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Biotech Investing in Tumultuous Markets (The Thesis)

posted Oct 2, 2011, 7:59 AM by Bryce Istvan
In these periods of extreme market volitility and on the heels of one of the worst quarters in several years it is important to remember the ultimate goal of long term growth investing; pick companies that have the ability to grow their revenue and cash flow over the years. To use the commonly citied examples Berkshire Hathaway (BRK.A) +1,404% since its IPO in 1990 and one of Berkshire's favorite investments, Coke, (KO) +4,300% since 1978 before including the billions in dividends paid. The goal of long term biotech investing is ultimately the same. Pick companies that are going to produce the next "Coke" of health care.
Before applying this idea to biotech I feel the need to highlight the difference between trading and investing. Trading is taking advantage of short term catalysts that drive stocks quickly in one direction or the other. These catalysts, generally study results or FDA findings, are common in the industry making it a favorite for traders. They often have major impacts on the long term direction of a company and should not be ignored by investors, but you must define whether you are entering into a trade or an investment before jumping into a biotech stock.
This article is the first of several (not sure how many yet) that I plan to write about the life of a biotech investment.
Remember, biotechs have some of the highest fail rates. Know your risk and be comfortable with the fact that you could lose everything.
The Thesis
If you are going to invest in a biotech company it is ultimately because you believe that their drug(s) will be a commercial success and that they have or can get the financial resources necessary to get through the incredibly expensive R&D, clinical trials and FDA approval process. If that thesis ever changes it's time to get out. Too often with biotechs investors hang on hoping for a miracle and ride the stock down to 0.
        The Science
Have a general understanding of the science behind what a company is trying to do before investing. This may take opening up an old textbook (or wikipedia), but can help you better understand the risk before investing. Applying another investing maxim, be able to expain in in a sentence. If the technology is based off of existing science, or better yet an already approved drug, the chances of success are higher. However, generally the rewards are lower. The general investing maxim applies- more risk=more reward.
        The Financials
Looking at cashflow and burn rate are critical before jumping into a biotech.  A company can have a cure for cancer, but if it can't get the funding necessary it isn't going to be sucessful. Also, look at the company's history of issuing additional equity. Issuing isn't necessarily a negative because it means other investors still believe in the company, but remember, the more stock a company issues, the less of the company you own. Also interesting to look at is who else owns the company. I consider strong insider ownership to be a good sign because then the interests of the management is aligned with your own. Institutional owners, especially ones with a strong track record in biotech are also a positive because they have done the analysis already, and probably have experts who didn't have to go back to biology class in order to understand the science.
Coming next- The Entry Point