5 Golden Rules to Follow for Successful Biotech Investing
– Bret Jensen, Editor, Biotech Gems
“The young man knows the rules, but the old man knows the exceptions.” – Oliver Wendell Holmes
The high-beta biotech sector is one of the most lucrative but also most volatile areas of the market. It also regularly alternates between sheer exuberance with massive rallies and manic depressions triggering frequent bear markets. The only way to survive and to prosper in this sector of gold mines and minefields is to remember these five golden rules which I have developed over two decades of successfully investing in this industry.
Proper Allocation:
“Don’t got the stones? You ignorant punk. I play for money. I owe rent. Child support. I play for money, not the world series on ESPN.” – Joey Knish (Rounders, 1998)
It seems every time the biotech sector rallies, investors soon forget the massive pain inflicted on them in the last bear market. When biotech declines it always hits the small caps of the space, especially the developmental firms with no approved products, the hardest. These are often the names that then rise the most in the next bull market.
The large cap industry heavyweights like Amgen (NASDAQ:AMGN) and AbbVie (NYSE:ABBV) that always decline the least in any big sell-off across the sector because of their strong cash flow, reasonable valuations, recurring revenue and earnings growth, strong balance sheets and deep pipelines are soon forgotten as investors chase the new “hot thing”. In order to avoid the inevitable big declines that will occur in small caps the next time a new bear market occurs, investors should always have at least 50% and up to 75% of their overall biotech holdings in these stable and less volatile large cap names, depending on their own risk preferences.
Taking Profits:
“See, I had this picture in my head. Me sitting at the big table, Doyle to my left, Amarillo Slim to my right, playing in the World Series of Poker. And I let that vision blind me at the table against KGB. Now, the closest I get to Vegas is west New York, driving this lousy route handed down from Knish…to rounders who forget the cardinal rule…Always leave yourself outs.” – Mike McDermott (Rounders, 1998)
I can’t tell you how many times I have watched an investor, myself included, buy a $5 stock at the beginning of a bull market and watch it go to $15 or $20 without taking a single cent of profit off the table. In the next bear market, often that same stock is back down to $5 a share again leaving the investor with a horrid feeling even though he is basically even.
The only worse feeling is selling out completely of a triple or quadruple-digit winner and then watching that small cap stock become the next biotech juggernaut. Given these extremes, I have devised a profit taking strategy to mitigate the possibility of making either mistake. I call them not immodestly the “Jensen Rules”. They go like this.
If you buy 1,000 shares of a small cap stock:
- If the equity goes up 50%, sell 100 shares.
- If the stock doubles, sell another 200 shares.
- If the shares triple, sell another 200 shares.
You have now locked in a guaranteed profit even if the stock goes to zero. You also have 50% of the original stake riding on the “house’s money”, one of the best free rides there is.
If It Is Too Good To Be True….
“And there is no such thing as a no sale call. A sale is made on every call you make. Either you sell the client some stock or he sells you a reason he can’t. Either way, a sale is made, the only question is who is gonna close? You or him? Now be relentless, that’s it, I’m done.” – Jim Young (Boiler Room, 2000).
Although 50% to 75% of everyone’s biotech portfolio should be in the large cap stalwarts of the industry, 90% to 95% of the scores of questions I field on the sector in a given week always involve the small cap names of this area of investing.
This makes sense. What investor does not want to catch the next five-bagger or make a 60% premium when a small cap like Relypsa (NASDAQ:RLYP) gets bought out by a larger player? There are also myriad small concerns that although speculative have attractive risk/reward profiles.
However, this part of the market is volatile enough without chasing even more risky opportunities. These include companies that have been on the public market for 10-20 years and still have not delivered any products or success to their shareholders. Even riskier are those plays with less than a $25 million market capitalization or listed on the pink sheets.
The other day I got an email from a gentlemen who wanted my advice on a 30 cent a share stock with a $15 million market cap that was developing the next “big thing” in erectile dysfunction. His reasoning was that since the stock was only 30 cents a share, what was the downside? Well, $10,000 invested in a 30 cent stock that goes to zero ends up being the same loss as $10,000 in a $10 stock that goes to zero using the math I learned in finance.
Buying these types of stocks is like buying a small gold mining stock on the Toronto Exchange or betting on the newly-minted Los Angeles Rams to win the Superbowl, they could hit at long odds but in most cases they will disappoint.
