How to Invest Smart in Biotech Stocks

September 23, 2020 - 12 minutes

Anyone investing in public biotech companies will find it challenging to answer the key question: does this company have a good chance to create real value? 

Medical breakthroughs can result in huge revenues, but being the first to develop and commercialize technologies based on cutting-edge research inherently comes with a high risk of failure. In addition, biotech companies face a lengthy and intricate development process all the way from discovery to clinical trials and commercialization. In order to attract money on the public market, they need to come up with an engaging proposition capable of capturing the trust of investors. 

While in other sectors stock valuation is often based on a financial analysis of the company, evaluating the stock of a biotech company is a much more qualitative task. Most biotech companies go public when they still have no earnings, so the value of their product is still theoretical. To evaluate biotech stocks, therefore, potential investors have to rely on a combination of industry data and a deep understanding of the drug or medical device. 

“The main difference is the risk profile,” said Peter Abelin, Life Science Senior Consultant at the Danish valuation consultancy firm Xplico. Abelin noted that there is a high development risk in pharma, whereas with other sectors the main risk falls in marketing. In addition, the products require a high technical level of development and take a long time to deliver results. “These may lead to difficulties in financing the projects [but] the upside is potential, immense value creation when compared to other branches of the economy, with a subsequent steep rise in the stock price.”

Despite these challenges, the advantage of investing in biotech is clear. While the chances of a drug or medical device making it to market might be small, they can rake in massive revenues. The higher the risk, the higher the reward.

The stock price is not always a faithful reflection of the company itself, especially in the biotech area. While the stock and the real value of the company tend to correlate in the long term, in the short term they can move in opposite directions.

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This means that a good analysis may reveal hidden gems that others have overlooked. A skilled valuation may determine whether a particular stock is over- or undervalued. To do so accurately, the analysis should capture the potential not just of the technology, but of the ability of the biotech company to succeed in the corporate world.

According to Abelin, a successful life sciences investor needs to understand the technical terms, be able to make comparisons and always consider the time periods. “In the short term you are looking for proof of principle in the project, as opposed to clinical development results. In the long term you want to strike a deal with a larger company and receive a phase III clinical result confirmation,” said Abelin. 

Searching for the ideal investment

The ideal biotech stock investment would be a disruptive company with global capacity, a solid financial position, several unique products that are already making money, a promising pipeline of programs in different development stages, clear chances of regulatory approval, undervalued, and unknown by most of the market. And the CEO would call you once a week to give you the latest insights. But this ideal does not exist. In biotech, you need to assume risks. It is part of the game.

While it is harder to opt for a pre-revenue biotech company, without any supporting cash flow, it might be much more profitable going forward.

Investing in biotech carries a degree of irrationality since the likelihood of approval for an early stage product is low. Why invest in something that has a 10% chance of success? Some regard it as a lottery,” said Abelin. “My sense is that people have become more aware of the specific traits of biotech, and evaluate the companies taking this into consideration.”                

A diversified biotech portfolio

Diversification is the most common strategy recommended by experts. Instead of depending on the success of a single project, a diverse portfolio helps the investor overcome the failure of some of their investments.  

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A diversified portfolio could include companies targeting different disease areas and technologies. It could also have a variety of company sizes: large caps have more possibilities to add revenue even in times of a global crisis; pre-revenue or smaller companies are riskier but potentially much more profitable; and mid-cap companies might be a more stable middle point. 

Other investors might prefer to focus on a specific area or stage and become experts in the intricacies of that particular target. The truth is that investing in biotech is complicated, and there are different arguments in favor of different portfolio strategies. Even the biggest investment experts can make totally different predictions for the same stock.

High risk, high reward  

Despite these obstacles to valuation, capital continues to flow to the biotech sector, which is projected to surge beyond €680M ($775B) by 2024 globally.

 Europe has become one of the main locations within the sector. “The massive amount of money that has come into the European biotech sector was previously unseen. This allows for companies with good ideas to raise large amounts of funding and have a balanced development,” said Jan de Kerpel, Managing Director of Life Sciences & Healthcare at the Dutch bank Kempen Corporate Finance.

Before, many companies were forced to put all efforts on one project, all or nothing, and usually with suboptimal funding, resulting in suboptimal clinical development.” 

Now, biotech companies are increasingly calling the attention of stock traders, especially after the coronavirus pandemic started, with companies such as Moderna in the US and BioNTech in Germany becoming known to the general public

But there is still room for improvement. “Almost all biotech stocks listed in the EU are undervalued,” said Damien Choplain, Senior Biotech Equity Analyst at the French financial services company Kepler Cheuvreux. “Unfortunately, the price does not converge towards the fair value of the company. Probably due to the lack of specialized investors in this area.”

What to look for in a biotech stock

Market potential 

A potential investor should look at the information provided by the company and at market research to determine the number of potential customers. This can be estimated by looking into how many people have or get a diagnosis of the target disease each year. 

The big treatment areas, for example cancer or cardiovascular diseases, have the greatest potential return on investment. However, they also have a lot of competition, meaning that the percentage of the market share of a new product will be limited, and highly dependent on how it compares to other products that are already on the market or in development. 

