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Special Report

Biotech Analysts' Roundtable

After several years of treading water, biotechnology stocks are enjoying a comeback. An increasing number of biotech firms are bringing products to market, and a few companies are even generating earnings. Moreover, a long-expected movement toward consolidation seems to be underway. Firms such as Alza and Centocor have agreed to be acquired by big pharmaceutical players. The market has rewarded these changes: Over the past year, the Nasdaq Biotechnology index has risen almost 120%.

In light of this surge, on July 1, 1999, Morningstar conducted a roundtable discussion with three mutual-fund managers who focus considerable attention on the biotechnology sector. Kurt Von Emster runs Franklin Biotechnology Discovery FBDIX--a dedicated biotechnology offering. Ken Kam is manager of Firsthand Medical Specialists and a comanager of Firsthand Technology Value TVFQX (although he will be leaving his post as comanager of Firsthand Technology Value in October 1999 to start his own firm). David Carlson, a comanager with Putnam Health Sciences PHSTX, focuses his attention on the small-cap end of the health-care market, where most biotech firms currently reside.

The following is part one of our talk with these managers.

Can you outline your investment strategy? What do you look for in a biotech stock?
Von Emster: Right now, we're using a relative revenue growth model where we're looking for companies with accelerating revenues, those that are expected to beat Wall Street's revenue estimates. And then of course the earnings will come into place later. We haven't been focusing on the earnings equation only because there are less than 20 profitable biotechs. Therefore, we felt the best correlation with performance over the last year or two was relative revenue growth. With that as a background, our big positions are things like MedImmune MEDI, where they have at least one strong year behind them of revenue growth and the forward year of high Synagis growth. [Note: Synagis, a drug given to infants for respiratory infection, is MedImmune's flagship product.]

Once we've looked at the revenue side, then we back it up with checks in hospitals about usage. In the case of MedImmune, we talk to consultants in the pediatric field. And then we compare our revenue estimates to what Wall Street's estimates for the revenues are. And if we have a discrepancy of 20% or more on the upside, we figure that's a very good candidate for our portfolio.

Also, we reserve about a third of our fund for early-stage companies--those in the discovery phase--where we're looking at some human data, but it's not all too clear at that point whether the product will make it to market. From the data we've seen, you lose about 50% of your candidates between phase two and phase three of clinical trials. So for those early-stage companies, we set ourselves a base of phase two-A trial results, and if we buy a stock at that point we're only taking very small, speculative-investment positions. And then the other two thirds of our fund is either focused on things past phase three or companies with products already on the market.

Kam: I'm willing to buy the biotech companies after they have solid phase-three data, usually prior to FDA approval. Earlier than that, I think, you're basically making a bet on how the clinical trials are going to come out. I try to stay away from companies where the major uncertainty is still, is the drug going to work? I wait to see how effective a drug is and how large the patient population it can help is.

Based on those two factors, you can make your decision as to whether the main driver of value for that firm is going to move from scientific milestones to business milestones. By that I mean, once the drug is proven to work, it still has to get FDA approval, and the firm also has to scale up manufacturing facilities and then figure out a way to get the product distributed. Those tend to be business issues, which these biotech firms share in common with many other kinds of companies. You can screw up a product launch in the biotech industry just as easily as you can in any other industry. But if you have the right management team making the right decisions, you can take even a "B" type product and turn that into a solid product. Whereas if you have a great product in the hands of a "B" management team, you can turn that into a failure.

Last year and this year one of our big winners is Immunex IMNX. We'd been buying that on the strength of their clinical trial data for their drug Enbrel. But the Street largely waited until the second quarter of significant Enbrel sales to really reward that company's stock. Because we were able to buy it looking at the clinical-trial data, we were in well before the big ramp up in the price. [Editor's note: This interview was conducted on July 1, 1999. According to the semi-annual report from Firsthand dated June 30, 1999, Immunex represented the third largest holding in the firm's Technology Value fund. Indeed, during the second quarter, the managers added to their Immunex position in the Technology Value portfolio. However, the semi-annual report also disclosed that Kam sold the stake in Immunex from the Firsthand Medical Specialists portfolio. The explanation given in the report is as follows: "IMNX started the quarter at $83.50 and reached a peak of nearly $146 during Q2. The sharp rise in the company's stock price drove the value of IMNX to an uncomfortably high percentage of the total portfolio, prompting us to start selling the position." As of June 30, 1999, the Medical Specialists fund did not hold any shares of Immunex. Kam didn't mention the sale during the discussion.]

