virtually the same drug as asoprisnil--which failed to get FDA approval. I see no reason to expect this washed out drug to get new life due to a mere name change. This company has a history of recycling losers and hoping for the best...you did read my article, right? However, I don't think RPRX will go away in 2009--they're too good at fooling people with name changes/press releases/misrepresented trial results.

Arena was a screaming short on technicals (any move from 3 to 7 and change that forms a double top and then reverses sharply demands a short, regardless of the fundamental case. Now that the stock is under 6, you're a good buck fifty away from the double top and so your pick can work. I'm ~+15 on my pick and you're flat, so we can both win here at ARNA.

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#6) On February 19, 2009 at 7:59 AM, GorillaGorilla (< 20) wrote:

Ok... with Javlin... I'll keep watching the "hyper-growth" - there should be a better word to describe large growth on small numbers  Perhaps hypo-growth :) Still, the penetration into UK hospitals is excellent and the FDA allow Ketorolac and it's associated excessive bleeding then I can't imagine they will stop Dyloject. 

Regarding ARNA - according to the last quarterly cc they said that they can see the aggregate data for weight loss. My interpretation of that is that they already work out that the drug is effective - if they assume an average weight loss for placebo people. So, I'm taking that there's a high probability for a successful trial. Anything to disagree with?

 Phil Nadeau - Cowen and Company

Okay. And your comments on the blinded data from the BLOOM trial. In that blinded data were you able to see weight loss figures or were you just looking at adverse event reports?

Jack Lief

You know, we do see aggregate weight loss figures. So we see what the entire cohort, the entire population loses in an aggregate fashion. And as I said we believe we are going to have a very effective, very potent and well tolerated compound.

So, assuming a successful trial, it seems that only the FDA is in it's way - given that Arena is Fen-phen with more sensitivity to which seretonin receptors it binds and without the amphetamine component I have become, not unusally for me, optomistic on it's chances of FDA and, obviously, hyper-growth. 

There was also a school of thought on Yahoo boards that it might only initially be used on morbidly obese. I was thinking that if the FDA is going to be consistent with past judgements - it's not about the greater good for a diet drug  it's about if the drug is absolutely safe - everybody or no-body. 

I also noticed you green thumbed VVUS - I haven't green thumbed that myself because I just can't believe that it will get through FDA because of the Topamax component - even if the combination seems safe. Is this a green thumb you would take through the FDA NDA?

The other thing I was interested in knowing was - does the Washington administration affect the FDA choices? I ask because weight loss is, something like, 10th on the list of things Obama wants to do. 

cheers

 rich

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