Occasionally people ask me for book recommendations regarding biotechnology investing. I always recommend the following two books:

Edit: Since the original publication of these recommendations, a new book has been published. The Pharmagellan Guide to Biotech Forecasting and Valuation is my new #1 recommendation.
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Back to the original post.....

The first book I always recommend: ​

I used to give this book to interns on their first day. It has two parts, the first is a concise and non-technical introduction to the space. My interns could typically read that in an hour or two. The second part is an introduction to option trading in biotechs, and is appropriate for those who want to step their trading up beyond straight equity.

The second book:

Have you ever been invested in a biotech company and seen it go down after it's drug was approved by the FDA? If you go to Yahoo message boards afterword, you will see investors saying "I just don't get it" and blaming short sellers. In reality, unsophisticated investors don't get valuation. Most likely, the stock was overvalued going into the FDA approval, and now its getting back to reality. This book with teach you rNPV modeling of pipelines, so you are not surprised again.

Full disclosure: I recently became a contributor at Chimera Research Group. The author of Biotech Traders Handbook, Tony Pelz, is a founder of Chimera. However, I have been recommending the book for years.

One my favorite things in the market is finding obscure situations that elude conventional analysis. My latest interest is the pricing of Priority Review Vouchers.

A little background:  The 2007 Food and Drug Administration Amendments Act (FDAAA) created Priority Review Vouchers (PRV). The purpose of the vouchers are to incentivize drug development for neglected tropical diseases which can represent a limited commercial opportunity. 

These vouchers reduce the FDA review time for drug approvals from 10 months to 6 months, and are awarded by the FDA to a company that obtains approval for a treatment for a neglected tropical disease.

Things got interesting in November when Gilead Sciences (GILD) paid $125,000,000 to purchase one of these vouchers from Knight Therapeutics (GUD/CN).

How many of these vouchers exist? According to Evaluate Pharma, only four have been issued, with three being of the Neglected Tropical Disease type, and one being for Rare Pediatric Disease. The two programs currently have some important differences, so for the purposes of this article we are focusing on  Neglected Tropical Diseases. Below are the status of all four: 

Things got even more interesting when the Senate voted for the Adding Ebola to the FDA Priority Review Voucher Program Act, which would change three elements of the  Neglected Tropical Disease Priority Review Voucher program:

1. Add Filovirus, which includes  Ebola,  Marburg, and Lloviu to the program.
2. Shorten the notice period to use the vouchers from 365 days to just 90 days. 
3. Allow the re-sale of the vouchers an unlimited number of times. The current limit is once.

The bill has broad bipartisan support, and is expected to be passed by the House and  signed into law by President Obama. While the headline is about Ebola, we are interested in points two and three, which would bring the neglected tropical disease program more in line with the rare pediatric disease program.

The reason we are interest in the time frame shift ( from 365 days to 90 days) is because it impact the value of the PRVs. Simply put, the sooner a firm can see revenue from a drug, the more its worth today. This is especially true if one were to factor in a the competitive landscape, where the first mover advantage can be critical. 

To estimate the impact of this shortened time frame I ran the back-of-the-envelope calculations below:

The take away here is once the Adding Ebola to the FDA Priority Review Voucher Program Act becomes law, the Neglected Tropical Disease PRVs will be come more valuable based on the reduced time frame alone. As for the discount rate, I came to 15% via a sophisticated method known as "from thin air". Yes, I can already hear you CFAs saying "you should use the WACC". To that I say drug development is a risky business and you should be more conservative in your modeling assumptions.

An additional factor that will drive up the value of PRVs is the lifted re-sale restrictions. Previously, if you bought the PRV you had to use it, as only one re-sale was allowed. However, with no re-sale restrictions, the pool of capital that could potentially purchase a voucher is much larger. One could see a healthcare firm with a large amount of capital scoop one of these up with the intent of selling it later. The liquidity premium is a real thing, and in this case I'm going to give it a conservative 2.5% liquidity premium, bringing the value to $142.3M. 