David: Just to put it into perspective, biotech right now is about 10% of what we have in the Putnam Health Sciences fund. That 10% is primarily loaded into the commercial stage companies. We look at biotech in terms of categories or stages. We have the commercial companies and then the late-stage-product companies. The late-stage-product companies would be the phase-three companies, where we've got good indication of clinical success.

We also look for companies that we feel have a credible management team--a team that has realistic aspirations about their ability to penetrate the market that they're going after. For example, if you're selling a product to general practitioners, you really don't have any chance of doing it on your own as a biotech company. Whereas if you're selling an efficacious life-saving cancer drug to the oncology community, you might have a chance. Or maybe if you're selling to a select neurology community, such as epileptologists, you might have a chance.

One thing we've noticed since the fall of 1998, is the willingness to pay significant premiums for the accelerating revenue growth of launched biotech products. I think the two examples given already, MedImmune and Immunex, are a clear indication of the premium people are willing to pay at this point for a successful, relatively open-ended growth story. We're struggling at this point in terms of how long we want to ride that trend with the valuations of Immunex and Biogen BGEN getting to relatively high levels.

What we'd really like to find is next year's Immunex or next year's MedImmune. In that case, it's a little discouraging at this point that there aren't that many late-stage, blockbuster-type biotech products. But one of the companies, for example, that has that type of next year's successful drug is QLT PhotoTherapeutics QLTI. Their drug [Visudyne] has shown efficacy in slowing the progression of age-related macular degeneration, which is a leading cause of blindness. So it's a big market and an unmet need, where the current therapies available are very unsatisfactory. There's a very receptive physician community so it's the type of drug that you might expect to have a successful first-year launch.

How does valuation fit into your investment approach? What do you do with a company like Immunex, which is currently trading at something like 1000-times earnings?
Von Emster: I think the biggest mistake most investors make is selling biotechs when they look expensive on relative-earnings basis--because these stocks have a wide variety of earnings-upside surprises that are relatively underestimated in most of Wall Street's assumptions about the company. You can sell a company that's trading at 40-times next year's numbers, but then next year's numbers go up by 30% or 40%, and all of a sudden you've sold a cheap stock relative to its earnings growth.

Kam: For me there is a role to play for valuation, and it has to do with the size of the patient population that the drug serves and the degree to which the drug is an improvement over existing conventional therapy. If it's a huge improvement, you factor in a bigger share of potential patients, and then multiply it out by the price and the expected net profits. That gives you an upper range of what kind of cash flows that drug can throw off if it were successfully managed as a business.

I whole-heartedly agree with Kurt, though, that the easiest mistake you can make, and one that I have made also, is selling a stock when its drug is already approved, because the stock looks expensive relative to conventional financial measures. You have to realize that most of the value of these companies--even after they're beginning to launch their first product--is not going to show up in their income statement or balance sheet. It's still in their clinical-trial data. That data doesn't show up anywhere in anyone's financial analysis. There is no database to screen for the value of clinical data relative to market price. It's very much a one-by-one kind of analysis.

Immunex is an example. Their drug Enbrel is for rheumatoid-arthritis patients, but only those patients who have failed all other therapies. There are 2 million people in the United States with rheumatoid arthritis, but if they first must have failed all other therapies, that might be only a half-million patients at best. But as they continue to do clinical trials, you can see from the strength of the data that it's a reasonable bet that the initial pool of patients could grow. And eventually Enbrel could be used not just as the last-stage therapy but perhaps as a first-stage therapy, in which case the market size could be four-times bigger than it currently is. That's with the existing drug, so there really is no science risk here.

I think if you look at the value of Immunex now, you're pretty much paying a fair price given current approvals. But that's still not contemplating all of the places Enbrel could be used. Another kind of upside surprise is that Enbrel is one of a new class of drugs that attack the disease by binding to a protein called TNF [tumor necrosis factor]. TNF is implicated in a number of other autoimmune diseases that could also add to the market potential of this drug. So we are not just limited to the 2 million rheumatoid arthritis patients. In fact, they just recently announced that they are moving Enbrel into phase-two trials for congestive-heart failure, and that could potentially be a bigger market than rheumatoid arthritis.

When you look at any of these companies on a financial basis, the financials do not reflect the potential growth in the market for a drug that acts in a unique way that might have broad applications. On any backward-looking analysis, it's going to look expensive. Looking backward is never the right way to make investments.

