Don’t Take a Shot on That Small-Cap Biotech

The odds of profitability are not in investors' favor

   

By my count, 10 different biotech companies have gone public in the past couple of months.

stockoftheweek Don’t Take a Shot on That Small Cap BiotechSurprisingly, five of them still are trading above their IPO pricing. That’s a track record much better than the market’s average, almost lending hope to investors looking to cash in on the tantalizing (alleged) upside of a new public offering; the inherent (and also usually alleged) bullishness behind a novel new drug is just a little gravy.

Despite a decent run for 2013’s biotech public offerings, though, IPOs generally remain bad for your portfolio for the first full year or so of their trading.

Biotech public offerings are doubly dangerous to traders who are certain their pick is a “sure thing.”

Par for the Course

Just as a reminder, Facebook (FB), Zynga (ZNGA) and Groupon (GRPN) were highly touted companies before any of them went public last year (or in the case of Groupon, in late 2011). The market couldn’t wait for any of them to hit the Street, as if they were the best thing since sliced bread. The Forbes story headline “Facebook IPO: Buy Early, and Buy as Much as You Can” pretty much sums up the mentality at the time.

Today, of those three, only Facebook trades above half of its initial publicly traded price.

Thing is, those early pullbacks from initial public offering prices aren’t the exception to the norm — they are the norm. Studies have shown that most IPOs underperform their peers for their first three years of trading. When BusinessWeek took a closer look at IPOs from 2010 and 2011, the publisher found that among the biggest 25 initial public offerings brought to the market during that time, 20 of them were more than a little below their initial trading price.

Biotech IPOs are no exception to that trend. 2011’s initial public offerings from Horizon Pharma (HZNP), Sagent Pharmaceuticals (SGNT), Tranzyme (TZYM) and BG Medicine (BGMD) are all well in the hole, leaving IPO investors deep in the red.

To be fair, there are just as many biotech IPOs from 2011 that are up. But, a 50/50 proposition isn’t exactly an ironclad investing approach.

Reality Check

If you’re a fan of speculating on small-cap and startup biotechs, here’s some bad news for you: Statistically speaking, the odds aren’t in your favor.

It’s not unlike going to Las Vegas. Sometimes some people make a little money at the casinos, and sometimes they lose a little. A few people lose a ton of money in Vegas, and every now and then, there’s that one guy who seems to make a killing.

It’s that “one guy,” however, that everyone remembers and likes to think they can emulate. As you all know, though, if the casinos keep you at the table long enough, eventually their tiny edge will take money out of your pocket and put it in their bank account.

It’s important to develop new drugs … a role that small-cap biotech developers have taken on and excelled at, while large-cap pharma companies have been content to sit on the R&D sidelines and simply acquire companies as they develop new treatments. The problem is, much more money is spent by small-cap biotech companies to develop drugs that never make it to the market than is ever put back in the pockets of investors.

Case in point: Remember when Cubist Pharmaceuticals (CBST) acquired Adolor in December 2011? Cubist paid $221 million, largely for Adolor’s portfolio of pain-management drugs. Adolor shareholders were celebrating the 143% premium (at the time) they were getting for their shares. Less touted was the fact that Adolor had spent $530 million to develop its portfolio of products. Who made up the $309 million difference between what was spent and what was received? Well, ultimately it was shareholders, who were more than happy to hand money over to the company as it was raising funds in the name of drug research.

To be fair, the Cubist/Adolor case is an extreme one … but not unusual. Merck’s (MRK) acquisition of Inspire in mid-2011 was a solid offer of $430 million, which seemed like a great deal at the time, but didn’t even fully cover the amount of money Inspire had spent to develop its pipeline at that time. In September of last year, Spectrum Pharma (SPPI) paid $206 million for Allos Therapeutics — a deal Allos owners were glad to say “yes” to. Never mind the fact that Allos had collected a little more than $565 million from investors over the course of its lifespan as a publicly traded company.

The math certainly makes sense to the acquiring company, but for the original (and patient) shareholders of the acquirees, it’s not always a winning deal.

The Last Word

When it’s all said and done, only about 20% of every drug that begins the development process is approved. That means four out of five don’t make it. Granted, the revenue created by that one out of five more than makes up for the four that don’t.

The deck is stacked against early investors, however, and even when the acquisition endzone is reached, the buyout offer doesn’t always cover the cost of developing the drug. If you still want to take a swing, that’s up to you, but the math doesn’t really make sense.

Ironically, some of the best small-cap biotech opportunities are enjoyed by firms that decide to not to take themselves public. About three-fourths of the biopharma acquisitions that have transpired this year were of privately held names. Thing is, it’s the private-company deals that might have offered the most upside to buyers.

The fact that a biotech outfit actually has to go to the public to raise money — rather than securing funding privately or by partnering with a major name — might well be the biggest investor red flag of all.

The best way to win the game seems to be not to play it.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities.


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