Introduction To Biotech Due Diligence
“Do your due diligence!”
It’s a phrase which has come to dominate the modern investing world. But much like an old rag, the spirit has been left far behind. Most people have little clue of how to follow the sacred phrase, and that sentiment rings doubly true in the volatile land of biotechnologies stocks. The biotech world has a tendency to toss out conventional knowledge in lieu of some more focused rules. Many people frequently ask me -a doctor turned novice investor- “how do I find good biotech stocks” or “how do I read financial documents” and, of course, the ever popular “what does this data mean!?”
Perhaps it’s altruism that made me write this little introductory guide to biotech due diligence. A way for me to help those I see struggling where my memories would remind me of my failures.
Either that or I just want them to stop asking me questions all the time.
As the Hippocratic Oath (or would it be hypocritical oath in this situation?) urges me, I’ll settle for the former of those two truths.
Finding A Biotech Company
Go to Biopharmcatalyst’s FDA Calendar and sort by catalyst date.
This is a broad net to start, no doubt, but it needs to be at the beginning. We’ll tighten it down as we go along after we’ve picked some interesting drugs that catch our eye. Now I tend to recommend people who have little knowledge of drug research to just sort by the catalyst dates and start looking from there, jotting down ones that are within his or her price range. Why within a specific price range and why the nearest catalysts?
Most people enjoy being able to buy lumps of shares at once instead of slowing adding over several deposits. This is mainly because a higher share count will allow a person more flexibility to sell off and lock in a specific dollar value of their gains.
Choosing from the nearer catalysts than the further is mainly for keeping interests high. Biotech stocks have a tendency to move relatively horizontally until their catalysts come up and having so much cash tied up in a horizontal stock can be cumbersome at times. A person only needs to scope out distant catalysts when seeking Long-Term-Capital-Gains .
After a list has been compiled, go down it and visit each company’s website. Within these websites, look for the tab or link that says ‘Pipeline’. The pipeline will show what sorts of products the company might be working on or planning to work on while also giving a general overview of each product. Most of it will be positively oriented –no surprise there- so take it all with a grain of salt for the time being.
After one has acquired a general overview of the drug and have chosen one which catches his or her eye, it’s time to move on to the next step.
How confident does management seem to be in their product?
Management confidence is the amount of vested interest the top brass of a company has in the success of said company. Basically it is how much the owners care about being successful.
Now this might come to a surprise since many people think a CEO would naturally want what’s best for a company, but that isn’t true in all situations. This article by Forbes goes over a research study that showed how the highest paid CEO’s had a tendency to bring the worst performance.
This is because the best CEO’s weren’t paid in salary, they were paid in stock and other equities! This makes sense when one thinks about it as well, does it not? The best CEO’s tend to be the ones who have the most amount of skin in the game, so to speak.
So when one is reviewing a biotech company, make sure the CEO and the CMO own a relatively large amount of shares in the company.
First, go to nasdaq and look up the company of interest’s ticker.
Scroll down and look for the “INSIDER (SEC FORM 4)” tab on the left-hand side and click on it.
And there you go! You now are now looking at a company’s insider transactions and history.
A higher degree of selling compared to buying can be a red flag, but it isn’t apocalyptic. A massive red flag would be the CEO or CMO not having any shares whatsoever.
Now that you’ve done that, it’s time to move onto the next step.
Understanding the financials behind bio-technologies companies follows a slightly different trend from most other industries or sectors.
It’s not quite as in depth as it might be elsewhere. What do I mean by that? Well let’s take a look by explaining the process in some detail.
First things first, let’s find these financial documents known as “earnings reports!”
Go to the SEC’s website and use the EDGAR system to look for your company. Searching by ticker here is usually the fastest and easiest method.
From here, look for the search box titled “Filing Type” and enter either 10-k or 10-q.
10-k for an annual and more in-depth look at the company and its operations
10-q for a more recent view of their financial status
Once you’re there, choose the most recent filing, and open the PDF file.
The astute observer will notice that there isn’t much going on in these filing. At least compared to other corporations in other industries.
Most biotech companies don’t have a single revenue stream because getting a single drug to market is incredibly difficult. Each one is a struggle that takes a massive investment. So the plan is simple; check the ratio of cash on hand to the rate of cash they burn.
It’s very likely the company you look at will be running deep in the red, don’t panic! Running in the red is normal so relax and just go back a few quarters. You want to check how much they usually seem to burn on a quarterly basis and make sure they have the cash to get through their nearest phase trial. Supposing they don’t, it is very likely they will have to dilute shares to raise capital.
If you’re having trouble at reading financial filings try reading the 10-K form instead. 10-K’s read more like big textbooks on the company and can be easier to swallow for some.
With the financials out of the way, it’s now time to move onto the most important, and difficult step of biotech due diligence…
Without a medical background, this step can be a bit difficult.
The average person will struggle to truly understand the research papers that get released or the phase studies as they come out without some help. Getting a doctor or two to talk to and discuss the studies will be the most recommended strategy here. If you don’t have doctors to discuss the findings with, find one.
Of course, ever elusive doctors may be, so here are some general tips and questions that can help you do your solo-research.
Important Questions To Answer
- Is the drug ground breaking or best in class?
- If the drug isn’t making a new market for itself or beating out the competitors in an existing one, it won’t bring in cash. And as the saying goes, “if it doesn’t make dollars, it doesn’t make sense.”
- Is there controversy surrounding the drug?
- Controversy has a tendency to bring in lawyers. Lawyers aren’t doctors and bringing more of them into the development of a drug isn’t exactly a good thing.
- Have other companies tried to develop the same drug but failed?
- Many companies failing to fully recognize a drug could mean it’s just difficult to make. That puts a damper on the possibilities of successful phase trials.
- Is this drug even needed?
- If no one needs it, it won’t bring in money, obviously.
On top of these simple questions, another easy way to check if data from a phase study went well is to look at the P-Value, the primary endpoint, and the secondary endpoint.
The FDA considers a P-Value over 0.05 a total FAILURE! I’m also wary when P-Values get close to 0.05, such as 0.045. So look for as low a number as possible.
Now from here, we come around to the end of our due diligence for biotech companies.
Valuing other sources can be difficult, especially when used to draw a general consensus of how people view a stock. Stocktwits, for example, is great for finding links to factual information, but terrible for rumors. It’s a great place to get all conference call transcripts, sec filings, and the latest news!
It runs its usefulness at around that point. Be wary when they mention price targets, any upcoming partnerships, buyouts, etc. Mainly since Stocktwits attracts possibly the worst crowd of investors; the ignorant kind. I like to go there whenever there’s as conference call or an investor meeting and I am unable to listen in as there is typically a play by play. Aside from that, I just take it all with a grain of salt.
Twitter is like Stocktwits and there are some people I follow there. Search your stock ticker and see if anyone has said anything about it, and see how credible they are. Follow on your own risk. It’s very similar to Stocktwits as a whole.
Disclosure: I’ve written a very basic “how to” on biotech due diligence. As many of you are, I am not an expert on biotech companies, and I spend hours researching and reading about these companies before I take a position in it. Please feel free to do your own due diligence and make your own choices.