Before we get into the setup, let me say that investing using this method entails significant risk. Look at what happened to Acadia Pharmaceuticals (ACAD) in
the summer of 2009 (discussed below). Before the market opened on September 1, the company reported its drug Pimavanserin failed phase 3 trials for people with
Parkinson's disease. The stock closed the day before at 5.84 and opened at 1.72, for a drop of 71% before closing at 2.00.
In other words, you could lose a substantial portion of your money by following this setup. Thus, if you use it at all, you should invest only a small
portion of your portfolio.
Buying Checklist: What to Look For
The consultant gives the following tips when searching for biotech stocks.
Large % Gainers on Yahoo. Because yahoo reworked their site, the location of this may have change or even been deleted.
Go to yahoo!finance and look down the left side of the page, toward the bottom. You'll find something similar to the
figure on the right. Click on "Most Price % Change" after the market close each day and then scan down the list. Look for pharmaceutical companies. If you find one then click
on "Profile" to read what the company makes. Often the search will end there because they make products that are not of interest. Just be aware that the information
may be out of date. If it says Phase 2 clinical trials, the company could have moved into phase 3.
Number of employees. Look at the number of full time employees listed on the profile page. This is a indication of the size of the company. Do you want to buy a company with just 5 employees or one with 50?
The smaller the company, the larger the risk of failure and the less likely they will come up with a billion dollar winner. I like to see at least 50 employees on the payroll.
A large payroll shows stability, that others are willing to take the risk of working for the company.
Pipeline. On the profile page is a link to the company website. Visit their site. Once there, they often list Pipeline as one of their menu options, so look at
the number of drugs under development. The more drugs in late-stage (phase 3) clinical trials, the better. That way, if one drug fails you still have others to bank on (but expect a
large loss anyway. Investors don't like negative surprises). If the company has only one drug in development and it fails, your investment could be wiped out (or nearly so).
Phase 3 only! When looking at their pipeline of drugs, you are most interested in drugs in Phase 3 clinical trials because this could be the last stage before the company submits a drug to
the FDA for approval. She will only buy a company with drugs in Phase 3 trials. Why? Because it could be years for the drugs to pass through Phases 1 & 2, and they could fail
along the way.
Side Effects. Does the drug have any side effects? That's a stupid question because they all do. A better question is, how bad and numerous are the side effects? If a side
effect is death, do you really want to risk taking the drug? I heard about one drug for dogs that had that kind of risk. How many vets do you think will prescribe that drug?
Check the website, and if you can't find the answer then ask the company.
Target market size. Somewhere on the company's website is an evaluation of the size of the intended market. Sometimes this is buried in the 10-K report but many
times they have the evaluation listed as a bullet item. What good is developing a drug that only 3 people in the world need? Instead, look for a huge potential audience for the drug.
Avoid orphans! Avoid drugs with orphan status. That means the drug gets special treatment since the market is small. To make money, the company has to charge big bucks for the drug because few
people need to take it.
Any competition? A good candidate is a drug that has no competition. If there is competition, make sure the drug has unique features that will set it apart. Perhaps this
pill you take only once daily or it has fewer side effects or it won't grow hair on your knuckles. That's the kind of advantage to look for.
The competition is not standing still, either. If their drug makes it to the store shelves, how long will it take before a new competitor comes on the scene? In other words, what
is the competition doing? How long will it take before technology renders the drug obsolete?
Investors page. Visit their Investors page and read what's there.
Fundamentals: Revenue, issuing new shares. Look at revenue. Do they have any to support their development efforts? If revenue is miniscule, then expect the company to issue stock periodically. When that happens,
the stock will take a hit. Metalico (a building materials company) issued 6 million shares at $4.18 (about 18% of shares outstanding). The stock dropped 22% from a close of 4.80 before
the announcement to the next day's low of 3.76. The stock has been weak ever since (to date, August 2009, about a month since the sale), bottoming at 3.64 so far.
Mannkind announced the
offering of 7.4 million shares (about 8% of shares outstanding) on August 5, 2009, and the stock dropped 11% from a close of 8.13 to a low of 7.21 a day later.
Burn rate. What is the burn rate? Burn rate is the amount of cash available to fund operations. If expenses chew up $10 million every quarter and they have $20 million in cash on hand with
no income, then they have 2 quarters worth of life left. That is a simplistic example, but you want to know how close to the edge are they riding? How quickly will they have to dip
into the well to replenish their cash on hand? Sometimes the website has that information. You can try asking investor relations and see what they say. Ask them how they intend
to finance operations and the drug trial.
Will the company be able to earn revenue from potential licenses? Is so, how much and what is the timing?
Phase 3 ends when? The phase 3 trial will likely last many months, perhaps a year or more. Find out when the trial is expected to be completed and preliminary results released. If the company
looks promising, you will want to buy into the stock before they announce results. On the announcement day, assuming it's a success, price can shoot up dramatically.
