The Seven Financial Indicators of Highly Successful Biotech Stocks Investing
Companies / BioTech Feb 21, 2015 - 10:41 AM GMTBy: Money_Morning
Ernie Tremblay writes: When evaluating biotech stocks, many key indicators that work for other industries – e.g. price-to-earnings ratio, profit margin, revenue-per-share – often don't apply.
Here's why they don't, and why seven of these critical financial indicators do…
The Usual Ratios Don't Apply
The reason is pretty straightforward: many low- and mid-cap biotechs haven't yet made a profit, and probably won't for years to come.
Unlike big pharmaceutical companies, these smaller startups focus their time, money, and effort on research and development, rather than marketing new products.
In fact, many of them don't maintain a sales force and have no intention of building one. Instead, they rely on business partnerships with companies that do concentrate on selling products to get their medications into the hands of doctors and hospitals.
For income, they rely on royalties, milestone payments, and public offerings of common stock.
Even those firms that do market their own products can go many years before seeing their first experimental drug approved, so thinking of valuation and potential in terms of profits won't take you very far.
Generally speaking, when assessing a biotech, the first thing an investor should look at is the company's drug pipeline. What great new medications is it developing to fill serious medical needs?
After that, however, there are some technical financial indicators – seven to be exact – that will prove very helpful in sizing up a stock before you buy it.
The Key Indicators
1) Burn Rate
This refers to the rate at which a company spends money versus its income. Ideally, you'd like a company to have enough cash on hand to operate for the next 13 to 18 months without having to raise money through a dilutive public offering.
The calculation is simple:
Burn rate = Capital expenditures + Negative cash flow from operating activities
You can retrieve these numbers from Yahoo Finance for any publicly traded stock. To get a more accurate picture of the financial road ahead, find these numbers for the most recent quarter and then divide the answer by three to estimate burn per month.
Next, calculate how much money the company has in its coffers:
Cash on hand = Cash and cash equivalents + Short-term investments
Finally, calculate the amount of time, in months, the company can continue to operate with current available funds:
Operation coverage = Available funds/monthly cash burn rate
2) Convertible Debt
Startup companies often use convertible debt to finance their operations. This simply means that the company borrows money from a lender and issues warrants to cover the debt. A warrant is a promise (bond) that gives the lender the right to purchase stock, often at a highly discounted, predetermined rate (strike price), in the future.
Using convertible debt is a perfectly legitimate way for a robust, larger, profitable company to raise financing, but for a fragile, small-cap, pre-profit biotech, not so much.
The problem is that lenders can – and often will – borrow shares and sell them short when a catalyst, such as an FDA approval, is driving share price rapidly upward, then cover (repurchase the shares) at a dirt cheap price by exercising their warrants. This is called convertible arbitrage.
If they do this with a sizable block of shares, the transactions can force the stock price to reverse direction, that is, sink when it should be rising.
To make matters worse, shares the lender purchases through warrants must be newly issued by the biotech, which has a dilutive effect, driving price down even more.
So your best bet is to look for biotechs with low or no warrants outstanding. This information isn't always obvious when looking over a balance sheet, but you can find it in their most recent 10-Q SEC filing, generally available on the company's website. Open the document and do a search on "contingent warrant liabilities."
3) Market Cap
Market capitalization is the total sum value of a company's outstanding shares, based on current price-per-share (PPS). This number can give you a couple of valuable hints about the attractiveness of a particular stock.
If the cap is very small, below about $250 million, the PPS can be extremely volatile on very low trading volume, so liquidity may be a problem-you can find yourself needing to sell with no one there to buy.
At the other extreme, if the cap is over $5 billion, the company may have reached the limits of its growth, unless it's developing a broad spectrum product portfolio that could help it become a full-fledged pharmaceutical company.
4) Volume/Average Volume
Like market cap, these numbers can help you decide if shares are liquid enough to allow you a quick exit, should you need to make one. Stocks that trade on average about 350,000 shares per day are a good bet. Fewer than 300,000 is getting into dicey territory. Under 200,000 is the Wild West.
You can also use volume to gauge investor sentiment – an important factor when trading stocks in an industry as volatile as biotech. A PPS downturn in lower than average volume probably indicates the stock's movement has little importance and does not indicate a trend.
The same price movement in high volume, however, can mean that institutions are bailing out, so it may be time to take the hint and follow their lead. The same principles apply to upward stock movement.
5) Beta
This measurement expresses how volatile a given stock is likely to be in comparison with the market, based on past performance. A Beta of 1 means equivalence with market volatility, while a number greater than 1 (e.g. 1.2, etc.) indicates higher volatility and less than 1 (e.g. 0.8, etc.) points to lower.
This number can give you some perspective on days when the stock market seems calm but one of your positions is jumping higher or lower for no apparent reason.
It can also help you buy stocks that fit your trading style. If you're a day trader, for example, you may want to get into stocks that can move significantly within a single session. Longer-term traders, however, might find stocks that move more gradually, along with the market, more attractive.
6) Short Interest
Short selling, as you probably know, is an investment tactic that can make money for a trader when a stock's value decreases. A short seller borrows shares from another shareholder, sells them, and then buys them back when the price goes lower, pocketing the difference.
An increase in short interest (expressed as short percentage of the float) can indicate a trend in market sentiment away from the stock, while a decrease in short interest can mean more confidence in the company's prospects.
If that were all there was to the story, short interest might be just an interesting risk indicator of where other investors feel the stock is going to go.
Unfortunately, the story doesn't stop there – the plot grows more sinister.
Because biotech stocks tend to be relatively inexpensive and trade in fairly low volume – especially in after-hours trading – they're vulnerable to price manipulation. And it happens.
It doesn't take much for a few hedge funds to sell large blocks of shares short, driving down price and creating negative momentum that scares longs into selling as well. At the same time, it's not uncommon to see anonymous campaigns to devalue a stock by disseminating false or misleading information about the issuing company through blogs, articles, and message boards.
This can happen even in the face of a strong positive catalyst, such as an FDA approval.
So a large percentage of short interest can indicate that fund managers are getting ready to force a particular company's PPS down, even if it has developed good new medications for sick and dying patients, all in the interest of short-term profits.
The question, then, is what represents a "large" percentage?
Although there are other factors to consider, in general, look for stocks with a short interest of less than 20%.
7) Bollinger Bands
Bollinger bands are a volatility indicator that can graphically show you a stock's standard deviations from a simple moving average over time. Go to the stock's Yahoo Finance page, bring up its chart, click on the Indicator button, and click Bollinger Bands in the dropdown menu.
This will bring up an upper and lower line that describe the stock's high and low volatility range. If the stock price touches or crosses either line more than once in a short period of time, it may be time to trade.
Touching the upper line repeatedly indicates the stock is probably overbought and may be headed downward soon – time to sell.
Touching the lower line repeatedly tells you the stock is oversold and should head upward – time to buy.
If a stock crosses over one of the lines and remains there for a few days, it's mostly likely consolidating at new high or low level.
A Final Word
None of these indicators will yield, by itself, a thumbs up or down for any given biotech stock.
Taken together, along with a deep understanding of a company's pipeline, they can be extremely helpful in maximizing your profits and minimizing your risk.
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