Biotech Risk Management – An Oxymoron?
With the vast majority of companies in the development stage and/or whose success is dependent on one key drug, biotechnology stocks are inherently quite volatile. Although the sector’s sizable rewards have been well documented of late, the outsized risks frankly never disappear. With many stocks trading at 52-week and/or all-time highs, the risk/reward profile for the majority in our view, appears less favorable. Historically, there have been many more losers than winners in biotechnology. With a failed drug, no pipeline and little cash – the downside is close to zero, or a stock that is left in perpetuity on the biotech garbage heap. Recent classic examples of negative binary events are the ZIOP release of Phase II soft tissue sarcoma data, and ASTM’s unexpected restructuring. This Issue, therefore, explores what may be considered the ultimate oxymoron – biotech risk management.
BINARY EVENTS – Most biotech companies face the inevitable unblinding of pivotal clinical data. The first thing investors should have is a grasp of the timing of events, which is not always predictable. The next is to decipher how much of a favorable outcome is discounted in the stock price. For example, NVAX is expected to release Phase II data on its RSV vaccine by early April, which we expect to be positive. In our view, there is very little value currently discounted into NVAX’ stock price based on a positive Phase II outcome and, hence, we believe the risk/reward is excellent at current prices. Phase II data are not as definitive as Phase III and/or pivotal trials, but nonetheless many investors’ can dissect mid-size trials rather well. While we believe the TSO worms offer exceptional risk/reward for CNDO investors, the stock is up almost 100% YTD and currently above our BUY LIMIT, therefore, protection should be considered as the Phase II Crohn’s disease data approaches in H2:13. Most biotech investors understand that biotech stocks are very risky, but often cannot believe how much a stock can drop on bad news. In optimistic markets such as these, some biotech risk management tools can hopefully help protect gains, but even more important – limit losses.
Risk Management Tools
Buy Limits – The previous Issue (MTSL #750) mentioned that while fundamentals are intact and in certain companies have vastly improved, most of our Recommended Portfolio stocks trade above our BUY LIMITs. One of the key disciplines incorporated in the MTSL Recommendations are BUY LIMITs. In other words, commit new stock purchases at a price that we believe offer favorable long-term risk/reward. In alpha stocks, patience can be difficult but also a smart strategy. Recently, two of our favorite companies – INCY and PCYC – fell below their BUY limits, offering attractive entry points. However, BUY LIMITs are not enough for prudent risk management.
Diversification – Of course, diversification is appropriate for any biotech portfolio. The MTSL Portfolio, for example, is comprised of 15 stocks of various risk profiles (see table below). CELG, BMRN and ALKS make up the established companies with existing marketed products with solid sales and earnings growth rates, and attractive R&D pipelines. INCY and PCRX are in the midst of first product launches. ISIS, IMGN and NKTR have novel platforms with partners receiving their first FDA approvals, thereby validating their technology while developing proprietary compounds. PCYC is on the verge of a blockbuster drug approval. The remaining companies are speculative in nature, relatively early in clinical trials (CNDO, NVAX), have an exciting platform that is still evolving (SGMO), or may have run into a short-term bump in the road (OGXI, ANTH, ASTM). A well-diversified biotech portfolio (table below), in our view, would be more heavily weighted towards the larger-caps but includes some potential home runs. The large cap Big Four have of late, in fact, offered substantial returns with significantly lower risk.
Options – Nothing is more definitive than the outcome of a classically designed clinical trial – a large, multi-center, randomized, placebo-controlled Phase III study – which the FDA often requires before approving a new drug. In many cases, the risk/reward is greatest in pivotal/registration studies (i.e., Phase III) but often times, the jury is already out based upon earlier studies, or the stock has already discounted a favorable outcome. In this scenario, put options are a smart way to protect gains before the release of clinical trial results. Sophisticated investors may take advantage of upcoming event-related volatility by positioning a straddle or strangle approach. A put option strategy in front of binary events is quite prudent to protect gains or limit losses in the face of a major inflection point while continuing to maintain a long-term long position.
Take Profit/Sell Before The News – An old adage reads, “You can never go broke taking a profit.” Investors that have major gains in stocks preceding an event can always take the easiest road – sell, lock in the gains and see what happens. Then one can decide – after the fact and with zero risk – to buy it back or walk away. It is important to be on top of the news flow and timing of binary events, and that is one thing MTSL hopes to continue to provide to subscribers. While our philosophy at BioInvest/MTSL of buying carefully selected biotech stocks at attractive prices and hold them for the long term, has not changed, selling before a binary event is perfectly understandable, especially when performing risk management techniques.
Hardly An Oxymoron – At the MTSL, we hope to maximize/protect returns but also, and just as important if not more important, limit losses by utilizing the risk management tools discussed above. In light of the biotech sector and individual stocks reaching all-time highs, in our view, this is an appropriate time for a risk management discussion. Having analyzed the sector for more than 25 years, there have been many periods when confidence is high – the current industry fundamentals have never been better – but it is imperative to look out below. Whether its being patient and buying under our BUY LIMITs, diversifying across established leaders and speculative darlings, staying on top of and preparing for binary events, buying protection or just outright profit-taking – biotech risk management is not really an oxymoron, we believe it’s just necessary.