TICKERS: AMGN, ABX, , IONS, IRWD, JNJ, NEM, PFE, RHHBY, VGQ

Junior Resource and Biotech Investing Share Profit Potential
Interview

Source:

Alex Daley Doug Hornig Several Casey Research publications focus on the junior resource sector because this is a prime speculative market—one where individual investors can still turn a small amount of money into a fortune, provided they bring the proper tools to the table. Yet resource juniors by no means stand alone. Biotechnology is another good market for speculation. In fact, despite the very different science and economics at work, the biotech and junior resource sectors share some interesting traits. Investors will find a lot to like in both.

Five prime factors. Before delving into what makes biotech such a great sector, it is important to establish precisely what makes any sector ripe for speculation.
  1. The potential for outsized gains, the ability for a stock to soar on a major advancement or big news. This means either some level of risk premium built in or a natural barrier to price discovery by the market; ideally a little of both.

  2. A large number of potential opportunities, making it difficult for any one analyst or firm to track the sector in its entirety. In a sector with 10 or 20 companies, it's easy for participants to turn over every rock and accurately value each company. With 100 or 1,000 companies it is much harder, leaving more room to discover an unpolished diamond.

  3. A requirement for specialized knowledge to value companies effectively, enough so that it takes considerable work to sort the best players from the worst.

  4. An exit, a chance to gain liquidity when the value of an investment increases. An investment you can't sell is worthless.

  5. Special circumstances within the market that investors can predictably take advantage of, an amplifier for potential gains if used correctly.

The creation of value. New economic output that is worth more than the sum of the inputs—and the wealth that results from it—is what ultimately drives us to invest. Thus, the best true investments are those companies that can take a small input and turn it into a product or service that commands attention in the marketplace. When the value of a company's assets and potential future earnings changes—as it moves from an idea to a viable business with growing potential or real revenues—is when the shares can really take off.

With junior resources, a company goes from a patch of dirt to a potential find to a working mine. For a few hundred thousand dollars, a prospecting company can stake out a claim and begin exploration. When it makes a promising find, it can drill core samples and determine just how valuable the deposit might be. The rest is simple math—factor in the quality of the resources, the amount in the ground, the price of the commodity, the cost to extract it, and if it adds up, a company formerly worth a few million dollars is now worth hundreds of millions.

Subscribers to Casey International Speculator are accustomed to following companies through that transition. Take Fronteer Gold, for instance, a junior that transitioned from explorer to takeover target after it proved up a high-grade open-pit asset in Nevada. That caught the attention of mining giant Newmont Mining Corp. (NEM:NYSE), which snapped up Fronteer in February 2011 for a cool $2.3 billion (B). That netted a 500% return for investors who bought into Fronteer two years earlier, when it was first recommended by Louis James and his team. Obviously, you never know when or if a buyout like Newmont's is going to happen. But if you research diligently, you can position yourself in companies that are creating value faster than their shares are rising, and that are thus primed for a takeover.

The same holds true for biotech. Compared to mining, biotechnology is a very young market. Its origins only go back to the 1980s, and it has really only matured in the past decade. But the sector has grown at a blistering pace, driven by early biotech successes that launched multibillion-dollar companies like Amgen and Genentech.

It's easy to see why there is a virtual gold rush of discovery work underway around the world, with tens of thousands of scientists at private corporations, universities and government research labs searching for the next great breakthrough. The pioneers are dressed in white coats and loafers instead of bush jackets and work boots and investment costs can be massive. The cost of bringing the average new therapy to market ranges from $100 million (M) to over $1B, but the payoff is comparably rewarding. Identifying a single promising or proven treatment can compound investments many times over.

Before facing generic competition, the cholesterol drug Lipitor, for example, brought in over $10B in sales per year for Pfizer Inc. (PFE:NYSE). Enbrel, an arthritis treatment from Amgen Inc. (AMGN:NASDAQ), rakes in over $5B per year. Avastin, a treatment for colon cancer from Genentech Roche Holding AG (RHHBY:OTCPK), generated $6.5B in revenues in 2010. The list goes on, with more than two dozen other therapies posting $1B or more per year in global sales, followed by hundreds more producing in the hundreds of millions.

