Nature Biotechnology | Trade Secrets

Would Graham and Dodd have avoided small cap biotech?


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.

Adam Bristol


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    Markus Elsner said:

    It seems that the problem is basically a scientific one. At the moment success or failure of promising pre-clinical drugs is basically impossible to predict, because we don’t know what to look for in animal studies or early stage clinical trials. Maybe there is a role for biotech companies in coming up with better predictors for drug efficacy and toxicity before late stage clinical trials?  

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    Adam Bristol said:

    I disagree.  Yes, preclinical and early clinical results often do not translate into later stage success, and the industry is working constantly to improve animal models and find meaningful biomarkers to change this. "Basically impossible", though, is too strong of a term – the field has a pretty good handle on screening out compounds that hit known hepatitc, renal, and cardiac funciton.  The issue I raise, of putting a monetary value on a drug or drug candidate, is not just scientific. There are many examples of drugs that ultimately got approved, so the drug development process was successful, but were commericial disappointments – this is hard to predict or model financially – it’s determined by the strength of the data, the changing treatment landscape, pricing, etc. 

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    Markus Elsner said:

    Agreed.  I just wanted to point out that when one looks at the results of Phase II trials there is a problem there. The success rate is low ( just 18% in 2008–2009) and lack of efficacy and safety accounts for about 2/3 of the failed trials.

    And even in Phase 3 trials only about 50% of the drugs make it. 66% fail on the basis of efficacy alone.

    Given all the other uncertainties, I guess that it would be much easier to put a value to a potential product if there was a better chance that it ever gains approval.

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    Adam Bristol said:

    I see your point.  If you imagine a world in which 100% of drug candidates are approved, then the commerical success of those products is conceptually similar to that of products in other industries.  Obviously, easier to handicap likelihood of success and model financially in under that scenario.