Where did my big run-up go?
I hate it when I'm right and lose money!
Amazing amounts of time with heads buried in the science are necessary in order to grasp even the basic fundamentals of the companies in this sector. "Easy" stories are rare. All this research into company fundamentals tends to rob time that should be taken for sober analysis of the overall market for a particular stock and macro market conditions. This is not a good thing.
I've been cogitating on this subject for a few weeks now, trying to come up with a good way to illustrate this phenomenon. A fellow Minyan pointed out a stock right under my nose to serve use as a perfect example of one of the more frustrating aspects of biotech investing, so let me share her example:
The small biotech company Indevus (IDEV:NASD) was heading towards an expected approval of its first drug Sanctura. This drug has an excellent competitive profile in the overactive bladder market (OAB) - a market that is growing at a compound 20% per year and is expected to be $3-5 billion by the end of the decade.
Sanctura has existing competition. The market leaders are Detrol LA and Ditropan XL, marketed by Pfizer (PFE:NYSE) and Johnson & Johnson (JNJ:NYSE) respectively. Novartis (NVS:NYSE) will have Enablex on the market for OAB late this year and Glaxo (GSK:NYSE) should debut Vesicare early next year. Fortunately for Indevus, Sanctura has a therapeutic profile giving it distinct advantages over all four drugs.
A couple of months ago, Indevus chose the relatively unknown European company PLIVA as their partner to market Sanctura. This came as a shock to many who expected the company to choose a recognizable partner with experience in the North American urological marketplace. The stock did not react well, though subsequent research shows PLIVA and Indevus should be effective marketers of this product.
Upon approval of Sanctura, Indevus would receive $120 million milestone payment. This would boost the company's cash level to about $200 million, or around $4.20/share in cash.
Heading into the approval day, the stock was trading between $8-$9 per share. Traditionally, 2x cash is considered something of a valuation floor for biotech stocks with no products on the market. Given this, it was reasonable to assume a company with an approved drug would trade above $8.50 or so - especially given the scientific superiority of the drug and the rapidly expanding overall market for this class of drugs.
The FDA's approval deadline (PDUFA date) was May 28. This was the Friday before the long Memorial Day weekend. True to form, the FDA did not issue the approval until the last minute, with the news breaking after lunchtime when nearly everyone on Wall Street had left for the day.
Buyers drive prices up
I'm constantly amazed at the number of investors who forget stock prices are a function of supply and demand. A stock simply cannot rise unless there is demand for those shares. Therein lies one of the most frustrating aspects of investing in development-stage biotech companies.
You've done the hard work to discover what you believe is a relatively unknown or unloved company with great prospects and a low market cap. Whether the low market cap comes on the heels of failure or from a broad lack of knowledge about a company's prospects, you are subject to the same double-edged sword. The price is low because nobody knows (or cares) about the company. However, the price is likely to stay low because nobody knows (or cares) about the company. Both situations are caused by a lack of buyers.
If you are to profit from your hard research, something must occur to make Wall Street know and care about the company. This brings buyers, and buyers are the only ones that will drive prices higher.
The dismal scenario
We were right about the promise of Sanctura and the likelihood it would be approved. The drug's label is also in line with our better-case scenarios. In other words, we were about as right on this story as we could be.
However, the stock is down some 30% since approval.
In hindsight, it appears everyone who had any interest in buying this company already bought ahead of approval. When the news of FDA approval hit, we didn't even get the usual momentum-player bump because it happened when everyone was away from their trading desks.
It all adds up to no new buyers. No new buyers means no price rise - and, in fact, means a price decline as existing holders want to move on to the next opportunity.
Any investment based upon fundamental analysis requires you get two things correct. The first is you need to accurately forecast the fundamental path of the company. Earnings must come in line with your expectations, drugs must get approved, trial data must be positive, etc. The second thing you must forecast is how other investors will react to the fundamentals as they change. Will anyone care? Will what you see as a positive be recognized by others as a positive?
For us, we find understanding how Wall Street will react to news to be at least as difficult as digging through the science behind a particular company. Indevus is a good example in that we had both the science and approval nailed, but Wall Street simply wasn't excited enough about a company to even pay 2x cash.
Moral of the story
How you react to such setbacks should be determined before you ever buy the stock in the first place. The best advice anyone can give to an investor is to write down all the reasons - fundamental and price-related - of why a stock should be sold. This detailed "selling plan" should be in place before the stock is purchased.
The point of this article is to help you understand one facet of that selling plan has to take into account a lack of demand in the face of good news. As best as you are able to do in advance of an expected event, you should determine whether the prudent course of action in the face of a lack of demand is selling or holding on until Wall Street "comes to their senses."
I guarantee you will choose the latter every time if you wait until after an event to formulate your selling plan. This can get you in serious trouble. In truth, the answer often lies somewhere in between with a strategy that includes selling some portion of your holdings to take immediate profit and holding some of the rest to see if Wall Street catches up to your level of intelligence and foresight (that's a bit of humor).
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