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Anatomy of a blown trade


The lesson is not always obvious


Experience is a double-edged sword in this business, but there is no question knowledge (whether gained through hard work or experience) is king. A long time ago I made up my mind to mercilessly dissect my failures so that I would not repeat them.

Our firm recently initiated coverage on Valentis (VLTS:NASD) and added them to the fictional model portfolio we keep so subscribers and potential subscribers can keep score on us. I have no problem telling you that we're underperforming our comparisons (NBI and BTK) in 2004. I figure if I can be comfortable telling people we beat them by 20 points in 2003 and by as much as 30 points (over the NBI) since inception, I have to be forthright about the bad times, too.

But, back to the point of this article... the anatomy of a blown call on Valentis.

Yawn at first sight

The company had been rattling around my desk for a number of months as spring turned into summer. I think the first time I really paid attention to it was when a subscriber of ours that I respect greatly pointed it out. At that time, it was trading around $3. I took a peek and discovered it was a gene therapy company. If it hadn't been for the source of the tip, I would have ash-canned the company right there. We already have two gene therapy companies in our coverage universe. On bad days, I tell myself that's exactly two more than nearly anyone else in the business for good reason.

I kept digging and discovered four things atypical about Deltavasc, this company's lead (and really only) product, that I really liked.

First, the gene was not delivered by a virus. This means there is little danger of the body's immune system fighting the drug when it is administered and, more importantly since the indication is a chronic one, when it is re-administered. It also makes for a slightly easier regulatory process.

Second, the disease indication of intermittent claudication is a localized disease. This means the company has a shot at avoiding the number one problem of gene therapy - delivering enough gene copies to make a difference in the disease.

Third, this gene therapy did not need to add a missing gene or repair a broken gene. It just needed to get the gene (called del-1) into cellular machinery long enough for some proteins to be produced.

Finally, del-1 isn't what I call the "terminus" gene. Scientists are fond of picking at a problem until they find the exact critter (protein, gene, molecule, etc.) they believe is the proximate cause of the affliction. The problem with this approach is the body is rarely that neat and tidy, tending to get things done via a cascade of critters. You can be too specific and miss unknowable but crucial parts of this cascade. The del-1 gene was a long ways upstream in the hierarchy and started a cascade of a number of identified and unidentified critters for its therapeutic effect.

These four items are highly unusual in gene therapy and not all that common in other areas. The fact Deltavasc had these four advantages really appealed to me.

A decent first date

So now I'm interested, but not hooked. A few hundred of pages off my long-suffering printer and I'm ready for a few days with a highlighter, note pad, and a very large stack of clinical research papers.

Fortunately, the key papers in the field were very well written and relatively easy to follow. A large body of work on the target disease made understanding the parameters of the disease easy. I was rolling through the few hundred pages with unusual speed.

Intermittent claudication, the initial disease target, is easily diagnosed and causes significant clinical problems. Awareness of the disease and its incidence rate are rising rapidly. In this disease, blood vessels disappear in the lower leg. This decreases circulation and makes it very painful for people to walk. While the most effective treatment is exercise, the pain precludes people from exercise even though they are motivated.

Deltavasc, via a series of multiple injections, is designed to form new blood vessels. This allows people to walk longer without pain. Ultimately, in our view, Deltavasc would be used to get people to the point where they could exercise and then exercise would do the remainder of the repair.

Wanting more

Our research team is unusual in that talking to management is the last thing on our research list. This allows us to stay out of their spin zone as long as possible. It also tends to create a good relationship with them right off the bat because we don't waste their time by requiring they walk us through the basics of the technology, the drug, or the market. It also makes them more likely to put us in direct touch with company scientists, which is when we really start learning something.

After we had spoken with several members of their management team, we were impressed. This was a good team who designed an industry-best Phase II trial. They were straight talkers who either gave us exactly what we asked for or explained clearly why they couldn't answer our questions (I figure if a company doesn't refuse to answer at least 25% of my questions on the grounds of non-disclosure or Reg. FD concerns, I'm not doing my job).

By the time we finished our analysis and initiated coverage, we were very high on the company. The stock was trading just shy of $10, though we expected that figure to decline ahead of the binary event of the release of Phase II data at the end of September as people took profits.

Going all the way

Our main concern about the trial was actually from a lesson we learned the hard way previously. In biotech, it is frustratingly common to be exactly right in one's prediction of the outcome of a clinical trial and still lose money. This happens most often when broader Wall Street has one impression of "right" and you have another.