Blockbusters only emerge at the end of a (sometimes excruciatingly) drawn-out regulatory process. Most newly discovered biological compounds never turn out to have a useful effect. And for those that show promise, the investment has only begun. It is a long, treacherous road from preclinical testing to market—just as it is a long way from first drill results to a mine. With junior resources, a hundred promising geological phenomena may be explored before any proves out. Likewise, biotechnologists may examine many compounds that look promising in the lab before one proves out in early animal or human testing—let alone is shown to be safe and effective in robust clinical trials. This means billions of dollars are sunk into development and vetting of research findings, as well as the expensive and risky testing required for government marketing approvals. Just as only one in thousands of hopeful digs will eventually become an operating mine, only one in thousands of promising biological compounds will eventually become a commercialized therapy—the biotech equivalent of the mother lode. This means the industry must do an incredible amount of financing to keep itself moving along, which is where a vast number of opportunities come into play.

Capital opportunities. One beef many investors have with technology is that it's difficult to participate in certain sectors, particularly web and Internet services. Early-stage, highly profitable investment opportunities frequently get sucked up by private investors such as venture capital firms. Why go to the market when there is ample funding available without all the hassles? Often, when it's finally time for an initial public offering (IPO), the high-tech company is already richly valued. Good for the company, not for the frustrated individual investor. The story is very different for biotechnology. As noted, the costs to bring new therapies to market can be immense. The entire U.S. venture capital system can only provide between $30–40B per year in funding across all industries. The largest 10 pharmaceutical companies kick in another $45B in direct funding of biotech and traditional pharmaceutical research, but less than a third of it goes to outside ventures. That is not nearly enough to meet all the funding needs of the thousands of startup biotechnology companies in this country, let alone the rest of the world. Only public markets can satisfy the need for vast amounts of capital, especially in the later stages of testing when costs escalate significantly and a large and diversified group of investors is needed.

In addition, a few large drug companies dominate the global sales and marketing channel. Relying solely on private funding would enable the big guys to hold an inordinate amount of power over the negotiations for marketing rights to a new therapy, placing smaller companies at a disadvantage. Many startups don't want to give rights away from the start, and public markets provide a viable means to attract capital without strings, letting companies invest in their assets before negotiating for royalty contracts and marketing terms. For these reasons, opportunities abound. There are hundreds of publicly traded biotechnology companies on U.S. markets, most pre-revenue, research-stage companies, with many more on major foreign exchanges such as those in London and Shanghai.

The trick, of course, is finding the right ones to invest in.

The knowledge edge. The secret lies in finding the right speculations more often than the wrong ones, managing risk and reward to come out ahead. In junior resources, that means grasping the geology better than other investors; understanding whether the company's financing gives it the ability to move forward with a prospective project; and having the confidence that management can turn a barren landscape into an operating mine. Knowing the business, the science and the people can make a big difference in the niche junior mining sector. That also holds for biotechnology.

Evaluate the people behind a biotech company in exactly the same way you would a mining company. Who is running the company? What is their experience? Have they taken previous projects through to completion? Have they proven that they can attract top-flight talent to their operations? Is their marketing department as good as their discovery team? Do they have solid financial officers on board?

The business case. How much does the company need to significantly advance the project? What is its burn rate? Does it have enough money on hand that it won't need to go begging for more, thereby diluting the value of the stock? When the company does raise money through a public offering, does it get filled at the ask price (or even get oversubscribed)? And, of course, what are the potential revenues if the company succeeds? This involves knowing how large the patient population is for a new drug and what they might be willing to spend on treatment.

Science matters. This is where the most intensive homework needs to be done, and where those who do their homework fatten their bank accounts. If you don't know what NI 43-101 compliance is, or can't tell orthoclase from laterite, then the junior mining market could be a tough slog. By the same token, success in biotechnology investing means you have to understand the differences between phase 1, 2 and 3 testing. You may need to be able to trace the lineage of telomerase extension research. You must be able to tell whether the failure to meet a secondary endpoint in a drug trial is merely an insignificant blip that creates a further buying opportunity, or whether it is a precursor to catastrophic failure.

Count on diversity. Choosing the right investment involves other factors, as well. For example, beware the one-trick ponies. That could be the mining company betting all of its capital on a single cluster of drill holes, or the biotech outfit staking everything on a positive outcome for its only drug candidate. It's a legitimate business model in some cases, and the only viable option in others. Regardless, you should be aware when your investment is binary—dependent on a single spin of the wheel of fortune—and when it is based on more than a single test result. On the flip side, you don't want a company that fires grapeshot willy-nilly into the sky in the hope that a goose will fly by. You want one that deploys its resources carefully, regardless of which path it chooses.

