3 QUESTIONS THAT EVERY BIOTECH INVESTOR SHOULD BE ASKING

“If you don’t ask the right question, you don’t get the right answer.” That was one of my great grandfather’s favorite sayings. He died thirty years before the biotech industry was even born, but his saying is as relevant today as it was a half century ago. Here are three questions that every biotech investor should ask while evaluating a potential stock purchase.

1. What is the company’s TAM?

TAM stands for Total Addressable Market. TAM is a common metric in the biotech industry, and it helps executives and investors understand the size of a business opportunity. For example, if you are considering investing in a company that is searching for a cure for Parkinson’s disease, you would be looking at a very large TAM. According to the Parkinson’s Foundation, about ten million people worldwide suffer from that disease, and very few effective treatments currently exist. So the commercial potential for an effective drug could be well into the billions in annual sales. That is a very large TAM. On the other end of the spectrum, you might consider investing in a company that has a drug candidate for Acid Sphingomyelinase Deficiency, a rare genetic disease that affects about 1 in 250,000 people. This would be a much smaller TAM.

A small TAM does not always mean a small financial opportunity but it does drastically affect the strategy of the biotech, and different TAM sizes tend to present different risk profiles to investors.

Let’s go back to the example above. At its core, the discovery and commercialization of a drug represents the resolution of a scientific riddle. Whether a disease affects ten million people, or just one in ten million, the malady is still a scientific mystery that must be solved. Solving that mystery can be a torturous journey of many years and many hundreds of millions of dollars. The problem is, it may cost just as much to cure Acid Sphingomyelinase Deficiency as it does to cure Parkinson’s. So we wind up with very different commercial propositions.

Parkinson’s is a notorious scourge; most of us can easily recognize the symptoms. This means that, if an effective treatment is discovered, the fixed costs can be shared by millions of people. It also means that the pharma company has a strong argument for charging high monthly fees to insurance companies, individuals and Uncle Sam. Let’s say the drug cost $1 billion to develop over many years. The biotech can charge $12,000 annually per person, and if one million patients go on the new medicine, they are looking at $12 billion in annual revenue. A handsome return indeed, and potentially an acceptable price to Society for a cure to this dread disease. That’s the magic of a large TAM.

Now let’s consider those lonely patients who suffer from ASD. Their drug also cost $1 billion and years to develop. But there may well be no more than 1,000 patients across the United States who would need the drug. At this rate, the biotech company would need to charge $100,000 per patient, per year, just to recoup the investment over ten years. Bad Math.

Does this mean that a wise investor should stay away from companies that seek to treat rare diseases? Not necessarily. In fact, there has been a wave of biotechs specifically built to address the needs of victims of rare diseases. The thinking has been that the bizarre economics in these niches would scare away competitors.

There may be nothing worse than diabetes in America. Our struggles with this widespread disease are well documented. However, such high publicity and large TAM have attracted dozens of competitors, large and small, who have launched many different kinds of medicines into the diabetes market. As a result, both patients and insurers can be choosey consumers. Diabetic patients have a lot of treatment options, which would make this market dicey for new entrants.

However, people unlucky enough to suffer from rare diseases have few options, if any. This means that insurers and patients may be willing to pay very high prices for medicines that only demonstrate marginal efficacy. The drama surrounding Duchenne Muscular Dystrophy (DMD) and Sarepta Therapeutics ($SRPT) is a perfect example of this phenomena.

There are a lot of ways to make money in biotech investing. Both companies targeting large TAM opportunities and small TAM opportunities can potentially mint money. But they are different beasts, who attract different kinds of investors. Investigate a biotech company’s TAM before anything else, and you will be much better positioned to make some wise decisions for yourself.

2. What is the Company’s Funding Situation?

Many of today’s publicly traded biotechs lose money. There may still be very good reasons to invest in a company with negative cash flow, but understanding the company’s current financial position is critical to understanding the risks that you would be taking as an investor. Let’s look at a few examples.

You have $1000 to invest, and you are choosing between two companies that seem promising to you. Company A went public two years ago, garnered a lot of publicity and big name investors, and raised $700million in their IPO. They are dealing with cutting edge science, and they are still very early in the discovery process. They are about to begin three phase I studies, and they have many other preclinical studies going on. This means that they could be years away from obtaining any meaningful revenue, let alone profit.