In the case of Valentis, we were very worried about this. Data from a competitor's drug showed increases over placebo of 50-100% in walking distance (a common way to measure improvement of drugs for intermittent claudication). The company's endpoint was walking time and they were only expecting a 25% increase. Even though that translates favorably into walking distance via mathematical formulae, we were worried Wall Street would see 100% for the competitor and 25% for Deltavasc, and sell Valentis stock (don't laugh, we've seen it happen often).

We spent a great deal of time talking with Valentis management about this. In a key conversation for us, they told me they were actively addressing this concern and would make certain the conference call announcing the results would address this very point. This was fantastic in that it not only eliminated a key concern of ours, but it demonstrated management was willing to listen to input. Very nice.

Rocky times

Like any new relationship, things got rocky. The stock was pressured by more profit taking than we thought, sinking to under $5. We were already down 50% in our model portfolio.

Honestly, this didn't really bother us as we are used to such vacillations. We don't like it much, but it is part of investing in biotech. That's why you never buy your desired position all at once. We redoubled our research efforts, casting a broader net to industry experts and others familiar with the company to make sure we didn't miss anything. When the search came up negative, we increased the weighting of Valentis in our model portfolio.

The binary event

As I've written continuously, biotech is about binary events. We knew from company guidance that data from the company's Phase II trial would be released in late September. They were exceptionally certain about this date. As September rolled towards its end, we heard nothing.

This is not usually a good sign and the first lesson you should take away from our mistake. If a company is certain enough to give you a month, then the day they are going to get their first peek at the data is already set. If the data are obviously good, writing and publishing the press release is simple and quick. Only when the data are unclear or bad do they need time-consuming additional analyses before presentation.

I was actually writing the Alert to reduce our weighting on Valentis the morning of September 29 when the news hit the wires: The trial failed.

In a normal intermittent claudication trial involving injections, the control group gets saline injected while the study group gets the active drug. For a couple of reasons, Valentis chose to use the poloxamer carrier system for the control arm instead. This is actually increasingly common these days after the FDA rejected ImClone's (IMCL:NASD) initial application for Erbitux. Since the poloxamer has been in use for years in multiple applications and is considered clinically inert beyond its ability to deliver things to cells, this did not concern us at all.

The trial failed because both the study arm using Deltavasc (which is the poloxamer plus the del-1 gene) and the control arm of the poloxamer alone performed exactly the same. They increased walking time by about 33%. The shocking conclusion gained from this trial? It's actually the poloxamer doing the work and not the gene therapy itself.

Needless to say we were stunned. This type of result simply doesn't happen. When it does, it usually means the drug simply doesn't work period and won't work ever. But there is enough circumstantial evidence to make the company's claim it is the poloxamer doing the work credible - but that's a story for another time.

Mistakes made

After punting the position off the model portfolio, we went diving back into the research, expecting to see some indication we missed in one of the hard science papers suggesting independent activity for the poloxamer. We were a little relieved to find nothing of the kind. Not only did we not consider the poloxamer had clinical activity of its own, neither did anyone else.

So where did we blow the call? What could we do different?

I suppose we could have waited until after the release of the Phase II data. We firmly believe it would have taken what was then a $7 stock and turned it into a $15 or $20 stock overnight. We felt the risk to the downside was worth it compared to a 100-200% up side.

I suppose we could have taken some caution at the fact the poloxamer had never been tried alone - even in preclinical trials. In our defense, however, if it never occurred to the brightest scientific minds in the field then we can't beat ourselves up for it not occurring to us.

I must confess to you now I'm leading you on a bit of a wild goose chase. We simply didn't make any egregious mistakes. We punished bad news by booting our exposure immediately. The outcome of the poloxamer having clinical activity could not realistically have been foreseen. I suppose we could have reduced our weighting a day earlier, but that's small consolation.

I'm fairly confident we did all the research possible to reduce the chance of being exposed to a negative result and still got blindsided. That's the number one lesson you should take away from this experience. It is something that will happen to you when you invest in biotechnology.

This is, therefore, really an abject lesson in the importance of portfolio diversification for biotech investors. I want to make clear here is that even though we absorbed a sharp loss, it didn't ruin us. Why? Because we didn't make the terminal mistake of being over-exposed to this name. Only diversification saved us.

Hopefully detailing this experience will drive that bit of education home once again. Diversification is the biotech investor's parachute. Don't leap into the space without it.

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