Biotechnology Investment Risk Management

One of the most risky and at the same time often pleasant, on the stock market, for the private investor is the small-cap Biotechnology sector (Small Cap). Investors are awaiting: treacherous regulation, promoters (pumpers) inflating prices for personal gain, as well as nefarious managers seeking to continually dilute the value of your shares (split). Therefore, you always need to be on the alert. Controlling common human emotion, how greed, help with investing in biotechnology due to the extremely volatile nature of the industry. Daily, private investors and hedge funds fail to deal with these risks and end up abandoning this potentially highly profitable area.
Managing these risks, in fact, does not require many years of experience, academic degrees or unlimited resources of time and money. In truth, there are some simple ways, so that the private investor can reduce the risk of fatal error and help separate gold from trash in the Biotech sector.
The following five points will help you avoid biotech traps and significantly improve the quality of stock selection..
1. Owners
One of the best ways to reduce your overall risk — it's sticking to companies, which are mostly owned by hedge funds and other professional investors. In companies, owned by institutional investors, you can be sure, as with due diligence, management (Board of Directors) thinks twice, before sharing with other large owners. You can easily find this information using Yahoo Finance under «Major Holders».
Also pay attention to promotions, which have one or more owners, possessing more 5 % shares. It is important, because the size of these positions is huge, and when sold, it can lead to a giant drop in the value of shares; because you will need to submit a Form 4 SEC for any change in position sizing, further affecting the stock. Because of this, holders of more 5% a long-term vote of confidence is issued by the issuing company. Respectively, companies with no owners more than 5% should be avoided. Professional investors do not want to take risks in them and you should not.
This indicator is a good indicator in identifying the so-called «PUMP and DUMP» and promotes the selection of more legitimate companies. Radient pharmaceuticals ($RPC) , one such example. She received a flurry of positive articles in December and January., which made it possible to interest many private investors. The stock took off from $0.50 to $1.50. Unfortunately for those, who bought in this wave, the share recently traded at $0.21. Private investors have been deceived. When researching this company, one can see, that it has no institutional owners with more than 5% shares and positive items, most likely, the handiwork of promoters accelerating the action. Other companies lack large institutional investors, worthy of mention Northwest Biotherapeutics ($NWBO), Rexahn Pharmaceuticals ($RNN), Adeona Pharmaceuticals ($AEN), MannKind ($MNKD), и Orexigen Therapeutics ($OREX). Therefore, the authors of the articles, that regularly publish excessively positive articles about companies with poor institutional ownership should be scrutinized.
Moreover, take the time to familiarize yourself with several more solid funds. Here are some companies with more than 5%: Orbimed, Deerfield, FMR (Fidelity), Blackrock Advisors. But even the good ones «stock» money can paint a fantastically bad picture at times, so no one is infallible in their choice.
2. Analysis of opinions
I like the analysis of price benchmarks (price targets) and ratings because, what are their predictions, usually, based on discounted cash flow estimates ( Discounted Cash Flow (DCF)). The result is, that they depend on realistic numbers and forecasts. DCF scores may be stronger for those biotech companies, which have a small number of products in production, since there is little chance of being wrong. Moreover, biotech valuations are not so related to macroeconomic changes and large-cap companies. As a simple example, the number of people with heart disease does not depend on, we are in the bull or bear market, but the company's shares Google will vary based on broader market factors.
Absolutely right, that most Research Teams (market research teams) have strong conflicts or interests, when it comes to companies, which they cover. Changes in estimates are often related to an ongoing financial transaction in one of these companies.. These Research Teams rarely make a recommendation. «Sell», since this is goodbye to any future financial transaction. Exploration Teams will often embellish the future in moderation., what it really is, since reputation is more important for them and it is important for them to keep capital under control.
Based on this, look at the price target from several companies, not one or two. Look at the estimates of most private analysts. The more interest is shown in the purchase, all the better. You also need to pay attention to the average price benchmark., which should be higher 40% compared to current price. Ideally, more than three analysts say «Buy» with a price target more than twice as high, than the current price.
