Ignorance is bliss, as they say.
I'm not convinced of that, but it sure is comfortable – right up until the moment your speculative biotech/medical company crashes because its tests were unsuccessful, or it ran out of money.
A little while ago I wrote a three-part overview of the major risks associated with biotechs, but in the light of recent activity at the likes of Prima BioMed Limited (ASX: PRR) and Prana Biotechnology Limited (ASX: PBT), I thought it might be time for a recap.
(You can follow the links to read Part 1, Part 2, and Part 3 of my earlier 'risks of biotechs' series).
The risks of investing in speculative biotechs can be broadly split into two categories: development, and financial.
'Development' risk – for want of a better word – refers to the risk that a company's product, therapy, implant, or device is not significantly better than existing treatments for a particular condition.
(The word 'significant' in this context has a special meaning – it means that the results can be accepted as due to the treatment itself, not a chance occurrence. In medical research, a 'significant' result usually has less than a 1% probability of being due to chance. 'Significant' doesn't refer to magnitude; results can be 2% better than a comparison therapy and still be significantly better).
It's important to remember that biotech stocks rely on investors for virtually all of their funding, and those investors need to be kept hopeful in order to keep the funding coming in. Structuring announcements to focus on the positives at the expense of the negative is almost routine.
Companies also like to remind investors of the potential of their research, which is fine, but investors get sucked in over the promise of 'someday' and conveniently lose sight of the fact that they could do just as well – usually better – out of a great company, as a biotech hopeful over the course of a decade.
Some things to keep in mind about the development process:
- There are four phases of treatment research, and a product enters the market after regulatory approval, which usually occurs after the end of phase 3
- Phases take ages! Prima BioMed took five years to generate the recently released results of its Phase 2 trials; this is not uncommon, and Phase 3 trials are typically the longest and most expensive
- Unsuccessful trials are very possible, especially in Phase 3 which involves the most rigorous testing; Sirtex Medical Limited (ASX: SRX) shares fell 57% after failure in trials earlier this year
The long time-frame and risk of failure are among the biggest risks associated with research; but they're matched by the risks to financing:
Major financial risks
- Dilution of equity from continuous capital raisings; trials are expensive and prolonged, and without a profitable product to sell, biotechs routinely run out of funds
- This can also lead to disadvantageous deals with major pharmaceutical companies in return for financing; Investors will see even smaller returns when the sales begin
- Chance of not being profitable despite successful development; Admedus Ltd (ASX: AHZ) is still posting huge losses despite the utility of its CardioCel patch
- Breaking into international markets is difficult, particularly if research on a product isn't published in that region's journals and/or primary language
- Lack of liquidity in these stocks leads to wild price swings; the hot stock of January, Phytotech Medical Ltd (ASX: PYL), has fallen to 31 cents per share, despite trading as high as 78 cents on its first day out
Lack of awareness of the lengthy research period is one of the biggest hidden risks I see investors take on. If Prima BioMed took five years to complete Phase 2 trials, it might take another 3-5 years to complete Phase 3, depending on its funding and other factors.
Combined with the likelihood of earnings dilution in one form or another, investors are relying solely on the 'greater fool' (lower case 'f') theory to turn a profit – hoping someone will buy a company from them for more than they paid.
I can virtually guarantee that buying into a biotech that recently soared is NOT the way to a wealthy retirement.
You could make money in the sector if you were supremely good at picking downtrodden biotechs, but why bother?
A company growing at just 5% per year will increase its profits by 27% in five years. Investors who achieve a 10% total return (share price appreciation and dividends) will see a 61% gain in that time.
Given that it takes far longer than five years to deliver a fully researched, marketable treatment, investors can very easily double their money with defensive stock selections during that time.
Admedus Ltd has returned 50% in the past 10 years. Prana Biotechnology Limited returned -5% in the same period. Prima BioMed Limited has returned just 24% – and that's including its recent 491% rise.
But Sirtex Medical Limited has returned 1,811% in that time, while CSL Limited (ASX: CSL) returned 859%. The key thing about those stocks is that they are delivering strongly growing profits, year after year, and investors had the opportunity to buy in along the way.
Buying a speculative company with no profits in the hope of making one is just asking for trouble.
