The biotechnology and pharmaceutical industry has something for everyone. Whether you are looking for a mature dividend aristocrat like GlaxoSmithKline (GSK, Financial) or a small-cap upstart like Sarepta (SRPT, Financial) that can double in value overnight, the sector will provide an option that suits your preferred risk-reward profile. Due to the technical nature of the industry, investing in these companies differs from investing in more conventional businesses, especially when we are talking about the smaller-cap biotechs.
These are companies that typically have only one or two drugs on the market, and frequently do not even have that, if they are still in the experimental stage. As such, they represent both high risk and high reward. The key to understanding how the market values these companies is knowing how they respond to various types of catalysts. Because they usually have very limited pipelines, the success or failure of these treatments can have huge effects on the valuation of these small caps.
Known catalysts
This is the simplest type of catalyst. These are what former Secretary of Defence Donald Rumsfeld once called "known knowns" -- pre-announced events during which important information pertaining to candidate drugs is revealed. Typically, these are either conferences at which the company is communicating some new data, or days on which the FDA is making an important regulatory ruling. Interestingly, when the outcome of the catalyst is widely expected to be positive, the stock will actually sell off after the event, as investors “buy the rumur, sell the news,” and take profits when their suspicions are confirmed.
Open-ended catalysts
These are the "known unknowns" -- catalysts that are known or expected to happen, but there is uncertainty about when. For instance, it may be rumored that the company is looking for someone to partner with in order to distribute their new drug. Everyone knows that it will probably happen at some point, and investors expect the stock to appreciate in value when it does. But no one knows for sure when, which makes investing in this space often frustrating.
Surprise catalysts
These are the "unknown unknowns" -- scenarios that are almost impossible to predict, but that have enormous consequences for the companies, due to their small size and reliance on a single (or handful of) product. These can take the form of an unexpected secondary offering (as in the case of Synergy Pharmaceuticals (SGYP, Financial) a few years ago), or a sudden suspension of a clinical trial. These sudden events are generally negative for the company, but can occasionally be positive, like a surprise announcement of a buyout.
Summary
The small-cap biotech space is full of potential winners, but also contains many losers. It requires a certain degree of specialist knowledge and appreciation for how scientific studies are conducted. More than almost any other industry, it is dependent on the decisions of the regulatory agencies that control which drugs may and may not be sold. But this high barrier to entry is also what makes the market relatively inefficient and creates mismatches between price and value. If you are willing to do your homework, there are definitely good opportunities out there.
Disclosure: The author owns no stocks mentioned.
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