The Speculator
A 12-stock strategy
for the biotech boom
The sector driven almost completely by hype has
risen substantially in 2003, and while there are solid reasons for the rally,
we've decided to follow the insiders.
By Victor
Niederhoffer and Laurel Kenner
"Even in the best big
pharmaceutical organizations, probabilities of success in research are very
low. In the best small biotechs, they are higher because everyone has skin in
the game."
-- Roger Longman, editor and publisher, Windhover Information
Biotech is the archetypal boom-and-bust industry.
From a starting value of 200 in November 1993, the Nasdaq Biotechnology
Index ($NBI.X) soared to a trading high
of 1,619 in March 2000 and then plunged to 397 in July last year. Now, biotech
is back. The index is up some 33% in 2003, fueled by such breakthroughs as the
May 19 announcement that Avastin, a Genentech (DNA, news, msgs) drug that blocks the flow of
blood to tumors, displayed better-than-hoped-for results in treating advanced
colon cancer.
There is a certain poetic justice in Genentech
sparking the current boom cycle. The company was founded in 1976 to profit from
molecular biologist Herbert Boyer’s invention of gene-splicing. In 1977,
Genentech produced the first human protein manufactured in bacteria. Together,
these developments can conveniently date the start of the biotech industry.
If prices could speak, Genentech’s chart would make the Harold Robbins
novel "The Betsy" seem like "Dick and Jane." The stock’s
peaks and valleys would tell of mergers, spinoffs, the early death from brain
cancer of one of the founders, devastating disappointments, deaths of patients,
irrationally exuberant marketing claims, self-aggrandizement, bitter patent and
royalty disputes, and life-or-death jury trials -- all intermingled with the
promise of cures for disease.
With a tapestry as rich as this, and given the technology bust in the new
millennium, it is not surprising that Genentech’s stock price has languished.
After reaching $122.50 on March 3, 2000, the stock rode the roller coaster down
to $25.50 last July. This year, it was trading in the $30s -- until last week’s
Avastin news. The stock jumped 45% on the day of the announcement and 61% for
the week.
Genentech has registered spectacular short-term moves before. Since its
July 1999 spinoff from Roche (RHHVF, news, msgs), the stock has risen 10% or more
in a month on 11 separate occasions. As the table shows, the average move in
the subsequent month was down 3%.
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Regrettably, it is difficult for us to balance the great potential of
biotech with the hype that drives its stocks. On the one hand, the Nasdaq
Biotech Index is losing $40 a share on its current price of 665. Yet Merrill
Lynch recently reported that 22% of all biotechs had market values lower than
their cash values at the end of 2002.
Stocks like Genentech tend to fall dramatically after big rises as cold
reality tempers the exuberant hopes for a cure for devastating diseases. But
when animal spirits start rising for biotech, the stocks can soar. After the
18% decline in biotech in 1994, the index jumped 86% in 1995. (All references
to “biotech” in this article refer to the Nasdaq Biotech Index, a
capitalization-weighted index of 75 companies with a market cap of $176
billion.)
4
reasons for biotech bullishness
Thus, the Spec Duo was particularly pleased when Roger Longman dropped by
to chat. Roger is managing partner and editor of Windhover Information,
publisher of In Vivo, Start-Up, In Vivo Europe Rx and Pharmaceutical Strategic
Alliances, the gold standard for venture capital information on biotech.
Roger is particularly bullish on biotech now for the following reasons:
While
Longman is quite bullish on the industry, he does not see a sustained takeoff
until two events take place. First, the big biotechs -- companies in the size
range of Exelixis (EXEL, news, msgs) and Millennium
Pharmaceuticals (MLNM, news, msgs) -- must be able to tap the
public market again for funds. Once they have the reserves, their expenditures
will trickle down to the rest of the industry. A rising tide lifts all boats in
this field, Roger says, adding (in a dig directed at the Spec Duo), “but in no
other.”
Second, Big Pharma must accept that biotech companies are more efficient
at discovering products than the big companies are on their own. The reason is
that everyone has a stake in success at the smaller biotechs, whereas in Big
Pharma, incentives are not so clear.
No matter how much we may admire the insights of an expert in the field
(and we devoted a whole chapter of our book, "Practical Speculation,"
to give and take between Vic and Longman about biotech), the Specs are never
content to funnel the wisdom of experts to readers without taking out the
pencil and envelope and adding their own views.
Watching the insiders
In this case, we add a preamble. One of our favorite techniques for making
money has been to buy beaten-down companies when officers and directors are
buying. We tested and reported the test-tube results of this system in our article of Oct. 25, 2001, as
well as in our book. Unhappily, the real-life tests had what would be called in
FDA jargon “a negative outcome.” We lost millions of our own money on them, and
the stocks performed even worse than the Nasdaq Biotech Index itself, which
dropped some 45% in 2002.
But why should that stop us? We have made the most money in the past by
following up good ideas that hadn’t worked recently. And we have many
theoretical and empirical reasons for believing that following the insiders
gives investors an edge.
We found 12 stocks among
the combined 85 companies in the Nasdaq and Amex biotech indexes with net
insider buying of more than 50,000 shares in the year 2003. These stocks, with
their prices, are:
Biotechs
with insider buying in 2003
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*end of most recent quarter
In view of the boom-and-bust cycle in biotech, we will be buying these on
a hedged basis. We’ll put an equal amount in each one of these stocks, and
we’ll short an equal-dollar amount: 25% in Genentech and 75% in the iShares
Nasdaq Biotechnology Index Fund (IBB, news, msgs), a security designed to
mimic the performance of the index.
Note
that more data on Avastin is being released June 1. Shorting Genentech before
or on that day is therefore quite a gamble, particularly since there already
has been a reasonable amount of hype about the company and about biotech in
general. By no means is it going to be clear sailing in biotech now.
Some statistics on the Nasdaq Biotech Index tell an interesting story. The
index has a market capitalization of $176 billion on sales of $19 billion. The
book value is about $50 billion. As mentioned previously, more than 20% of the
companies were selling below cash value at year-end 2002. Where did the cash
and the book value come from? Certainly not from earnings, which have been
negative, in aggregate, from time immemorial. They came from prudent sales of
shares to the public, mainly near the top of the market in 2000 -- a level from
which the index has plummeted 60%.
Why is it so hard for these biotech companies to earn money? Two simple
reasons. For one, many of the diseases these products target are not readily
amenable to being cured by a single targeted product. For another, at the top
of the feeding pyramid stands the U.S. Food & Drug Administration, which
approves only 15 or 20 new drugs a year. Approval for a new drug takes about
$800 million and 18 years. That kind of commitment is impossible for all but
the most plucky and lucky.
This
background is good to keep in mind when rushing in to buy biotech after word of
the latest cancer breakthrough hits the press.
Final note
Readers are invited to e-mail us with comments, queries
and kudos. Visit our Web site. We answer all
correspondence.
At the time of publication, Laurel Kenner and Victor Niederhoffer were
short Genentech. They did not own or control shares of any of the other
equities mentioned.