The research report is very helpful, but usually does not offer additional information, except for the one that is available to the public. There are many research reports., but these are other people's opinions, which should not be a substitute for your own opinion. The reports of the Research Teams are more than enough for the private investor.
As with institutional investors, it will take time to find out who they work for. In my experience Canaccord Genuity, Collins Stewart, Cowen, and Jefferies usually offer good enough research for Small Cap Biotechnology. There are usually many MBAs in Equity Research Teams, MD and PhDs from leading universities, who have built an impeccable reputation over the years in the biotech industry.
3. Short Interest
Before that, we talked about bad institutional ownership. (no owners with packages more 5%) and weak analytical activity, being red flags in Biotechnology, which can lead to more risky play when placing long positions. Third potential risk — this is a short interest (how many shares are currently short of the total number of offered shares). Short Interest can be found on any of the financial sites, but my favorite is, since here presented schedule changes in short interest over time, besides the usual Short Ratio and Days to Cover data.
Short Interest suggests, how many shares are now being short-circuited and borrowed for sale from funds, then to return to the lender. This is overwhelmingly done by hedge fund managers.. As I said earlier, they are professional, more experienced investors, having much more resources and time to study the company, than any private investor. In this way, by entering a long position in a stock with a large Short Interest, you play against professionals. This activity is akin to playing Blackjack in Las Vegas., you can win sometimes, and sometimes win a lot, but it will take a very long time to play.
This brings me to one of the most overused phrases in stock trading., as «Short Squeeze». In theory, Short Squeeze occurs when there is a positive fundamental change in a stock., which has a lot of shorts. Caught traders with shorts close their positions abruptly, which leads to a rapid rise in the share price.
The theoretical foundations for Short Squeeze are heard all the time, and happen from time to time. Article writers and promoters call it «high potential short squeeze». But even if the Short Sqeeze was predicted, it may not come true. Most often, positive fundamental changes do not come to mind, and hedge funds with short positions, as planned, get their profit. Even then, when positive fundamental changes occur, share price changes, reflecting the news without any period of change and even more overbought.
The phrase is especially insidious, since it tends to attract those, who are especially susceptible to aspects of simple human nature, which kill the invested profit. Greed, thirst for quick profit, pride, starts there, where professional traders go wrong and most unruly investors are prone to it.
And at the end of my speech about Short Squeze, I want to add: when someone tells you to buy stock, because Short Squeze is possible there, think about, what do they really tell you, — this promotion is good to buy, because professional traders think it's terrible. It doesn't make any sense!
Not all stocks with high short interest are bad for long positions. for example, there are stocks with a large number of institutional owners and a high Short Interest. A concrete example of Vivus (NASDAQ: VVUS), developer of a drug for obesity and pills for erectile dysfunction at the stage of the final phase of research. This is real «stock battlefield». Has many owners with more packages 5%, such as Chilton, Caxton, Suttonbrook и First Manhattan, and at the same time Short Interest 23% of the total number of shares on the market, what makes this company one of 100 the most shrouded on the NASDAQ. Someone, apparently, very wrong here. Most likely there are great interests on the one hand, so on the other.
Generally, Short Interest 10% typical for small biotech companies, but if he 20%, then it is already dangerous. By combining Short Interest with institutional ownership information and analytical opinions, you can get a more complete picture of a particular stock..
4. Risk «dilution» shares
There is always risk when holding shares in any biotech company, but especially that, with an important event coming soon, and if an additional issue or sale of shares is planned. The additional issue of shares is related to, that the company wants to raise additional money to finance ongoing business operations. Increasing the total number of shares decreases the total number of owners per share. It is called «dilution» existing shareholders. This event can have serious consequences for the share price and a fall by 10%.
Terms of additional offers of shares, as known, hard to predict. If it was easy to predict, then the price would have dropped lower even before this event and the company would have raised less money. Management is interested, so that the timing of dilutions is completely unpredictable.