Carlson: I think that there are various ways that you can look at biotech. I'd say that Immunex is this classic open-ended upside. But I still think that you need to make some attempt to putting a valuation on it. In the case of Immunex, I think you need to make sure the stock hasn't traded beyond even the highest potential for the drug.

So you go through an exercise. You look at earlier stage rheumatoid-arthritis patients. You look at a relatively high penetration rate, and then you add in congestive-heart failure. And you do this out through a number of years. And then you would assign some valuation or multiple to earnings at some point in the future. You'd also be asking, " Does the company have a pipeline in addition to Enbrel?" In the case of Immunex, there's a new advance for asthma. And then you discount that back at some rate. The problem with this exercise, obviously, is that there's a lot of estimation in valuation. But at least it would give you some sense of whether the stock has carried beyond any reasonable level.

There are other cases, such as Transkaryotic Therapies TKTX, where you're looking at the potential for a major product and the potential for a high valuation in the future, but there's also a certain amount of risk. In which case you have more probabilistic approach as to how you would view the valuation of the stock.

So in general, we do go through the exercise of trying to determine the future markets for the drugs--the potential upside to them. We take it several steps into the future, and then try to figure whether the stock has significant upside from where it is at this point. That's our basic approach.

So you might sell a biotechnology stock because you thought it looked too pricey?
Carlson: Yes. If we felt that the stock price was overly optimistic about the future of a product, we would use that opportunity to sell. Or we would sell if we felt there was any type of slow down or problem or risk--such as a new competitor. Any one of those things could cause us to sell the stock.

Kurt Von Emster and Ken Kam, when do you decide to sell a stock?
Von Emster: Normally we have a two-year time horizon on our positions. But we have fundamental events that we look for that might trigger a sell. For example, if a company's revenue growth is going to come in below analyst expectations, that could trigger a sell for us. And if we see timelines that are missed, that's probably our biggest selling issue. If a company is due to file a drug or due to have data results out on a particular day or month and those are delayed, those are usually negative signals that we use to sell positions. We probably sell on valuation less than one third of the time. But on the downside, we do implement stop-losses. We can't always pick the bottoms on these stocks, and sometimes we get caught in the market melee where we'll sell a position if it's down 10% or 15% from our initial starting point for reasons we have no control over. However, I'd say when I look at my fund here, the majority of these positions have been in the fund for more than a year or so.

Kam: On the upside, I use the same mental exercise that David Carlson described in trying to place values on these stocks, but I am a lot less confident that I can get within 10% or 20% of the value since there are so many unknowns. Basically what I do is I ask myself, "Given all the factors that I know about this company now, can we make the case that over the next two years this stock will hit enough milestones to reasonably expect to double in market cap?" If you can't make the case that the stock can double in two years, then it becomes a candidate to sell. Because there are so many other opportunities where you can put your money away and have confidence that the underlying fundamentals of the company justify a doubling in market cap within the two-year time horizon.

That's the good reason--the stock's gone up and you're asking should you hang on? The bad reason is that if you buy it and it starts to fall apart for reasons that you don't understand. If it falls apart because things that were inside your equation just went against you, that might not be a strong reason to sell. In fact, that might be a reason to step up to the plate and buy more. But if it falls apart for reasons that you don't understand or things you didn't foresee then I think the market is telling you that you don't understand this situation. If you don't know what you're getting into then you have no business investing shareholders' money in it and you ought to get out of it.

Do you have an example where a stock you owned went down and you stepped up to the plate to buy more?
Von Emster: Everybody's got a hero story. One of the examples that I like to bring up is IDEC Pharmaceuticals IDPH, which had a product on the market last year. It was really misunderstood by Wall Street. It was a slow launch, their partner wasn't really talking much about it, and people got concerned. But when you step back, you realize that any new biotech product faces challenges when it goes on the market. Doctors are very wary of these products because of the potential side effects. It really takes a year or two to get the product potential built into the market and widely accepted by physicians. That presents opportunities for the more-observant investor. IDEC traded down to, I think, the low $20s, and basically a year or so later it's here at $76.00 per share. We've sold a little bit on the way up in order to keep it from becoming our single-largest position in the fund. It's these sort of market inefficiencies that really drive the specialists in biotech to enjoy their job on certain days more than others.

Stay tuned for parts two and three of the biotech roundtable, coming soon.