As a self-described value investor, cast in the mold of Benjamin Graham and Warren Buffett, I would not, in the ordinary course of events, be caught dead with a biotechnology stock in my portfolio. The fundamentals alone are anathema to any value investor. The simple fact that one cannot evaluate these companies in the same manner as a stock in the financial, basic materials or other sectors is, at best, off-putting. Venturing into biotech stock requires the adoption of a completely different paradigm and an entirely different approach to analysis.
However, just as Warren Buffett stepped outside his comfort zone by buying IBM (IBM) the addition of Intel Corporation (INTC) to the Berkshire Hathaway Inc. (BRK.B, BRK.A) portfolio, we value investors might consider a step away from our comfort zone as well. To that end, I have embarked on a series of articles that undertakes the analysis of roughly 30 biotechnology companies.
The successful analysis of a biotechnology company does not rely very much on established fundamentals. Important considerations, in no particular order, when evaluating a biotech stock are:
1) What is the company’s research focus
2) Is the company developing more than one product
3) Is the company teamed up with others or pursuing its goal(s) alone
4) Is the company adequately capitalized and what is the source of capitalization
5) What is the company’s debt load
6) Is the company close to bringing a product to market (and ideally, ablockbuster)
7) Has the company encountered any roadblocks and if so, can they be surmounted
8) Does company management have solid academic credentials
I’ll begin with Ariad Pharmaceuticals Inc. (NASDAQ:ARIA), a small cap ($1.63 billion) trading at just over $13 per share. It has no published price/earnings ratio and sports a negative 1.75 price/earnings growth ratio. The price to book ratio is 60.69 and the reported return on equity is -327.33%. Quarterly year-over-year revenue growth is 1921.00% but quarterly year-over-year earnings growth tops out at 154.96%. The two truly bright spots in Ariad’s fundamentals are the debt/equity ratio of 48.56 and the current ratio of 4.28.
The stock is trading pennies below its 52 week high of $13.50. Nearly 60% of Ariad’s 132.85 million outstanding shares are held by institutional investors and the analysts’ consensus is “buy”. In fact, 7 rate the stock a strong buy, 4 rate it a buy and only the remaining 2 suggest holding. Traditional fundamentals simply do not support the enthusiasm for this stock, so what’s going on? To answer this, we’ll look at the stock in the context of the 8 bullet points above.
1) Ariad is focused on small-molecule drugs for the treatment of cancer; a malady affecting millions worldwide. This guarantees a huge market for any successful therapy discovered.
2) They are developing more than one drug. This is important because you don’t want to invest in a company that has all its eggs in one basket.
3) The firm is partnered with SARC and EORTC. You can read the detailshere. They have also collaborated with Merck & Co.Inc. (NYSE:MRK).
4) Ariad appears to be adequately capitalized as evidenced by a wildlysuccessful public offering which raised some $243 million.
5) ARIA has a debt/equity ratio of 48.56 and a current ratio of 4.28 suggesting they are well positioned to handle long term debt and current obligations.
6) A recent Reuters’ article suggests that a drug Ariad has developed for the treatment of leukemia is well into successful trial stages.
7) Ariad successfully litigated a patent infringement case against pharmaceutical giant Eli Lilly & Co. (NYSE:LLY). This was a few years back but solidly established ARIA as a company that can protect its intellectual property and overcome adversity.
8) The founder and CEO, Harvey J. Berger, is an M.D. and there are numerous Ph.D.’s in key management positions suggesting a high level of academic competence.
My review of Ariad in the context of the 8 factors we’ve identified as key to the success of a biotechnology company seems to support the analysts’ strong buy position.
Let’s quickly run through 2 more companies in the remaining space allotted, beginning with Chelsea Therapeutics International Ltd. (CHTP) which trades at just over $5.00 per share and has a market capitalization of $327.79 million. The fundamentals would choke a maggot off a gut wagon, but we know that is the last place to look for value in a biotech stock.
Chelsea is pursuing treatments for a variety of diseases including fibromyalgia, Parkinson’s disease, ADHD and chronic fatigue syndrome to name a few. Not the malady de jour that cancer represents, but certainly well known and widely suffered maladies that make for a good potential market. The firm has some strategic alliances, most significantly with Japanese firm, Dainippon Sumitomo Pharma Co., Ltd. (DNPUF.PK). Chelsea is adequately capitalized and justannounced a $20 million public offering. The company has no long term debt and its current ratio of 4.30 is indicative of financial strength. Chelsea has at least one drug, Northera droxidopa, in phase II trials. Chelsea has encounteredsome problems with this drug in terms of meeting endpoints. The management team is chock full of M.D.s and Ph.D.s which should be the hallmark of any solid biotech stock.
Six analysts are evenly split on the stock with 3 calling it a strong buy and 3 calling it a buy. I lean toward a “buy”.
China Biologic Products, Inc. (NASDAQ:CBPO) is the last company we have time for today. This stock is trading at about $10.00 and the company’s market capitalization is $268.29 million. CBPO actually has a few decent fundamentals, at least they don’t cause you to assume a fetal position and begin drooling into your pillow, but, we know what we need to look for so let’s get to it.
CBPO is the ‘vampire’ of biotechnology, specializing in a variety of plasma based pharmaceutical products to treat everything from shock to rabies. Its primary market is the Peoples Republic of China. While I could not find any evidence of collaborative efforts with other companies, this may not be an important consideration in China.
CBPO’s debt/equity ratio is very low at 7.51 and its current ratio is more than adequate at 2.86. A review of the balance sheet adds further support for the financial soundness of the company. The firm has no FDA hurdles to bridge although any drugs or drug components exported to the U.S. market would be subject to FDA inspection. Company management is comparatively weak with respect to M.D. and Ph.D. representation.
There is only one analyst on this stock and he gives it a strong buy. I am just not comfortable with coming out that strong for this stock but I can accept that it has considerable potential and I am impressed by the fact that it garnered a nomination for the 7th Annual Scrip Awards in the category of "Best Company in an Emerging Market." It did not win, however. I recommend taking a look atcoiled spring biotechs for additional ideas.
About the author:
At Investment Underground, our editors are disciplined, independent thinkers who will inform you when to buy undervalued investments, recognize catalysts, and sell when full value is realized. We provide timely, detailed analysis of our value investing strategies and help you achieve your goals of a reduced-risk trading environment.
If you are fed up with volatile markets and manipulation that put your financial well-being in jeopardy, join us to achieve those gains you deserve without the headache.