This brings the total gain from the legislation to +$17.3M per PVR. While this amount isn't going to move the needle for giants like J&J or Gilead, it certainly is material for a firm like Knight Therapeutics, which has a market cap of just $540M (Canadian). Ask them if they would like another $17 million for the PRV they sold to Gilead.

It is no surprise the Biotechnology Industry Organization (BIO) has come out in support of the bill.

Of course there are additional factors at play here, as I said this a back of the envelope exercise. For example, from a drug developers perspective, much of the value is derived from the drug and indication for which the priority review will be used. Furthermore, as the FDA issues more PRVs over time, the increased supply may drive down prices. One could also Again there are many factors that firms buying and selling will consider next time these trade hands, but I digress.

Those who want to learn more about Ebola can check out the classic The Hot Zone: The Terrifying True Story of the Origins of the Ebola Virus.

One last thing, once Filoviruses (Ebola et al) gets added to the list of indications PRVs can be used on, what does that list look like? See below:

My favorite way to generate investment ideas is reviewing Form 13F filings from great healthcare investors. I first read of this approach years ago in Mebane Faber's book. 

If searching for investment ideas is like looking for a needle in a haystack, then 13F filings are a stack of needles.

I later found out the great Mohnish Pabrai  also uses filings for idea generation. 

I've backtested the filings of 60+ healthcare focused investors, and I have ten that are worth following. These include the well known Perceptive Advisors, and Baker Bros Advisors, but also more under- the-radar firms such as Broadfin Capital. It is important that 13Fs are the beginning of an investment research process. Due diligence is still critical.

Some of my most successful biotechnology stock picks generated by 13Fs have been in the oncology space. An example would be when I bought Pharmacyclics (PCYC) at $19 in February 2012, and held it for a multibagger.

The most recent set of 13Fs were as of September 30, 2014. Here are the two most popular oncology stocks held by my group of hedge funds.  

Pharmacyclics (PCYC): A long time favorite of Baker Bros., also owned by Perceptive and BB Biotech, as of September 30, 2014. Ibruvica is currently approved for Mantle cell lymphoma (MCL)  and Chronic lymphocytic leukemia (CLL)  patients who have received at least one prior treatment. 

PCYC is in growth mode, after having Ibruvica approved, the company swung into profitability during the 3rd Quarter of 2014. Analysts expect 37% year over year revenue growth in 2015. 

At the upcoming ASH conference the company will be presenting data in the effort to get indication expansion into B-Cell Lymphoma. 

Investors are clearly very excited about the growth story here, as the stock currently trades at 11x next years estimated revenue. The bear case revolves around next generation competitors to Ibruvica.

The stock does appears to be near full value, as analyst average price target is $161, which is only 16% higher than current prices.




Celgene (CELG): Owned by RA Capital, Orbimed, BB Biotech, and Perceptive as of September 30,  2013. Celgene is a major player in the oncology space and has products approved for many indications. Revlimid represents 66% of Celgene's revenue. It is approved for  Multiple myeloma (MM), myelodysplastic syndromes (MDS), and Mantle cell lymphoma (MCL). Furthermore, there will be many presentations at ASH 2014.

It is worth noting this company has a less concentrated product portfolio than PCYC, with a single product on the market.

Analyst are expecting very strong growth from CELG specifically from their Revlimid, and  Abraxane franchises. Celgene's IR site tracks analyst estimates, and it states that EPS growth of 32% is expected in 2015.

CELG investors have been impressed with the growth story. The company trades as 9.7x forward sales estimates, and 25x forward EPS estimates. These valuations  could be justified if the firm can pull off its growth plans without any miss-steps. 

No value investor would call this either PCYC or CELG "cheap".

Most analyst would not call CELG cheap either. The current analyst price target is $116, which is about where the stock trades now. Investors would be wise to wait for a pull back, or wait for analyst upgrades.

Disclosure: I own none of the stocks mentioned in these articles and have no plans on buying them in the next 48 hour

Data: Ycharts.com/Morningstar and 4-Traders.com/Thompson Reuters.