Ugly lessons in biotech: Avoid binary events
I had originally planned to make Biotech Rule #9 the one about investing based solely on pundit opinion, then decided that there was another rule that really needed to be established. So my prior Rule #9 is now Rule #10, and what I had in mind for Rule #10 will now be a biotech Meta-Rule, a rule that renders all the other rules irrelevant. But that's for the next post. For now, I want to address the issue that impoverishes biotech investors more than any other, which is the practice of investing in small cap biotechs immediately before an important binary event such as phase III data or an FDA decision.
The most obvious reason for this being a terrible strategy is that most biotech investor buy IN to a stock prior to the binary event, while the majority of these events and decisions go AGAINST the company. More phase III trials are negative than positive (once company spin is neutralized), and the FDA hands out many more non-approvable or approvable letters than approvals. Therefore, the investment is a pure gamble and on average a losing one. So why do retail investors tend to go long? I think there are three major reasons. One is that most investors become interested in a baby biotech by some sort of a pump, whether it emanates from the company itself or from the media. Few articles are written to describe the true crappiness of a company or developmental product. The intrinsic bias is towards optimism. Second is that many retail investors use non-marginable accounts such as retirement accounts and can only make long plays. Third is the pervasive and probably appropriate discomfort with short positions, as everyone is aware of the potential for unlimited losses.
As any Fool playing CAPS can see from the performance of players who achieve high rankings by indiscriminately red thumbing every unprofitable small cap they can find (which includes most baby biotechs), a universal short strategy would have been highly profitable in biotech over the last two years. Of course, it can be a lot easier to end an underperform pick than to cover a short position in a thinly traded biotech which is rocketing upward without rhyme or reason (see Dendreon in May 2007). A short squeeze can wipe out a brokerage account in a few days, so an investor adopting this strategy needs to make a careful assessment of his reserves and watch the charts extremely closely. Unless you're a pro, I can't recommend playing around with shorting.
The remaining alternative is to attempt to profit simply from the volatility of a biotech around the time of the binary event using options. A straddle or strangle play with puts and calls on either side should render the actual decision irrelevant, as long as it moves the stock significantly in one direction. The profit from one option should be much greater than the loss on the other. So what's the rub? Delays and equivocal decisions that cause the options to expire with the stock price unchanged. Anybody seeing how the FDA has handled decisions on Cardiome and Ligand, among others, would be loath to buy options that depend on the FDA meeting a PDUFA date. And phase III data can end up as a wash if it's only weakly significant, or if it misses significance but the company successfully spins it positive for the short term. Some binary events are virtually certain to be major stock movers, and one finds that the free options market has set those prices correspondingly high.
The temptation to play binary events is obvious. Stock gains can be huge, and the profit margin on a call can multiply the gains exponentially. But in baby biotech, no matter how certain it appears that a trial will be successful or the FDA will approve, surprise and disappointment are the two most common words in post-event press releases. Successful biotech investors (if there are any) wait until the binary event has been successfully passed and then buy on a dip. If phase III data is positive the stock will often rise again when the NDA is submitted, and if FDA approval is granted the stock will often rise again once the first sales are reported. The share price won't double, but a relatively safe bet on a 10% gain is better than spinning the roulette wheel for 100%.