If you can find a company that has the ability to spread its choices across multiple venues, and the discipline to manage multiple competing priorities on an exploratory budget, you may have a serious winner on your hands. This was the case with Virginia Mines Inc. (VGQ:TSX), which drilled many promising holes in diverse locations. The company could have picked a single location and missed entirely. Or it could have failed to manage its resources across multiple projects, and never turned up a big result. In the end it conducted a diligent exploration of multiple properties and hit it big with the Eleonore discovery in Canada. The company then sold the project off to mining giant Goldcorp for $750M.

When looking for a corollary in biotech, search for a company with a deep drug pipeline and the wherewithal to keep the pipeline moving, so that if one candidate doesn't pay off the company can shift its attention to another. It also helps if the pipeline is wide—if a therapy under development has more than one application, or if the same technology can be applied to multiple therapies.

For example, we have long been partial to Isis Pharmaceuticals Inc. (ISIS:NASDAQ). It has a pipeline of highly promising drugs, headed by lead candidate Kynamro (mipomersen), with its new drug application (NDA) submission expected this quarter. Second, the antisense development platform it created allows the company to discover more promising drugs than it could handle by itself. That means Isis can license drugs to partners prior to late-phase development and commercialization, building a broad base of license fees, milestone payments and royalty income. The question is whether it will pick the big winners for itself or end up farming out the real gems for lesser return.

Politics plays a role. In both the biotech and mining politics is always in play. Miners have to go where the deposits are, and some of the biggest will inevitably be in politically unstable countries. Even in stable regions, profitable mines are juicy targets for nationalization or ruinous taxation imposed by kleptocratic governments. This is a major consideration when you're evaluating a junior prospecting in an inhospitable place—although bad politics can also be turned to one's advantage. A change in government may bring a mining-friendly government to power, or the company may receive a long-delayed permit, so that speculators may make a killing when latecomers start piling in.

In biotech, researchers are by-and-large U.S.-based, and Washington doesn't pose any real confiscation threat. But political risk is by no means nonexistent. First, there is the FDA review, a politically charged process—and there are similar review boards in Europe, Japan, China and elsewhere. One can never be certain when, if, or why an agency may turn a thumbs-down on a new therapy. For instance, Discovery Labs (DSCO:NASDAQ) was granted approval for its respiratory distress syndrome artificial surfactant only after a seven-year battle with the FDA, more than double the original expectation.

Moreover, the trend toward socialization of medicine that is now firmly in place will have consequences for biotechnology. Fewer payers, potential reluctance to try novel therapies and increased compliance costs must be considered.

Public timing. Many biotech startups remain private for a long time before going public, often beginning public life with market valuations in the tens or hundreds of millions. Some are valued higher, such as the 2010 IPO for Ironwood Pharmaceuticals Inc. (IRWD:NASDAQ), worth $1.4B at its debut. That's multiple orders of magnitude higher than your average junior miner, whose early stock is more typically priced in pennies rather than in dollars. But biotech is a much more expensive business in the early years.

While junior miners can and do issue stock when their only concrete holding is 500 acres of moose pasture, biotechs tend to be much more advanced by the time they reach IPO. They already may have promising results from phase 1 and 2 drug trials. They also may have received substantial early private financing from venture capitalists, often reaching well into the eight figures, before needing to turn to public markets. And they are more visible, trading on major exchanges like the NASDAQ rather than in Toronto or on the pink sheets in the U.S.

This leads to great differences in liquidity and leverage. Junior resource stocks typically offer a high degree of leverage. If you get in early enough, you can sell shares for which you paid pennies for several dollars. But you must contend with the very real prospect that the company will go belly up before it intercepts a workable deposit. Risk/reward is substantial on both ends.

With biotechs, the buy-in price will be higher. Thus doubling or tripling your money is a more realistic hope than the 10:1 or more that a successful miner might return. That, of course, depends on how early you buy in, as preclinical and phase 1 companies receive a much steeper discount than their phase 2 or phase 3 counterparts. Part of the lure of biotechs revolves around stocks such as Cell Therapeutics (CTIC:NASDAQ), one of the great boom-bust-boom-bust stories of all time. It gained 833% between April 1997 and October 2000. Then it fell almost continually for nearly a decade, until February 2009, losing 99.9% of its value. Then it soared 4,100% in less than four months, before subsiding again and dropping 87% to where it stands today (after adjusting for the 1:6 stock split in May 2011). That's about as volatile as a company can be without going bankrupt.

Consider liquidity. The matter of getting out is of great importance. One of the prime characteristics of junior resource outfits is how thinly traded the stocks are. If a junior miner normally moves 10,000 (10K) shares a day, and a mass of people reading drill results suddenly want to buy or sell 500K shares, then the price is going to spike sharply. Exiting when others are piling in is critical.

