Biotech Investing Revisited

In a previous post, I outlined the major characteristics of biotech investing. It is a high risk environment requiring heavy due diligence and a lot of patience.  Small cap biotech is especially treacherous and filled with dangers for most investors. In my earlier post, I mentioned the pipeline, the trial phases, and the return potential for small cap biotech. When I first became interested in this investment class, I was told hitting on 1 out of 5 companies was a solid success rate. That means 80% of the time, the investor is likely to lose money or walk away without being compensated for the risk or the time. Why then would anyone want to invest in these companies if there was only a 20% chance of success? One of the reasons is that the success can be huge multiples and the other reason is that some people are risk seekers. If that 1 out of 5 is able grow by 10x, it can compensate for the other 4 companies loss. That is the game that is played by a variety of biotech investors.

A wide variety of players participate in the small biotech game. The characters run the gamut from novice pumpers to paid bashers and college know-it-alls to retired hopefuls. Most of the time, investors have a small percentage of a large amount of small cap biotechs through their retirement portfolio. Investors can see this by looking at how much of their portfolio is weighted in healthcare or biotech and then what part of that is in the small cap arena. Some portfolio weight is allocated to this sector because it tends to be uncorrelated with the market and provide a healthy diversification benefit despite the additional risk.

The novice pumpers are the people that participate on the message boards or continue to hold out hope after each failed trial phase. To them, something big is always coming around the corner and they tend not to due the proper due diligence of reviewing the company and the SEC Filings of the company. You hear a lot about paid bashers in the biotech sphere and this is referring to people who repeatedly write about the failures of the company, the ignorance of the management, and the overall impossibility of success. It is difficult to determine if short sellers actually fund this behavior but it is odd to see a lot of people adamantly rooting against cures or treatments of deadly diseases for pure profit sake. Not out of the realm of possibility though as short sellers are very active in biotech and there tends to be a large ‘sell the news’ reaction in this investment class. I find it beneficial to track the behavior of institutional investors that specialize in the biotech sector. There are a few of them that primarily invest in a bucket of small cap stocks that they have done heavy due diligence on. You can see this by picking a biotech and reviewing the Institutional Holders in the Sage Data Research Platform. Following the big boys can lead to great idea generation as well as direct investors to where the smart money is allocating assets.