BioPharm Executive: Nine Ways to Avoid Investing in Biotech Duds

February 25, 2015
By Karl Thiel for BioSpace.com

If, like me, you're a biotech investor, then you already have a stomach for volatility. You know that even with the best diligence, your investment dollars are riding on unknowable outcomes. Losses can come hard and fast, but the winners—well, they can make it all worthwhile.

There's no simple formula for finding solid biotech investments—every company has its own story. But you can take some simple steps to weed out the likely losers. Below is a list of warning signs you should be wary of. Some are red flags I'd probably never violate; others are yellow flags that may be worth the risk, but heighten the need for extra diligence. Maybe some of the points below can save you a little money.

Red Flags:

Are fewer than 75 percent of shares held by institutional investors? Your own mileage may vary, but this is a hard and fast rule for me. In fact, I draw the line closer to 90 percent. Biotech stocks with a huge retail fan base almost invariably deal in hype, hope, and little else. I actually can't think of any long-term exceptions to the "stay away" rule, though maybe some are out there. But you know what? If all the "smart money" turns out to be wrong—if that institutionally shunned stock turns out to be winner—professional money managers will happily acknowledge it. Go ahead and buy after the institutions come in.

Did it come public through a shell or by reverse merger? Fans of reverse mergers (that is, the lawyers that facilitate them) like point to some successful companies that came public that way, like Waste Management or Blockbuster Video (which was at least successful for a good long while). What they don't mention is that these companies merged into strategic assets, not empty shells. The chances of finding a successful biotech this way are slim indeed. You'd think that with the biotech IPO window open wide, there'd be less call for reverse mergers, but they actually jumped in 2014. Don't do it.

Orange Flags:

You really don't want to be stuck with a company that is out of cash. Assuming the company is not yet profitable and is actually making some clinical progress, it will burn through cash at an alarming rate. However, that may be okay if the company is close to a make-or-break event (and you're already ok with that risk). Also, companies in good positions to raise cash will do it whether they need to or not. Bluebird Bio's recent decision to raise cash after seeing its stock double over a one week period in December, for example, is management being smartly opportunistic. But don't count on financing always being easily available. Bluebird Bio's first incarnation was Genetix Pharmaceuticals, and it spent years in virtual limbo when funding around gene therapy dried up.

Does management just love to issue press releases? You know the ones--announcements touting the success of in vitro work or clinical trials involving single-digit numbers of patients. Then there's the talk of multi-billion-dollar market opportunities the company's product can never really hope to address. Or the promises or near-promises of outcomes the company can't guarantee. Look for the use of words like "stunning," or "breakthrough" (outside an FDA Breakthrough Designation)... You get the picture. The only reason this is an orange, rather than red flag is that there are certain circumstances when announcements concerning clinical results in very small numbers of patients are legit. But the management's tone should be measured and sober nonetheless.

Yellow Flags:

Is it led by the scientific founder? Look, there are some great companies led by scientific founders—I'll admit to being partial to Isis Pharmaceuticals, for instance. But biotech is a business, and the skills necessary to become a great lab investigator aren't the same ones that will make a company a success. Add in the ego that leads someone to maintain control of the company they founded based on their own discoveries and...well, it should raise your hackles just a little. Never say never; just exercise some extra caution.

Are the VC backers successful vets of the industry? This has actually become an easier question to answer in the past few years, as many of the firms more tangentially involved in biotech have had their heads handed to them and gotten out of the sector. But if you don't recognize the names, that's a warning sign. This is an area where it doesn't pay to be a contrarian—the same familiar casts of 15 or so characters is who you want to see, again and again.

Is the technology validated? By this I mean, is there something besides the company's own word to indicate that this drug or technology has value. That typically means a licensing deal, joint venture, or profit-sharing arrangement with a deep-pocketed partner. Although getting to or near market with all rights to a drug can be a blessing, make sure you understand how or why that happened. A related situation occurs when a drug was once partnered but then returned. Again, there are cases where that's a boon for the smaller partner, but it means you have extra digging to do.

Is the company located outside a biotech hub? Look, I support efforts on the parts of many state and municipal governments to foster homegrown biotech sectors. Nor am I suggesting that, say, NewLink Genetics (Ames, Iowa) can't be a wildly successful company—I hope it will be. But I give extra scrutiny to companies located in unusual areas. Companies outside biotech hubs lack some of the infrastructure, the talent, and the industry interaction that benefits companies in San Diego, the Bay Area, Cambridge, Mass., and so on. As Craig Venter once said, the raw materials for a biotech startup are really smart people. Some areas have just built a critical mass of them.

Are you basing the investment on a phase II success? This can absolutely be a winning strategy, but it is also a tricky one that needs to be taken on a case-by-case basis. Data suggest that only about 32 percent of drugs entering phase II make it to phase III. Then from phase III, about 60 percent make it to regulatory filing. So a lot of risk gets taken out after a phase II trial. Good, right? But there is a huge variability in the quality of phase II programs, and small, cash-strapped companies in particular often feel pressure to take shortcuts that will get them more quickly into pivotal trials—say, arriving at a dose based on too few patients only to find that safety issues look in a larger population. Phase II studies also often measure markers or surrogate endpoints while phase III measures real outcomes. For some diseases, that works out pretty well. For others...well, just ask anyone who has backed a lot of Alzheimer's drugs.

There are plenty of more things to evaluate in your due diligence, of course, but you could do worse than to start off with a quick pass through this checklist. Happy investing!

-Karl Thiel

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