There is some information, which will help you predict, when approximately dilution may take place. Firstly, this is how much cash the company has to continue operating as usual. This information can be found in the company's quarterly press release., which is accompanied by 10Q or 10K SEC Filing. CFO, usually, explains in detail, how much cash they have until the next quarter. If you have more than 24 months, then the risk of dilution is minimal, but still not a guarantee. You can also see, when was the last dilution, the company is unlikely to dilute shares again, so as not to scare away shareholders.
One should always expect, that a company with less than 24 months, may dilute shares up to three quarters before the expected main event. Someone might state, what «If they dilute the stock, then they expect bad results. Otherwise, why not dilute after at a higher price?». These commentators are extremely wrong. This is because, that even the company itself cannot predict with certainty, that it will be successful at any stage of development and especially at the stage of FDA approval. The company will endeavor to always conduct the dilution prior to an important event., thereby reducing risks.
After dilution, the most important information, which one should pay attention to, is the placement price. Usually, the company will place shares at a fixed price. Price provides many interesting views for the investment community, discussing his justice. The placement price is significantly lower than the current price, is serious «red flag», while the price of placement near the current level may not be such a big event and may give a positive mood, for institutional investors to increase their packages (cm. Part 1).
There are several strategies to mitigate the risks of dilution. Firstly, just averaging your positions. Instead of opening a large position right away, dial it at two, three or more transactions with a break of two to three weeks. In this way, dilution will only negatively affect part of your package, than if the dilution happened the next day, after you have typed the whole position at once.
Another way to reduce the risk of potential dilution — buy it after dilution, assuming, that the placement is about a reasonable price, and the share price will recover quickly. This goes for those biotech companies, who will have an important event soon. A recent example of dilution followed by rapid recovery (and rally) is BioSante Pharmaceuticals ( NASDAQ: BPAX ), which placed shares on $25 million. by price $2.06 per share, and then there was a rally, as a result of which the price rose to $3.00 in less than three months. Dilution can be a good time, to enter the position. Or if you already hold shares, then dilution is one of the rare cases, when can you double your position, and not go out with a loss.
5. Risk of an Important Event (Catalyst)
To survive and make money when investing in biotechnology, you must be aware of Important Events (Catalysts), and about minor major events, and highlight what factors will primarily affect the price of the company's shares, and which ones in the second. These activities are usually Data Releases and FDA Regulatory Decisions., but may also include sales reports and court decisions. Catalysts must be monitored carefully, since the share price may change by two, or even three times, depending on positive or negative Catalyst, respectively. The dates of these events can be found by researching the company's press releases., SEC presentations and quarterly filings (SEC Fillings) (10Qs и 10Ks).
Realizing that, that the company will have an important event soon, a proper Catalyst risk analysis must be performed, since it is associated with a certain decrease. The easiest way to do it: do not conduct an open position through the Catalyst. Another way to cut your losses is to reduce your position or hedge with options.. Whatever you choose, good strategy, when the time of the Catalyst approaches, first determine the maximum percentage of the portfolio, which are you willing to lose, and adjust the position or hedge accordingly. My personal loss limit, which I suggest, it's no more 5% from portfolio, but it all depends on risk appetite.
When decreasing the size of your position, the first thing to do, is to determine the share price in «worst case». For small developing biotechs, worst case, usually, but not always, is the price based on Cash per share (Cash per Share). Then, set your position according to, what's your portfolio, worst-case scenario, will lose no more 5%.
Options are also a great way to manage Catalyst Risk.. Protective PUTs are bought relative to that price, which reflects the loss you accept as a result of the Catalyst. Selling to covered Calls you can get a premium in your pocket, preventing decline. Direct Call and Put are much more difficult in reality, what do they seem, and you cannot be profitable, even if you correctly guess the outcome of the Catalyst, as volatility collapse is possible, but they offer a high winning potential at a certain reduction.
