The Cross-Border Biotech Blog

Biotechnology, Health and Business in Canada, the United States and Worldwide

Capital Markets – The Biotech Analyst: Part 21 of Valuation and Other Biotech Mysteries

[Ed. This is the twenty-first part in Wayne’s series. You can access the whole thing by clicking here. Please leave comments or questions on the blog and Wayne will address them in future posts in this series.]

In the 20 years since I started my first stint as a biotech stock analyst, both the biotech and financial industries have seen major changes. I was the third new biotech analyst hired in 1992 by a Canadian investment dealer, bringing the total to 5 or 6 at that time. During the biotech boom there were over 30 analysts in Canada but that number has declined back to the 1992 levels. There were only about a dozen public Canadian biotech companies in 1992 whereas there are now about 100 developing therapeutics, diagnostics and medical devices. Here are answers to three common questions about biotech stock analysts:

Question 1 – why has the number of biotech analysts declined? The answer is just simple economics. Investment dealers have analysts, and i-bankers, in sectors where they can make a profit. There has not been a large Canadian biotech IPO sold primarily to Canadian funds since IMRIS in the fall of 2007. The largest financing by a Canadian biotech company in 2012 was the US$80.5 million raised for YM BioSciences by a syndicate of 5 U.S. and only 1 Canadian investment dealers. Current Canadian biotech financing and trading fees cannot support a large group of biotech analysts and i-bankers

Question 2 – why do analysts cover certain companies and not others? Again, the answer is just simple economics. Analysts work for investment dealers which get their revenues primarily from institutional funds, either directly through trading or indirectly through corporate finance transactions. It is only logical that an analyst would write research reports on companies in which institutional funds currently have or might develop an interest.

Question 3 – what do the recommendations and target prices mean? This is a more complex question and the answer varies from dealer to dealer and by type of company. On a broad market basis, most stock analysts publish reports on companies which have revenue and earnings. However, biotech analysts cover many companies which do not have revenues or earnings and whose products may be several years from regulatory approval.

I have seen three general types of recommendations for a time period which is usually either 12 or 12 to 18 months.

  1. Movement of the share price: the four basic recommendations are strong buy, buy, hold and sell, based on movement from the current share price. A share price increase of about 10 to 15% would usually be the basis for a buy and a decrease of 15% or more would be the basis for a sell recommendation. A hold recommendation can mean no reason to buy it now but, if you already own it and like it for the longer term, also no reason to sell it now.

    A frequent complaint ten years ago was that every recommendation was a buy. The recommendation summaries of a few investment dealers (look at the end of research reports) showed strong buy and buy for 50% to 70%, hold for 25% to 45% and sell for less than 5% of reports.

  2. Comparison to broad market performance: the three basic recommendations are market out-perform, perform and under- perform. The base for this type of analysis is an expectation of broad market performance. Institutional funds are often ranked by performance relative to the broad market, which makes individual stock performance relative to the broad market a useful metric for a fund manager.
  3. Comparison to sector performance: the three basic recommendations are sector out-perform, perform and under- perform. The base for this type of analysis is an expectation of sector performance, which might cause a fund manager to overweight or underweight a sector. In addition a fund manager might choose to own only a portion of the top 10 companies in a large sector, so knowing which companies are predicted to out-perform the sector is useful information.

Target prices are based on a series of assumptions by the analyst on the market, sector and individual company performance. When the companies have a long history of revenue and earnings growth and provide annual guidance, an analyst has a relatively easy job creating and modifying the financial model but a more difficult time differentiating their analysis from the other analyst covering that stock and sector.

When calculating a target price for a biotech stock where 90% or more of the value is attributed to a product still in clinical development, most analysts still use a risk-adjusted net present value analysis because this is the most familiar analysis tool for small cap fund managers. I have always preferred an analysis which looks at the range of valuations of comparable companies in two stages. The first set of comparable companies is those at the same stage of clinical development, which indicates whether the company has a valuation within the range of valuations for its current peers. The second set is those which would be comparables if the clinical trial was a success, which gives a valuation range from within which the analyst will probably choose a target price (possibly the mean, median or average). If the clinical trial is a failure, the valuation could drop to as low as 50% of the cash remaining in the company.

The biotech analyst is being asked to pick winners in a sector where up to 90% of drug candidates never get approved and many approved drugs never meet sales expectations. One tool used by big pharma to mitigate this risk is portfolio strategy, the same basic tool used by fund managers in order to mitigate investment risks. In the following posts, I will take a look at some investment strategies which could be used for looking at biotech companies.

Repeated Note: Prospectus offerings for Canadian biotech companies from about 10 years ago contained a statement similar to the following, which I considered an accurate representation of the risk associated with biotech investing.

An investment in the common shares of Company X should be considered highly speculative due to the stage and nature of our business and should only be made by persons who can afford a total loss of their investment.

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