Forewarning, this essay is basically just 1,800 words explaining why you should light your money on fire instead of investing in junior biotech firms.
I’m a structuralist when it comes to markets. In my mind the pipes and wires of the system account for the bulk of market movements. Or rather that markets move in accordance with the strictures of the governing – for lack of a better term – algorithms. I don’t mean literally a series of code – though code is certainly involved here – but rather a set of logical parameters embodied in computers, humans, and the nexus in-between.
That likely sounded like a bunch of mumbo jumbo but let me explain.
Imagine that you are a lowly equity research associate at a shop like Morgan Stanley. Your coverage universe is something like consumer-packaged goods. You hold in your hands a valuation model that’s been handed down from generation to generation of underlings. The inputs are simple enough and are applied to the P&G’s of the world equally. You have the three forms of valuation: a type of discounted cashflows, precedent transactions, and comparable multiples. It ain’t exactly rocket science but people read your team’s reports anyways.
At some point in the model there is the most important calculation – that of the cost of capital (or WACC for the nerds in the back). As a shiny equity research associate, you’re going to mix the risk-free rate with a market risk premium and then discount future cashflows accordingly with the output. Now, obviously discounted cashflows are just one type of valuation. However, if you look at the other two forms of valuation you realize that there’s no there there. Instead, those valuations are second, third, fourth – or what ever ordinal you want to use – order derivatives of the discounted cashflows. In a sense, what happens is that one often starts with the cashflows and then applies alchemy to justify any given figure as presented in the market presumably in response to hubris and sentiment. Think of it as valuation by gut check. Or as they say on the streets ‘slap a multiple on it and see who bites’
Where’s my evidence for this? Simple. Look at what happens when the Fed raises rates. What is the most impactful – for finance jabronis – result of the Fed raising rates? The risk-free rate component of the cost of capital equation goes up. As the rate goes up, the net present value of the cashflows come down. At the same time equity valuations start to fall across the board (minus a few great ones). Sure, there are macro factors that influence movements, but to one extent or another, the risk-free rate is an indicator (albeit lagging) of the macro-environment. The cost of capital equation in turn, is where the macro enters the framework of professional finance. Get it? Sort of? Anyways, it’s not actually that important except as the counterpoint to where we’re going here.
So there, I’m a structuralist. As such I think models are the tail wagging the dog. Although I can’t prove my position since it’s a matter of epistemology as opposed to science, I feel comfortable enough given that it would seem to jibe with the sociologist Donald McKenzie’s work An Engine, Not a Camera which despite my best evangelism no one ever seems to read. However, the structure only works most of the time. Sometimes the structure is secondary. In these cases, expertise is what matters, and it is here that wild shit happens. It’s also where the frauds and scams dwell.
Now, there are only a few sectors that consciously rely on expertise as opposed to the exclusive reading of tea leaves. Junior exploration and production companies in the oil and gas sector would be such a world of expertise. However, the oil and gas markets are so large that resources, studies, and interest have flowed into them over the past century at such a rate and size that folks more or less know where the reserves are at. They’re located in moderately well understood basins.
The issue is not that oil is hard to find, it’s that cheap oil is scarce. Only with advances in technology like horizontal drilling and hydraulic fracturing do untapped basins get the old moar drilling razzle dazzle exhibited in exhibit 1 below:
Although the junior O&G sector requires expertise for risk management purposes. The market is generally large enough for there to be informational transparency in terms of prospects. At the very least, if someone walks out saying ‘shit man I’m gonna drill in the exurbs of Trenton, New Jersey’ you’re going to ask some questions. The same cannot be said for fields like mining and biotechnology though to very different degrees.
If I asked the average person on the street whether they thought a mining company searching for gold or a biotechnology firm looking for a diabetes treatment were a riskier investment I’d bet that about 97% of respondents would choose the mining company. Why? Because they literally have to strike gold. But the answer is that the biotech firm is further up shit creek than the pick swinging boys.
Mining companies have the benefit of knowing that there is gold out there somewhere. In contrast, the biotech companies have no idea whether or not an effective cure is available or possible. Furthermore, following scandals like what happened in Canada with Bre-X, there’s at least paperwork required for public disclosures around mining companies. Thus, giving some level of insight into an otherwise opaque world. But even with an NI 43-101 (for Canadian firms) in hand, you’re going to need somebody with moderate amounts of expertise to understand the true risk profile of an investment.
