Author: Jeremy Zhou
Covestor model: Biotech and Medtech
Disclosure: Long TSPT
While the details could be different, the mechanics and mental exercise are essentially the same when trading Biotech stocks. I’ve distilled the process down to five steps, and I’ll use Transcept Pharmaceuticals (TSPT) as an example.
First, know the timing of the catalyst event. In most biotech life cycles, there are always several defining moments that could make or break their valuations–and a Federal Drug Administration approval event is arguably the most important. For Transcept, traders could have anticipated the November 23, 2011 decision by the FDA to approve the insomnia drug Intermezzo about a year earlier based on guidance in the company’s third quarter release in 2010.
Second, know the risk by calculating the downside. As of 11/11/2010, Transcept had $62 million net cash and a market capitalization of $80 million, which translated into a downside floor of about 20%. In other words, no matter what happened to the FDA decision outcome, it’s unlikely that Transcept could trade below its net cash value.
Third, know the reward by calculating the upside. To do this, one simple way is to look up the best selling drugs approved for the insomnia indication, which was what Transcept was pursuing.
Sanofi’s (SNY) insomnia drug Ambien generated an average of $1 billion annual sales for the previous three years, and if Transcept’s drug were to achieve only one-tenth of Ambien’s sales, that would mean $100 million.
But since Transcept signed away its insomnia drug rights to Purdue Pharma, it would receive only about 20% of the sales, or $20 million. Most of this $20 million (assume $15 million) could fall straight to the bottom line as earnings because Transcept didn’t need to incur a lot of the costs of sales and marketing.
Multiply this $15 million by an extremely conservative multiple of 10 (i.e. P/E = 10) would yield a market valuation of $150 million. In conclusion, Transcept could be worth about $212 million in market capitalization ($150 + $62), or an upside of 165% from its then $80 million market capitalization.
Hence, after going through Step 1 to 3, one should have a good idea of what’s the desirable price range to buy on or around 11/11/2010. For Transcept, it’s between $6 to $7 per share, or $80 to $94 million market capitalization.
Fourth, know the key clinical trial findings about safety and efficacy. For Transcept, its insomnia drug had been shown to be equally safe and effective as other approved drugs. This knowledge is of the utmost importance because as the FDA approval date approaches, media releases would become increasingly manipulative and biased, often negative, but sometimes positive.
Fifth, know when and how much to sell, and act on it. No matter how certain you are that the drug will be approved, always sell some before the decision date. Generally, I sell 70% to 80% of my total holdings one to two weeks prior to the decision date. The reason is simple, if the drug is any good, a lot of the upside would have been priced into the stock; if the drug is no good or mediocre, the reverse happens.
One could have purchased Transcept at around $6.50 per share in November of 2010, held, and sold at $9 to $10 one to two weeks prior to the 7/14/2011 FDA approval decision date, for a 40% to 50% return in seven months. This pattern is not unique to Transcept but rather quite common among Biotech stocks entering the FDA approval decision pipeline.
Disclosure: Any investments discussed in this presentation are for illustrative purposes only and there is no assurance that the adviser will make any investments with the same or similar characteristics as any investments presented. The investments are presented for discussion purposes only and are not a reliable indicator of the performance or investment profile of any composite or client account. Further, the reader should not assume that any investments identified were or will be profitable or that any investment recommendations or that investment decisions we make in the future will be profitable.
