Benjamin Graham and David Dodd are synonymous with an investing strategy called “value investing.” As outlined in their classic 1934 book Security Analysis, value investing involves investing only in securities that the stock market has significantly undervalued. Warren Buffett is the most famous practitioner of this approach, and millions of other investors apply aspects of value investing to their own portfolios. Graham died in 1976, the year Genentech was founded. Would he have applied his methodology to the biotech industry? I doubt it.
In essence, value investing asks two fundamental questions: How much does it cost? And what is it worth? If something is worth more than it costs, it’s a good buy; this is the proverbial “buying a dollar for fifty cents.” As applied to investing, to know the current cost is easy: the market value of a company’s stock is simply the price at which the securities are trading. Estimating a company’s intrinsic value, or what it should be worth, is much more difficult. In most industries, investors analyze a wide variety of financial metrics to assess the value of a company’s assets and performance. Two simple examples would be ascribing a monetary value to an inventory’s worth of unsold merchandise or determining the yearly growth in product revenues.
The problem with biotechnology companies, especially small cap companies involved in drug development, is that the common financial metrics are imperfect or misleading, making a standard value approach nearly impossible. These companies usually have irregular or no revenues, can be unprofitable for many years, and may have few tangible assets. Rather, intrinsic value for many biotech companies must be derived largely from a mix of a body of qualitative metrics (such as strength of clinical data, management team, intellectual property and competitive positioning) with a few essential quantitative measures (such as cash balance and cash burn rate). Analysts flesh out financial valuation models using additional industry data and scenario testing, which definitely helps, but in my experience, the substantial qualitative component inherent in a company’s overall valuation can create real world price fluctuations that deviate substantially from the models.
Certainly, value investing as Graham, Dodd, and Buffett practice it involves qualitative judgments; the brand value of Coca-Cola was an important factor in Buffett’s investment. But Coca-Cola also has profit margins, earnings growth, and real bottling factories that you can touch, which can be ascribed present and future value. If Biotech X is on its seventh unprofitable year, with a year’s worth of cash, developing a small molecule oncology drug in Phase 2 after having achieved a partial response and five instances of stable disease in a Phase 1 trial – what’s that worth? This is not your father’s discounted cash flow (DCF) analysis of an appliance manufacturer.
Yet, the pricing inefficiencies that occur in biotech are exactly what a value investor needs to find great investments. If a market is perfectly efficient, all securities are accurately valued and there are no bargains for investors to seize. And one does see generalist value investors like Seth Klarman, occasionally take positions in small cap biotech companies, but these seems to be in opportunistic cases in which companies are trading below cash value. But a value investor’s mindset, if not the traditional tools, can be a successful approach to biotech investing.