With biotech though, the shit is off the walls. Especially in the medical sub-sector. Why? Because there’s a lot of MDs and PhDs involved. Sure, the mining companies have Professional Engineers and Professional Geologists on board, but we all tend to discount those specialties here because – come on – they ain’t doctors. Whether a real doctor or a ‘real’ doctor (if you know what I mean), we expect that they know what they’re doing.
In reality though, biotech – we’re just focusing on the medical side from here on out – is an absolute crap shoot for everyone. There are at least three sources of chicanery that come with the biotech space. The first is that junior firms (we’re ignoring the big boys here) go public in anticipation of creating a product. It’s expensive to bring a drug to market and as such they need to tap public market to get through the clinical trial process. The second source is the clinical trial process itself. At several stages along the way the CDC – or other regulators depending on jurisdiction – can step in and say that the treatment fails to meet efficacy and safety standards. The last source is that treatment discovery does not occur in a vacuum. At any one time there are several competitors racing for market entry. The first to market is the first to capture name recognition via branded marketing campaigns aimed to health care practitioners.
Safe to say that there is a lot of red flags with biotech. The upside risk here is that the winner gets a patent for several years that allows them to charge insurance companies – and governments – a literal boatload. Yet as far as investing goes it’s a wild goose chase where other forms of due diligence simply fail. Or, put differently, biotech investing is more a form of consumption (like angel investing) than investment per se.
Traditional modelling methods do not work with junior biotech firms because there’s no representative cashflows occurring. Furthermore, success and failure is a binary option at each stage of the regulatory process. Would-be investors are stuck using the generic VC methodology of looking at the addressable market and then discounting that value based on the pedigree of management teams. Hence why seemingly every NASDAQ listed junior biotech firm has a CEO or Chairman who has a track record of taking another firm to the commercialization stage and then selling to the Pfizers, Mercks, and UCBs of the world.
The problem with this approach is that it is effectively nothing more than survivorship bias. Nobody at these firms knows whether or not the treatment is going to work out with any meaningful level of likelihood. Instead, it’s a series of folks who have lasted through a couple rounds of Russian roulette with their skulls intact.
Let’s look at two examples in the news today. The first is Rigel Pharmaceutics. The second is Tiziana Life Sciences. If you look at either of the firms’ management teams they are more or less equally credentialed and experienced. I’m sure everyone involved on both sides are good people who work hard. Yet, Rigel’s stock is down around 50% today on news of negative results from a phase 3 clinical trial while Tiziana is flat to up based on a SECOND patient having a good time with its MS treatment. What’s difference maker? Luck and time. Rigel went up when phase 2 went well and now the roll of the dice went against them. Nothing more, nothing less. Sometimes the shit slaps. Sometimes its just shit.
What we see in both of the firms mentioned above is that credentials and experience do not matter much in the wake of the reality that is the junior biotech experience. Yet, investors are more than happy to throw a fair amount of cash into the fray. The investment bank HC Wainwright makes a good penny focusing on the biotech space and hosting investor conference. JP Morgan does the same every year. But at the end of the day, expertise really doesn’t exist in the biotech space since even the world’s greatest pharmacological scientist/physician can’t know whether or not a development path is a good idea or not. Instead, it’s high risk consumption that leads to pump and dump bot/trolls like the following:
What’s the take away here? Well, it’s more or less that there exists a spectrum of due diligence effectiveness. On one side you have traditional valuation modelling that, more or less, anyone can do. As such, the likely alpha you’re going to get is limited because everyone has the same models with slightly different inputs. They all move in the same general direction though. In the middle you have sectors where subject matter expertise comes into play. Oil and gas are a weak form of this while mining is of the stronger sort. Expertise matters here. But then you have the junior biotechs. Here, expertise ain’t worth shit. If you have a firm with a smattering of MDs and PhDs alongside a modicum of experience and subject familiarity then you have cleared the only hurdle towards respectability. At which point it’s all about riding the lightning as opposed to anything else.
End Notes:
Since nobody asked for it and presumably nobody cares I’m slapping in my ongoing reading pipeline for shits and giggles here.
Just finished: What is Philosophy? by Dietrich von Hildebrand
Currently Reading: How the World Really Works by Vaclav Smil
Up Next: Feeding the World by Giovanni Federico