Smaller markets, such as rare diseases, have the advantage that there is much less competition, or none. In addition, underserved areas often benefit from access to accelerated regulatory approval and funding from non-profit organizations.

Another important factor is the price that customers will be willing to pay for the treatment, as well as the number of doses required. A one-time solution such as gene therapy can bring bigger revenues faster but might be more difficult to sell, whereas chronic treatments might bring smaller but regular revenues over the years. 

The pipeline

Whether a company is dependent on a single product or is developing several of them is a very important factor to take into account when performing a stock valuation. Generally, the fewer products in the company’s portfolio, the higher the risk. Up to 90% of projects never make it to clinical trials, and almost 95% of those that make it end up failing. 

On the other hand, developing multiple products significantly increases the costs the company will have to face before it can start generating revenue. In this case, the valuation must consider the entire portfolio, considering the market potential of each drug and its chances to get regulatory approval and generating sufficient return to cover the company costs.

But when a drug does make it to market, the stock has the potential to increase massively. This could happen in a short period of time triggered by a particular event such as the Covid-19 pandemic, as was the case of diagnostics firm Novacyt, whose stock has grown over 600% since the beginning of the year. It could also be a matter of progressive growth over the course of several years, as has happened with companies such as Amgen, Biogen, and Gilead.

Milestones

Biotech stocks particularly call traders’ attention when they reach key milestones such as the successful completion of a clinical trial, which can result in massive stock jumps. However, a negative result can massively shrink its stock price too, and even provoke the ruin of the company.

A warning for the public investor is that companies can sometimes limit the amount of details they reveal about their results, making it difficult to accurately evaluate the potential of a drug candidate. There have also been scandals around data manipulation in the life sciences, but these are rare. 

Still, accomplishing EMA or FDA approval does not necessarily translate into market success. That has been the case, for example, of the gene therapy Glybera. Either way, specialists note that you should not discard a stock because of a small trial setback. For that matter, perhaps you might have found an affordable opportunity to invest in.

Cash burn

A company needs to have access to sufficient capital resources in order to sustain its research and development activities. Especially in the case of small biotech firms, there is potential for bankruptcy when the liquidities get low if the company does not raise enough new capital on time. 

Few companies have sufficient cash available to last more than five years. Therefore investors must pay special attention to the cash burn rate, which reflects the average monthly costs of the company. This can easily be estimated by looking at the quarterly reports of the company’s balance sheet. A growing company will typically have a large cash burn rate, but this should be paired with a strategy that ensures the company will get new investment or some other sources of funds before reaching bankruptcy. 

A recent example is the case of Moleculin Biotech, a US-based company whose shareholders started to get concerned last month as the company’s increasing burn rate started to significantly shorten the amount of time available before it runs out of cash.   

The human capital

To evaluate a biotech stock it is also decisive to know the professionals behind the company. Does their background have a competitive advantage? Is there a diversity of skills across the company? Does the management have previous experience in that field? What about their commercial skills?

Trust in the management can significantly impact share price. For example, research has shown that when a new CEOs shares their new company strategy, the share price can increase by 5.3% on average.

Some investors are also attentive to look to the trading activity of the company’s top executives. A CEO selling some of their stocks could be a warning of the company’s financial health, although there can also be other unrelated motivations behind it.

A sound strategy 

Each biotech company follows a different strategy to raise money and survive during the years of development. A company might obtain these funds through private investments, public offerings, loans, licensing deals and partnerships with larger companies that are eager to invest in their products and ideas.

Strategic partnerships can give biotech companies vital cash to complete drug development. Nowadays, approximately, two-thirds of the development of new drugs happens within smaller companies. Down the line, a partnership with a larger company may end up leading to an acquisition. 

Manufacturing, marketing and distribution also impact value as they determine how quickly a product can start generating revenue. This requires the ability to produce enough quantities of the drug at a reasonable cost, create demand, and bring the product to the customers.

The commercial stage requires large amounts of capital, something that many small biotech companies do not possess — this is where strategic alliances to outsource all or part of the process can have a big impact. For example, the German company BioNTech saw its stock price rise earlier this year after announcing a partnership with Pfizer to develop a vaccine for Covid-19.

Intellectual property

It is important to make sure the company sufficiently controls the rights to their portfolio to prevent competitors from copying a technology or product. Royalty rates get higher as the firm moves along the development pipeline. Another important parameter is the feed rate, which represents the ability of the company to generate or to license projects.

A biotech stock also can face patent expirations protecting their drugs. So, be careful with pharmaceutical companies with a valuable patent set to expire, since biosimilars may start competing with the drug when it does. The big impact patent protection can have on a company can be seen in the recent case of Amarin. The patents for its drug Vascepa were revoked just months after the launch, giving an opportunity to competitors to start selling biosimilars and therefore limiting the chances that the drug can become a blockbuster as originally planned.  


While a qualitative analysis taking into account all these factors is essential to perform a biotech stock valuation accurately, looking at the company’s prospects quantitatively is also a key resource for professional investors to decide whether to invest in a particular stock and how much. We will be exploring the diverse methods used by biotech investors in the second part of the series, coming out next week. 

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