How to invest smartly in biotech?

The big difference in biotech investments compared to more established businesses is that you need to assess a possible future success rather than consider existing cash flow and profit.

>

Pekka Simula 30.09.2019

The subject line is of course provocative. Biotech investments are associated with high risks so, depending on your personal risk profile, it might never be smart for you to invest in biotech. On the other hand, any investment in the stock market is risky. Investing in the Nasdaq Biotechnology Index a decade ago turned your €5 into €20; however, in the past four years it has lost 20%.

The big difference in biotech investments compared to more established businesses is that you need to assess a possible future success rather than consider existing cash flow and profit. You cannot calculate a price-earnings ratio if there are no earnings! Instead, one has to estimate the present value of something that may have a significant market potential if it makes it to the market.

That makes a simple calculation, doesn’t it: Value = may x significant x if…

If one could only tell the ‘may’ and the ‘if’. The earlier stage the project is, the smaller the probability of success, and the harder to estimate the likelihood of success.

And yet professional life science investors, corporate funds, venture capitalists, and others – who enable a great part of the life sciences industry – invest dozens of billions of dollars in this sector year after year. Many of them are very successful too, year after year. How do they make educated investment decisions and pick the most likely winners?

I’d personally follow common investment advices such as: Invest in what you understand; Diversify; and Follow the insiders. Specific to pre-revenue biotech companies I would also look at several other things:

  • Detailed analyst reports. A private investor cannot possibly complete a detailed analysis on the science, development plans, and market of a large number of potential investment targets. Analyst reports covering both the scientific and commercial aspects are very useful. Ensure however that the research comes from a source that’s considered professional and trustworthy.
  • Follow the experts. Did recent funding rounds involve an investor with expertise in the subject and a strong track record in similar investments? In addition to investing in most promising companies they can boost those companies considerably with their own experience and network.
  • Stage of development. The risks decrease gradually as development proceeds from preclinical to early and late stage clinical development. A significant value increase may be seen at clinical proof-of-concept, such as the read-out of a Phase 2 study. However, remain skeptical with any ‘proof-of-concept’ not based on a randomized, placebo-controlled study. Some companies claim clinical efficacy by comparison against ‘historical controls.’ In most cases that will not convince any expert.
  • Cash burn vs. cash position. Reaching the end of the runway may indicate the need for a desperate financing round – possibly with a big discount to the current market price.
  • Differentiation from competitors. As an example, cancer immunotherapies are changing the treatment of cancer; consequently, dozens of billions of dollars have been poured in the development of the first new drugs already in the market, the hundreds in clinical development, and the thousands in preclinical development. One would need very strong scientific expertise on the nuances of the different approaches to assess their potential against competition.
  • Valuation compared to peers. Early stage, micro-cap biotech companies may have very limited liquidity and even individual trades can impact share prices without any apparent reason.

Other aspects can be considered too. For instance, some people invest based on the disease target, simply because they want to fight that disease for personal or philantropic reasons. However you approach this, never underestimate the risks. It only takes one serious side effect in a clinical study, even not related to the drug-in-development, to put the study on a long clinical hold by the authorities and push the company, and your investment, in a severe crisis. (On the other hand, good progress in clinical development can result in significant valuation increases. If an analyst increases the chances of success from 5% to 25% based on a successful clinical study, their probabilistic net present value of the program should increase by 400%! Which, of course, still leaves a 75% chance for failure… that’s biotech.)

Finally, closest to my heart: Investment in life sciences is more than responsible investing. It’s impactful investing. Investments make life science projects possible. While many of those projects fail, some of them will change the world and improve the lives of thousands of people. Even the failing ones produce novel scientific data, which will enable future breakthroughs.

I personally wouldn’t put all my life savings in such high-risk investments, no matter how noble. But I do feel good having invested in something meaningful. It makes me, the fortunate and healthy first world person, feel slightly better about myself.

This blogging is NOT a recommendation to invest in ANYTHING. It only reflects the opinions of the author and not those of Herantis Pharma.