Generally, biotech and value investing aren’t concepts that fit together, and they’re right. Most biotech investors are speculators, momentum investors, and traders. What makes investing in biotech so different then value investing is the ability to place a value on biotech, especially small pre-revenue biotech companies (in this article when I refer to biotech it is specifically small pre-revenue biotech). Value investors use a few tools for creating an estimate of intrinsic value, but the most common is a discounted cashflow. When you use a discounted cashflow and build an intrinsic value of a company, you are looking for companies that aren’t efficiently valued, and you are assuming when you buy the company that the market will eventually become rational and reach or surpass your intrinsic value. For years I focused solely on value investing in this way, and I did well. I beat the market regularly, but like most investors I wanted more.
Some of you may have followed Peter Lynch, and one of the things he talked about was investing in things that you know. When I value invested, I didn’t invest in things that I knew, I just looked for good value. Most of the time it worked for me, but there were a few times that the market burned me due to my lack of understanding. Peter Lynch turned my thoughts inward, and at the time I was working at one of the largest biotech companies in the world. So, I looked around at biotech investments, and realized there was too much risk in biotech, and the extreme price movements scared the value investor in me, but I still wanted to research and find out if I could mitigate my risk a bit more. I then started to take apart biotech companies and try to do discounted cashflows to see if I could understand the intrinsic value. I will tell you right now, without a doubt there is no pre-revenue biotech company that is worth the market valuation if you try to use a discounted cashflow. Then the lightbulb went off and I called my broker. The conversation went like this.
Me: Good morning broker!
Broker: Good morning, how may I help you today?
Me: I’ve been performing cashflows on a lot of biotech companies (pre-revenue), and I’ve realized they all have a negative intrinsic value. This is a major problem for you, and I’m here to solve it.
Broker: Uhhh… I don’t…
Me: I know, I’m great right, I’m solving a big problem for you! So I’ll take all the biotech shares you have, and you can pay me $.10 for each share! You win, I win, we all win. You’ll probably get promoted to president of the company because you were lucky enough to answer this phone call!
Broker: … click…
Me: Hello? Hello? Broker? Are you there?
Obviously valuing a biotech using DCF is inappropriate, but is there any other way to figure out the appropriate value for find an intrinsic value? I believe so, but you need to know a few things about the drug, and the costs to produce that drug. Did you catch that nuance there? I said “drug.” The reason why I like pre-revenue biotech companies is because they’re success is usually contingent upon a single drugs approval. Because of this it’s easier to estimate a value. I have theories on how to do something more complex, but as an individual investor I like to go after easier targets. Here’s the list of things I must know about the drug:
- How many patients need this drug in the U.S. (or Europe, but rarely do I figure out both)?
- How much money is the current therapy charge annually?
- How much does it cost to produce similar therapies?
Looks like an easy list, but it’s easy to spend hours finding the information and analyzing the information, but I must have those three things just to move forward. When I started doing this I tried to rebuild a DCF with this new data to figure out the intrinsic value, but the problem is how much do you discount the cashflows to account for the risk. You could pull a number out of the air, but I’ve never been one to pull numbers out of the air. So more often I’ll create my cashflows and then reverse engineer the discount factor the market is using. That’s when the magic happens for me, and that’s when the real research starts. When the market uses an extremely large discount factor I must decide whether I agree with the market. I scour every news article I can get a hold of to try to figure out what the market is thinking, and I always assume the market is right, but occasionally I get lucky. Sometimes I can’t find any reason for the markets behavior, sometimes it has to do with overall market sentiment. That’s when I like buying these biotech companies, when I can’t figure out why the market hates the company.
Book Value and Asymmetry
I lovingly ask the question “Is this company priced for perfection or priced for failure?” As a value investor I prefer finding companies that are priced for failure. That means that even a little bit of good news helps the stock move.
Lesson tip: Just because you think it’s good news, doesn’t mean the market caress. Sometimes it is good news, and the market still doesn’t care. Those with patience win this battle, because sooner or later the market can’t ignore the news.
That’s mostly it on how I look at biotech companies. I have a few other tricks, and a few other things I’m working on, but those are the building blocks on how I value a biotech.