Dendreon doubled in a day but moved from 4 to 27 in about a month.
Legal rights and patents. Is another company trying to assert patent infringement? How much litigation is the company involved in? The cleaner the company (the fewer lawsuits it
is involved in), the better.
Check latest news. Be sure to read the latest news while on the website. See what happened during the quarterly earnings announcements to the stock. If earnings are due within 3 weeks, then postpone
buying. Otherwise, the stock could tumble on the news. If they have issued new stock to fund operations, then see how much the stock dropped as a result.
FDA approval. What are the chances the FDA will ask for additional clinical trials, perhaps to demonstrate efficacy or safety?
History. Have similar drugs been tried in the past but failed either FDA approval or commercially? If the FDA has a track record of turning down such drugs, what makes
you think it will approve this new one? If drugs have been approved by the FDA, but they fail commercially, how does this drug differ, increasing the chances of success?
Profits? What profits? Has the company ever been profitable? When do they expect to turn profitable? How much debt has accumulated and how long will it take to pay it back?
How extensive (how much will it cost?) is the Phase III clinical trial?
Post approval: build factory? Partner with another company? Once the drug gets approval, then what? Will they have to partner with another company to market it? Will they have
to build a factory to produce it? If so, they will have to get financing from somewhere. Do they have a process to mass produce the drug? Are ingredients readily available at reasonable costs?
Read the 10-K report for answers.
Doctors. Have they conducted a survey of doctors to see if the doc's will prescribe the thing? How difficult will it be to get market acceptance of the drug, including insurance
companies to pay for it? You may be able to find an
answer to that on their website, but if not, then email the company and ask.
Read the 10-K. If that document doesn't scare you out of buying the stock then maybe it's worth owning.
When To Sell
Determining when to sell is not as difficult as one might think. Clearly you want to make top dollar, but you also risk losing that profit if expectations are not met. Here's a brief
list of tips to help determine when to sell.
If you double your money (or more) then consider selling.
If price rises substantially (in one day or in a few days), then consider selling. Review the article on the inverted dead-cat bounce event
pattern. I also have a few trades showing how I made money off that pattern several times (CNO and YRCW as well as
other trades). Pay close attention to YRCW. After I sold, the stock plummeted on November 2 from a prior close of 3.65 to a low that day of 1.22.
That's a drop of 67% in one session.
There's an old saying: You never go broke taking a profit. If the move up is a result of a rumor, then I would consider it an inverted dead-cat bounce and would sell immediately.
If the company announces results that are better than expected, then I would hang around. In a year or two, the drug may get approval and profits could tumble in. If that's too
long to wait, then sell.
Sell when the company gets a marketing partner or after the announcement of good news. Follow the adage of buy on the rumor and sell on the news.
The examples below show what happens when a company announces drug trial results that miss expectations and one that does well.
Example: Acadia Pharmaceuticals (ACAD)
Shown is the chart of Acadia Pharmaceuticals (ACAD) on the daily scale. It represents an investor's or trader's worst nightmare.
On July 24, A, the stock gapped higher on a rumor and speculation that data from a drug trial would be released soon. Call options trading was heavy on that day, according to published reports.
The stock moved from a close of 2.60 to 4.40, a gain of 69% but that pales to the intraday high of 5.24, for a potential gain of 102%.
In the coming days, price moved up even more, reaching a high at B of 6.60 (154% above the close on 7/23/09.
And then disaster struck. On September 1, C, the stock gapped lower from a prior close of 5.84 to a low of 1.69, a drop of 71%. Why?
"Pimavanserin failed to meet key treatment goals in a
late-stage study focusing on patients with Parkinson's disease psychosis," according to the associated press.
Price followed the pattern of an dead cat bounce event pattern by moving up (bouncing higher one day) and then dropping. As I write this on November 23, shares are
trading at 1.30.
Those that sold the stock on the rumor did well. Those that held onto the stock saw their profits evaporate. If you want to know what happens after a drug fails clinical trials, the chart
shows the answer.
Example: Dendreon (DNDN)
This chart shows Dendreon (DNDN) stock on the daily scale. It is a case study of how the market could behave when things go right and what rumors can do to the stock.
On April 14, A, the stock gapped higher on news that two brokerage firms upgraded the stock and the announcement headlined, "Provenge
significantly prolongs survival in men with advanced
prostate cancer in pivotal phase 3 impact study," according to the company website. The stock moved from a close of 7.30 to a high of 22.10, or a rise of 208%.
Two weeks later, B, the stock faced a volatile session, plunging as low as 7.50, well below the day's high of 25. Why? It's not clear. In three minutes, the stock traded several
million shares just before the announcement of a cancer drug trial.
The stock closed down 45%, at 11.81. The next day, the stock opened at 26.82, up 127%, and closed at 22.94, up 94%. The stock has been relatively flat since then.