Monday, September 3, 2007

Choosing a Biotech Stock 1: Overview

September 3. Earnings reports for Q2 are mostly over except for the occasional firm with the odd fiscal year. Q3 does not end until September 30 for most companies. There will be some news, of course, and market fluctuations, of course, and maybe even some profit warnings. Basically this is a slow spell looming before me.

But I do have a project you might be interested in watching. I need to pick a new stock to invest in, and most likely it will be a biotechnology stock.

Note this is not "choose the best biotech stock for investors in general." There is no such thing as an investor in general. There are investors who have no biotech stocks and have decided to start accumulating some, including new investors who have no stocks at all. There are people whose main strategy is rotating sectors. There are people who like to spread out risk, and those who don't mind concentrating it. While my needs are very specific to my own portfolio and situation in life, I will try to illuminate factors that investors should research and consider when picking stocks, particularly biotechnology stocks, which have some peculiarities.

So first, how did I get here. Much as I would like to tell the story of how my grandpa lost his farm in a poker game and bring that on up to the present, let's just look at the current situation. I've been doing research for sophisticated investors for a few years now, and before that had a fair amount of experience in IT and other industries. I have a portfolio that currently contains only nine stocks: MCHP, RACK, MSFT, NAPS, AMD, and MRVL are in the IT camp. In the biotechnology camp I have only CELG, DNDN, and ANSV. I have some cash in my account I want to convert to stock, regardless of which direction the market takes short term. In the other hand I have some cash reserved for use only if a panick results in further bargain shopping opportunities. While I would never absolutely rule it out, I don't leverage investments with bets on stock options or even with buying on margin.

I think some biotechnology stocks are going to be worth a lot more money (better than market returns) in a few years than they are now, and may make me filthy rich if I live to see the long run. I could spread the risk out by buying a lot of different biotechs, or going to a fund. But, well, while I would recommend a fund to anyone too lazy to do their own research, the problem with spreading risk broadly is that you can't get any alpha (profits above typical market) that way.

Couple of other things. I aced Biology in high school. I worked for a biostatistics company in my youth. I spent a couple of decades writing novels and short stories, which is why I am not rich yet. Having fallen behind on biochemistry since high school, I am chewing my way through books with titles like Biochemistry, Cell Biology, and Molecular Biology of the Gene. You can pick these kinds of books up, only slightly out of date, used and cheap. Beware that there are management teams out there with listed biotech stocks that are not entirely honest with investors about matters of human chemistry and statistics. Also be aware that the FDA drug approval game is something like poker: a good hand is better than a bad hand, but it still may not be a winning hand. On the other hand a not-so-great hand can win if it is the best of the lot.

I have been following a number of biotech stocks at least to the extent of listening to their quarterly analyst conferences. I am familiar with their currently marketed drugs and their pipelines. These stocks are AMGN, BIIB, DNA (Genentech), GILD, and ONXX. All of these are good companies. I also follow some biotechs for a client that specializes in bottom fishing very high risk companies; these are not for me, or anyone that can't put together and follow a very diverse portfolio.

Among the stocks I follow the two I lean towards are BIIB and GILD. I'd be fine buying either, and that would save me a lot of time. But I like doing research; it is fun; I have the time. So what am I looking for? A stock that has good appreciation potential both over a short time frame (up to two years) and a long time frame (2 to 20 years). In the long time frame the most important factors are technology and management. I the shorter time frame the single most important factor is stock price. I want something that is clearly undervalued today. That provides the kind of safety net I like.

I try to think in terms of probability spreads. For example, stock B has a 10% chance of crashing (a better drug comes out, or a unexpected safety concern arises), a 20% chance of muddling along, a 50% chance of doing well enough to make me happy, and a 20% chance of major upside. Thinking there is only one path a stock can follow is a fools way of investing. Even if you are wrong with your probabilities in a single stock, you aren't very likely to be far wrong in your overall portfolio.

Keeping all this in mind, I am going to start researching stocks. The next installment of this series will probably be an analysis of BIIB or GILD. That will provide a baseline. I'll be looking for biotech companies that could beat the baseline. I want a company that has top-quality science, looks competent to convert that into a truly beneficial drug or therapy, and yet has a reasonable price. I will show you how I weigh the prospects of a small company with nothing approved by the FDA yet to a successful company like GILD. How much risk am I willing to swallow? I'll let you know as we go along.

In the meantime you can find some help at my Biotechnology Investor Aids Page.

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