Knowing When To Double Down, Knowing When To Fold:
“Maybe I am not such a high-class piece of property right now, but a 25% slice of something big is better than a 100% slice of nothing” – Fast Eddie Felson (The Hustler 1961).
This is one of the toughest things to learn on your way to being a successful biotech investor. If a large cap “core” stock in the sector has a decent decline within a down market, it is relatively easy and usually correct to add a few shares to your holdings. The same is true in small cap growth names or “Tier 2” stocks with recurring revenues and earnings. Even “Tier 3” stocks that aren’t profitable yet but have approved product(s) like BioDelivery Sciences (NASDAQ:BDSI) are buyable on significant dips.
The hard part is knowing when to double down on the “Tier 4” stocks that are strictly developmental concerns. For the most part these types of stocks are binary plays. They either work very well or they implode. Drug discovery is just a very tricky business leading to many “home runs”, an occasional “grand slam”, and many “strikeouts”. Throwing good money after bad is one of the easiest ways to negatively impact the performance of your portfolio.
A perfect example happened after the bell Wednesday on Cerulean Pharma (NASDAQ:CERU) which dropped some 55% after announcing that its lead product candidate failed in a Phase II test against kidney cancer. The company then soon after said it was laying off nearly half of its employees while it ponders its “next steps”. Although the stock is trading not too much above its cash balance, I am going to wait for a slight bounce and then exit this position and take my lumps.
However, there are exceptions to every rule. The same day Cerulean announced its likely journey to irrelevance, Portola Pharmaceuticals (NASDAQ:PTLA)also got bad news that caused its stock to drop some 30%. Its much-anticipated drug Andexxa, which would have been its first approved compound, got a complete response letter (CRL) from the FDA.
However, most of the issues raised in the letter were around manufacturing of the compound, not the drug itself. Although disappointed that management did not have its “i’s” dotted and “t’s” crossed, this does not seem like a fatal blow to this important niche drug getting approved, just a disappointing delay. I added to my holdings at $19.11 a share in yesterday’s trading as the result of that outlook.
Keeping Your Emotions In Check:
“Gillom Rogers: Mr. Books, how is it that you have killed so many men? My spread was not that much bigger than yours.”
“John Bernard Books: First of all, friend, there’s no one up there shooting back at you. Second, I have found most men aren’t willing, they bat an eye or draw a breath before they shoot. I won’t.” – The Shootist 1976, John Wayne’s last movie.
After college, I spent a year making a living in Las Vegas playing $10/$20 limit Hold’em. It was a great learning experience and formed some of the beginning foundations of being a successful investor in biotech.
I certainly wasn’t the most experienced poker player or for that matter the best. However, I made a nice living at the tables because I learned to be disciplined and keep my emotions in check. I even won a couple of decent sized tournaments. In that time, I saw way too many and in many ways better Hold’em players alter their play because of how the cards and their luck were running.
Solid professional players would throw away good hands they usually would play aggressively because they were on a “bad beat”. They also would throw money into the pot chasing very marginal hands when they were on a roll. Neither was a good strategy over the long term.
The same thing happens with biotech investors. When times are good and the sector is rallying, their allocation to speculative small cap stocks gets way too high within their portfolios and they pay the price the next time the Bear rears his ugly head again. Near the bottom of bear markets they tend to be mostly out of the market, too scared to buy an attractive $10 small cap stock they would have happily bought for $20 or $25 when the entire sector was rallying.
It is critical if one is to invest in this space successfully to remain level headed. Your goal is to beat your benchmark over time. Try not to look or be influenced by the day to day, week to week, or month to month volatility in this high beta sector. Keep your discipline in up and down markets.
My goal is to beat the performance of the largest biotech ETF, the “IBB” within my biotech portfolio over time. The Biotech Gems portfolio which copies my own biotech holdings has done that since launch in May of 2015. Although biotech has been in a bear market for a good portion of that timeframe, our portfolio still beats the benchmark by a wide margin.
If you remain disciplined and apply the 5 golden rules I have outlined above, your biotech holdings will profit from this hard-learned knowledge I have gathered over my investing career.
“You have to learn the rules of the game. And then you have to play better than anyone else.” – Unknown