Small biotechs are much more liquid than juniors, certainly. Yet they are also similar on a relative basis. Isis, for example, moves maybe 500K shares on an average day, a pittance compared with the 10M a pharma giant like Johnson & Johnson (JNJ:NYSE) will trade. That's not unlike the difference between a junior that sees a daily movement of 50K shares versus the 7M trades a big miner like Barrick Gold Corp. (ABX:TSX; ABX:NYSE) generates.

In either instance, good or bad news from the lab or the drill site is anxiously awaited, and the outcome can rocket the share price higher or slice it to bits in a matter of hours. You don't want to be on the wrong end of the latter, as liquidity dries up.

Analyst coverage. As with junior miners, analysts are not watching early-phase biotechs closely at all. They can't. There are just too many of them, and even those with market caps of $100M are too small for the biggest firms to track.

Junior biotechs generally find themselves tramping around the investor conference circuit, trying to drum up interest, just like a junior miner at the yearly Prospectors & Developers Association of Canada conference. When a major investment house picks one of them up, that almost guarantees a boost to the share price—to the benefit of those who rely on independent analysts like ourselves.

The power of partnering. Of course, no junior miner is worth the gold it has in the ground if it has no way to pull it out, refine it and get it into the hands of consumers. The hope of most explorers is to be acquired by a company with expertise and deep pockets. It's no different with biotech. A little firm doesn't have the manpower or knowhow to manage distributing a drug worldwide. With hundreds of regulatory agencies to deal with, the need for large-scale certified manufacturing facilities and potentially thousands of distributors and millions of customers, it's work best left to the big boys. Smart biotech companies will develop pacts with the global pharma giants, taking large upfront payments plus a future royalty split in return for some measure of distribution rights. That is almost always the best way to maximize return, for shareholders and corporate officers alike.

Major international miners are depleting their resources at a faster-than-replacement rate and are hungry to gobble up juniors with decent prospects to keep the metal flowing. Similarly, the pipelines of the pharmaceutical mega-corporations have grown thin in recent years. Combine that with an increasing number of blockbuster drugs that are losing patent protection, and you have a market desperate for companies whose therapies have shown well in early trials. Virtually anyone who makes it to phase 3 testing is likely to get a bid.

The Casey Research publications that specialize in junior resources, International Speculator, Casey Energy Report, and their alert service brethren, only consider these kinds of small-cap companies. In general we also prefer companies that have not yet made the transition from speculative to investment grade, when much of the profits will already have been booked. Like our colleagues on the junior side, we seek well-run companies with great technology that the market has yet to discover—thereby greatly increasing our likelihood of serial success.

Biotechnology, like junior resources, is a fertile field for this sort of investing. Many of the startup biotechs are too small for hedge funds and big banks to take positions in without creating massive distortions. Or they are too early-stage for the risk tolerance of the large institutional investors, like pension funds and insurance companies, which prefer to make just a few percentage points on a much more staid investment. The big guys are the buyers when we're selling. When that chancy company with multifold upside potential becomes closer to a sure thing, we can trade in our double (or more) to institutions content to loose hundreds of millions in the lower-risk chase for a far smaller gain.

The risk is higher. A biotech trying to prove a new treatment is more vulnerable to failure than an established company and a well-established therapy. Just as it is with an explorer still drilling versus a mature gold producer. Odds are neither is going to hit it big. In the end, 9 out of 10 therapies submitted to the FDA will be rejected or withdrawn; only one in 300 junior miners ever see production. However, with companies that have the goods but not the proof, you have the opportunity to book outstanding returns. We like stocks with the potential to rocket 100% quite suddenly. While risk can never be eliminated, it can be mitigated with careful research and an intimate familiarity with the underlying technology.

The reward can be great. As we've shown, the basic investment principles in biotech are the same as for a software startup in Silicon Valley or a company that's outlined a new gold trend in Alaska. Get in early, during preliminary findings announcements. Supplement with deep knowledge of the technology, the people, the finances and the market. Then you can identify the companies with the best chance of making serious profits for investors.

That's our colleagues' approach to mining, and ours to biotech.

Alex Daley and Doug Hornig, Casey Research

DISCLOSURE:
From time to time, Streetwise Reports LLC and its directors, officers, employees or members of their families, as well as persons interviewed for articles on the site, may have a long or short position in securities mentioned and may make purchases and/or sales of those securities in the open market or otherwise. Johnson & Johnson is not affiliated with Streetwise Reports.




Get Our Streetwise Reports Newsletter Free

A valid email address is required to subscribe