Small cap biotech investing in the era of underperformance
October 10, 2008
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Now that I'm flirting with a 99 rating, I feel like I can start writing down some of my thoughts without feeling like a complete idiot. Don't get me wrong - I don't recommend that anyone buy stocks I write favorably about or use my speculations for anything except entertainment. CAPS rankings are virtually meaningless for many reasons (accuracy, red thumbing unshortable bulletin board garbage, keeping long-inactive players in the rankings, etc.). I've been getting creamed just like everyone else in the last couple of weeks, mainly because of an ill-advised decision two weeks ago to liquidate my large holdings of ultrashort ETF's and go hard long into beaten down oil and tech stocks. I was expecting a short upward burst with passage of the bailout bill in the house the first time round, and we all know how that turned out. So I ended up going to cash a couple of days ago and took a huge loss on my two week investments, but right now I'm glad I bit the bullet. At least I've got something left to buy with when this piece of crap finally hits a bottom it can live with.
So the question becomes, when the market does stabilize and you have any cash left, what small cap biotechs should you buy? First and foremost, it's a dubious question whether you should buy small cap biotechs at all. Since I started following them two years ago, probably five were down for every one that was up even before the recent round of decapitations. But if you do feel compelled to embrace the agony and the volatility, I do feel I've gained some valuable perspectives while I've helped to line the pockets of CEO's and hedge fund managers .
The most important thing to keep in mind is that each new medication needs to overcome three major hurdles before becoming profitable. It has to be successful in clinical trials, it has to achieve FDA approval (and/or approval in other large markets), and it has to be commercially successful. The last of these is far from trivial. The majority of approved drugs from small cap biotechs in the last two years have yet to achieve significant sales. Notable flops have been Nitromed's Bidil, Zymogenetics Recothrom, Nektar's Exubera. The only major success I can think of offhand is Alexion's Soliris. So we see that the odds of success for a small cap biotech are quite small. My best estimate is that of all the small cap biotechs with market caps between 100 million and 1 billion two years ago, probably 10-15% are trading in pennies and on their way to dissolution. Most of the remaining companies are trading at significant discounts. As old companies fade away, change their names, or merge, new ones IPO to take their places (although that party may be over for a while).
On my next post I'll describe the major mistake I made when I first started investing in small cap biotech, which I think most other retail investors make as well. But I would like some idea whether anyone is actually reading these ramblings. So please leave a reply or a rec, so I'll know whether it's worthwhile continuing this thread.
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