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Grabbing Bottoms in Miami Beach: A Trader's Manifesto

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January 11, 2010 – Comments (4) | RELATED TICKERS: MYGN , GTXI , ALKS

Greetings from Miami Beach. Those of you who know me as a trader, know me to be a specialist in speculative small cap biotech stocks. I'm not a cheerleader or a detractor of the sector; my red thumbs and green thumbs are distributed evenly (often on the same stock). My modus operandi is to remain rational and objective in an arena where emotion, wild speculation, and manipulation rule the day. I also lack knowledge, experience, and raw talent when it comes to understanding the business element of biotech companies. An ill-advised venture into profitable large cap biotechs and biotech ETF's had disastrous consequences for my score and accuracy, largely because I have minimal grasp of or interest in financial concepts such as P/E or ROI. My only edge over the market, if I have one at all, comes from a passing familiarity with the science underlying developmental biopharmaceuticals. I've also benefitted from having a steady focus on an array of about 200 of these companies over the past two years. The fairly large sample size helps me to generate a rough valuation model for small unprofitable biotechs, which is one of the most critical aspects of investing in the sector.

My goal is to make money through trading, not to be an expert on any company's pipeline or management. I'm also not looking for 10% gains in a year that will translate to a comfortable retirement when I'm 65. I already have a job I enjoy which compensates me sufficiently to meet all my financial needs. But I'm only planning to live once and I'd like to take a shot at achieving extreme wealth by mastering the art of stock speculation. I'd also like to take my shot without seriously endangering the stake I've built through years of education and hard work. Unrealistic? Almost certainly. But for each of us CAPS is the chronicle of  those efforts, and only the future will tell us if we were destined for success or failure. After two years, and enormous waves of market volatility, I believe I'm at break-even and ready to enter a new phase of educated trading strategy.

My previous strategy, which I delineated over a year ago on this blog, was to identify small cap biotechs which were fundamentally GOOD and invest in them, to the exclusion of biotechs which were fundamentally BAD. The strategy was essentially a failure, giving break-even results in a year where the S&P rebounded dramatically. I either failed to correctly identify companies as GOOD or BAD, or market irrationality extended beyond the one year window I allowed myself to determine the success of the strategy. Even if my shambling GOOD biotechs are destined for eventual greatness, I could and should have picked them up later at lower prices.

This realization helped to shape my new strategy of immediate gratification and relatively high short term returns. The best way to make money in a highly volatile sector such as small cap biotech is to correctly identify market bottoms, regardless of the long-term potential of the equity. Hence the name of my 2010 strategy and the title of the post, GBMB for short. The strategy has two obvious drawbacks. First is the failure to correctly identify a bottom, resulting in short-term losses. The second is to await a bottom that never comes, missing out on potential gains. The answer to the first drawback is skill and experience, which unfortunately are just as necessary to execute this strategy as any other strategy. The answer to the second is to forget it. As long as the pool of candidate equities is large enough, there will always be some that drop far enough below fair value to present buying opportunities. Some gains will be missed, but others will be captured. As long as bottoms are correctly identified, money will be made.

So how does one identify a bottom in baby biotech? One must be cognizant of the following factors: market capitalization, cash, debt, burn (or profit), catalysts, historical stock performance, and long-term potential. For example, regarding a company with a high burn and significantly more debt than cash, a bottom might be undefinable as the company is at risk of bankruptcy. Regardless of how much volatility is present, bankruptcy usually represents the death sentence for your investment. Occasionally market capitalization will drop below cash in a company with minimal debt. When this occurs, the quarterly burn and long-term potential of the stock must be closely evaluated as the stock may well be approaching a juicy bottom. If the burn is high and prospects are weak, the cap may continue to drop along with the cash reserves indefinitely. But if the cash position promises to remain relatively stable over time and future positive developments are likely, the probability of a comeback rises substantially. Catalysts are in general an enemy of the GBMB strategy. By definition any catalytic event might have positive or negative results, and our primary directive is for our investment not to be pushed downward in value. Much better to allow a bottomed out stock to recover to equilibrium naturally than to take chances on a short-term catalyst. And of course once we have correctly identified a bottom, we don't want to see it again while we still hold the investment. This is a short-term strategy and by definition, a stock which has gained in value substantially is no longer at a bottom. On any given day, I will not hold a stock if I wouldn't have bought it for that same price that day.

My bottom-feeding strategy has recently served me well. Readers of my pitches will be aware of recent profits I made in Myriad Genetics and GTX, and a profitable active position in Alkermes. As with my prior strategy, I will hold myself accountable to it by reporting my actual buys and sells in pitches and blogs. CAPS is a useful tool in the strategy, as a green thumb serves as a marker for stocks that may be approaching a bottom. CAPS is also helpful in that I have found that green thumbs from several of the Top Fools are positively correlated with bottoms. The lower the price gets, the more frequently I re-evaluate the stock and lower my buy threshold until finally the moment of truth arrives. I've definitely missed some beauties when my target bottom was never reached (Allos and Mannkind come to mind), but I'm willing to let them go if it means I'm able to avoid buying other undervalued stocks too early.

Now that I've outlined my strategy, my next post will discuss several stocks that I believe should be closely watched for bottoming. As a counterpoint, I'll point out others that are at the highest risk for short-term losses, the anti-bottoms. For today, I think I've bored you enough.

4 Comments – Post Your Own

#1) On January 11, 2010 at 1:46 PM, ChrisGraley (29.69) wrote:

I got arrested for grabbing bottoms on Miami Beach once.

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#2) On January 12, 2010 at 11:22 AM, TSIF (99.96) wrote:

Grabbing bottoms without getting in trouble is a fine art. It probably helps to grab the ones that "want to be grabbed".

ZZ, thanks for the insight.  While I'm sometimes on the opposite side of the fence, there are no definitives with bios, so therefore, no right or wrong, just hindsight, (when Chris isn't grabbing it)....

I appreciate your insight.  This is the area where the CAPs community shines, when investors are willing to put thier thoughts/rationale out and others add to it.  The bios are probably the trickiest with most of thier potential "off balance sheet.  I look forward to your series!!!

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#3) On January 13, 2010 at 8:03 AM, retiredpharma (< 20) wrote:

ZZ,

 First time reading your site. I must confess we are very similiar in our picks. I too am long AMAG, INFI,ALTH,CRIS and several others but recently I have delved into Genomic Diagnostic plays.

I see you have Genomic Health as a target and I was intrigued w/ them to start some recent DD. The share p has come down and I said last month if we get near 15 I will buy. I like their Breast Ca focus but wonder what the Colon assays will bring to the table realistically?

I have gone long a competitor called Response Genetics(RGDX) 12,000 shares at 1.00/net and would like your take! I will be watching for your feedback!

Frank

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#4) On January 13, 2010 at 9:54 PM, zzlangerhans (99.85) wrote:

@#3 - check again. I'm short ALTH and CRIS in CAPS although I wish I could reverse direction on ALTH. GHDX was going to be in yesterday's post but I was falling asleep at my computer. I'm writing them up now. I haven't heard of RGDX and I'm too busy combing my harem for bottoms to research new companies. But I'll add it to my general watchlist, thanks.

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