I strongly discourage taking a position before the FDA's decision to use a New Drug (NDA) (it is PDUFA). I can tell you, that even professional investors have great difficulty in predicting the outcome of these events. Some argue, that the more correct game through the PDUFA date is PUT's and SHORT's, as the market tends to react more strongly to negative data, than positive. Still others argue, that playing against prevailing market sentiment is correct, due to the highly unpredictable nature of the FDA. Anyway, keep in mind, that the FDA is extremely unpredictable in its decisions on NDAs and by opening simple Long or Short positions your trading turns into a roulette, unless of course you are this guy.
BioRunUP — subscription service, seeking to make money directly in front of the Catalyst or in between, but not through him. Good strategy, to avoid the risk of Catalyst. The strategy is aimed at, to use the stock price model common to most companies, developing. Most of my own investments will be classified as a Run-UP strategy. I wholeheartedly recommend BioRunUP as a strategy itself, and subscriber service, as it is a valuable way to increase your bottom line when investing in biotechnology. Work strategy, valuable services, and I can with 100% to say with confidence, that Mike and Mark will never use their subscribers for short-term benefits. They sincerely want, so that you are good.
I would also like to recommend The Biotech Trader Handbook by Tony Pelz as a resource on various strategies., designed for Catalysts. Using strategies like butterflies, hesitation, spreads and much more, Tony Peltz describes a number of ways to profit from the Catalyst, whether it was positive or negative. The book must be read by those, who are new to advanced strategy options, as it contains a lot of information regarding general investment in biotechnology, as well as those who trade StockPicking.
Looking for big holders, paying attention to analysts' opinions, considering the Short Ratio, Dilution Management and Catalyst Risks, properly, you can significantly reduce the overall risk when investing in biotechnology.
I urge you to turn around and check these principles, and i'm sure, you will see, what biotech, who pass these guidelines are significantly more successful, those that fall flat. Here are some examples of biotech stocks, which fit these guidelines, as well as some selected for the future.
Amarin Corporation (NASDAQ: AMRN) — Amarin was a perfect fit prior to the announcement of the Phase III results of its AMR101 drug.. He had three institutional investors, owning software packages 5% — Orbimed, Abingworth, Fidelity. Analysts predicted a price more than double the current April share price, which averaged $7.00 and spoke unanimously «buy». Short Interest was exceptionally low at about 2.5% of the total number of shares outstanding. Cash was over $100 mln., which covered operational activities by more than 24 months. Phase III data was expected in the second half of April. Amarin has posted Phase III data in line with all primary and secondary requirements. The share price has approximately doubled after the published data.
Amarin was an exceptional game, in accordance with all guidelines, which I have outlined. And even now, analysts are predicting a target price $24.00, what is 64% premiums from the current price level.
Pacira Pharmaceuticals (NASDAQ: PCRX) — Pacira presents another perfect case. Pacira was and remains the property of insiders with huge chunks of shares, owned by Orbimed, HBM Bioventures и MPM Asset Management. Pacira enjoys solid cash following recent IPO and has almost no Short Interest. Another company, about the shares of which analysts unanimously spoke «buy», the target was twice the price level at the beginning of this year. Up to date PDUFA for Exparel, scheduled for late July, there were no risky Catalysts. In early April, his shares were traded in the area $7.00 long time at low volumes. At the end of May, the price exceeded $14.00.
BioSante Pharmaceuticals (NASDAQ: BPAX) — moving forward, BioSante strives to comply with the guidelines, good enough. Large partners have significant interest in small biotech and own more than 7%. The rating of the shares is unanimous «buy» with an average target price of coverage $6.00. Short Interest is growing, but is still within 14% of the total. The company recently increased its cash flow, minimizing the risk of dilution in the short term, and awaits safe and effective data on Libigel, which will be published in the fall 2011 of the year. The share price is already showing a strong rally, rising from less than $2.00 early April to $3.00 in the end of May, but this is not the limit.
I can't promise, that applying all these principles can lead to explosive growth like Amarin, Pacira or BioSante, but i can guarantee, that you will avoid those disastrous surprises, that flush your briefcase down the sink. Biotechnology is a risky sector, but applying these five common sense rules, he ceases to be like that.

Scroll up