After looking at the cash flow statement on their quarterly report, you can estimate their “burn rate,” or amount of capital that they use per year. Two years ago, after the IPO, they started with $700 Million in the bank, and now they have $500Million left. So, they are burning through about $100 million per year. If they maintain their current burn rate, they could go 5 years before having to worry about keeping the lights on.

Company B was founded by a few professors from MIT, and didn’t garner as much publicity. They raised just $60 million at their IPO two years ago. When you check their balance sheet, you can see that they have just $20 million left in the bank. When you check the cash flow statement, it looks like they have been burning through about $20 million per year. Since their IPO, they have had some success with phase I trials, and they currently have an ongoing phase II trial. It looks like they have some exciting science in their possession, but some kind of financial event is going to have to happen within a year, or they will “run out of gas” and go bankrupt.

Which company is a better place to invest your $1,000? The answer is, “it depends.” It depends on what kind of investment you are looking for, and how much risk you are willing to take.

On the surface, company A is less risky. They are so well funded that they can just keep scraping away at scientific discovery, with little regard to revenue, for years. If they don’t start to bring in revenue within the next few years, they will still be in a strong negotiating position to raise more capital. They can chug along for a long time, with nothing really happening.

Some might view that as a “pro,” but more aggressive investors might view that stability as a “con.” The well fed executive team leading company A could easily become complacent. Focusing on science is great, but many more aggressive investors might prefer a company’s management to seek profitable opportunities, sooner. With five years worth of cash in the bank, there may be a certain sense of urgency that is missing.

Company B needs to make something happen, and soon. That makes it a risky investment. They might issue new stock shares on the open market, which could dilute existing shareholders. They might sell a big block of shares to a new investor, which, if done at unfavorable terms, does not help existing shareholders. Someone might loan them money at a very high interest rate. Or they might sell the company outright. If they are just months away from running out of cash, you can imagine, company B is not in a great position to negotiate.

However, some thrill seeking investors prefer just these kinds of situations. Depending on where exactly the science is, company B may still obtain new capital at favorable terms. Analysts and nay sayers may have realized that the Company B is low on cash, and pushed share prices down far below their intrinsic value,meaning shares can now be purchased at bargain prices by investors who don’t mind going on a roller coaster ride.

In short, there is no simple, “right” answer. Company A might be better for a long term, “steady as she goes,” investor, while Company B might be better for a thrill junkie. But if you haven’t done your homework, then you are just blindly gambling on whatever stock looks sexy today. Asking the right questions around a biotech’s finances will help you gain a more solid understanding of the stock. You’ll sleep better at night knowing what you are buying.

3. What is My Own Tolerance for Risk?

The two questions above should help you determine what class of company you may be investing in, and how risky that investment could be. The last question may be the most important: how much risk can you handle?

Here is an interesting fact: most American investors under-perform the Market on a regular basis. In fact, investors typically earn between 2 and 4% less than the benchmark index. In the world of investing, that 2% gap, year after year, can easily add up to millions of dollars lost. One reason why investors do so poorly, even when the Market does well, is that they don’t know themselves, and they buy the wrong investments for them. If they buy something that is too risky for them, they panic, and they sell at the wrong time. If they buy something that is not risky enough, they get bored, and they sell at the wrong time. Assembling the right equity portfolio for yourself is like going to the grocery store and picking just the right items off the shelf. Most grocery stores these days are filled with all kinds of delicious treats. But what if you buy strawberries when you should have bought bananas? What if you bought Special K, when you should have bought Frosted Flakes? All of these options are good, but are they all good for you?

One time honored method of smart shoppers is to make a list before you enter the store. This method causes a shopper to think about what she needs before she enters the store, which results in less buyer’s remorse later. You can do the same for stocks. Let’s say you already have a portfolio of steady value stocks that grind out dividends quarter after quarter. You could use some excitement in your life. So you dedicate 10% of your capital to those riskier biotech stocks. Or you already have a bunch of risky biotech stocks, and the constant gyrations in share price have given you too much indigestion. Start dedicating capital to some larger, more mature biotech stocks such as Amgen, Gilead, or Biogen. Asking yourself how much risk you can stomach before you go shopping gives you a better chance of building a winning portfolio for yourself.

A lot of people never move forward in stock market investing simply because they don’t know where to begin. The three questions above are a great place to start. Once you get used to asking these same three questions, again and again, you will be surprised at how good you get at ferreting out the answers. Good questions will bring good answers; good profits are rarely far behind.

DISCLOSURE: The Sick Economist owns shares in $GILD