Before I get into evaluating stocks, I thought I’d talk today about my strategy for investing in small/startup biotech companies.

Drugs/Platform-High Probability of Success

Well, clearly this is the most important thing to evaluate and it’s where I’ll spend most of my time (then again, I’m a scientist, so maybe I’m biased). If the drug gets FDA approval, chances are really good that the stock is going to go up. So, we’re looking for drugs that will likely get approval, but we’ll still have to confirm that the drug has the chance to make money. If it’s got no competitor, great, but more likely we’ll have to figure out how much market share the drug can take if it’s only slightly better than its competitor; anything else is gravy.

We’ll take a look at the pipeline too, but companies don’t usually provide much information about drugs they have in the pipeline. We definitely want to invest in companies that have potential upcoming dugs, but they’re a long shot and years away at best, so drugs not currently in clinical trials won’t be counted towards potential share price. In short, we’ll count the lack of a pipeline as a strike against the company, but you don’t get any credit for having someone warming in the bullpen.

People-Money Before Brains

Now, you’d think that the most important thing in terms of management was how smart they are. While that’s important, and we’ll certainly take a look at it, I’m more interested in how invested the top management people are in the company. If their shirt is on the line, I figure our interests (share price) will be aligned. After a stock purchase, this is something to keep an eye on. If you see insider selling, it’s a good idea to reevaluate your position. On the other hand, if you see them buying more shares, it’s a sign they have confidence in their potential product; you might want to have a second look and add to your position.

Financials-Burn Rate Is King

Since the companies I’ll be evaluating generally don’t have any profits, the number one criteria for evaluating their financials is their burn rate. If they don’t have enough money to last until they get their first drug to market, they’re going to have to get more financing (by taking on a development partner, selling the rights to the product, or by offering more shares). This usually results in a lower share value because of the loss (or dilution) of the potential profits.

Bringing It All Together-A Formula

So assuming no red flags have popped up in the above sections we can use a simple formula for figuring out stock price:

(Drug market * Expected market share * Chance of getting to market)/ total shares=Expected earnings per share

Expected earnings per share * expected PE = Buy price

If the actual stock price is lower, then it’s a buying opportunity. Does that mean you should buy? Well, maybe, but maybe not. The two I put in bold are basically educated guesses. You have to feel comfortable that your guesses are correct. Also, you need to balance your risk. If a drug has a 5% chance of getting to market, it doesn’t really matter if it’s a current bargain, because it’s still a long shot. The law of averages says you need to invest in a lot of those (about 60) to make sure you’re going to make money.

Next up on babybiotechs.com: Synta Pharmaceuticals

Filed under: Investment Strategy