http://biotechinvestmentparadigm.com/2011/06/managing-risk-in-biotech-investing- part-2/
Managing Risk in Biotech Investing: Part 2
By Rockford Coscia ⋅ June 20, 2011 ⋅ Post a comment
This article is part of a three part series. To read Part 1, click here.
Short Interest
So far weve talked about poor institutional ownership (no >5% owners) and poor analyst coverage as red flags in biotech each indicating that a long position in a particular biotech may be an especially risky play. The third potential red flag is short interest. Short interest can be found at any number of financial sites but I like DailyFinance.com especially, as they have charts of short interest over time in addition to the typical short ratio and days-to-cover data.
Short interest is especially telling because shorting a stock, or borrowing a stock to sell now then buying back later to return the stock to the lender, is overwhelmingly executed by hedge fund investors. As Ive mentioned before, these professional investors are almost always more experienced, have significantly more resources, and have much more time to research a company than nearly any retail investor. As such, going long a stock with a particularly high short interest is, in effect, betting against the professionals. This sort of activity is akin to playing blackjack in Las Vegas; you can win sometimes, and sometimes you win big, but play long enough and the house always wins.
Which brings me to one of the most over-hyped phrases bandied about when discussing a stock play: the so-called short squeeze. In theory, a short squeeze occurs when a positive fundamental change occurs in a stock that is highly shorted. The traders caught short all scramble to cover their positions before the upward surge in share price. This, of course, causes the share price to surge higher and faster. The longs make a killing while the shorts lay slaughtered.
While the theoretical basis of the short squeeze is sound, and they most certainly do occur from time to time, an overwhelming majority of the times a writer or promoter calls high potential for a short squeeze, the predicted squeeze never materializes. Most often, the positive fundamental change never occurs and the hedge funds with short positions will profit as planned. Even when a positive fundamental change occurs, the stock price typically changes to reflect the news without any period of of being especially overbought.
The phrase is especially insidious as it tends to attract those most susceptible to the aspects of simple human nature that kill investing returns. The greed associated with potential quick and inflated returns and the pride associated with being right where all those professional investors were wrong is a lot for the undisciplined investor to overcome.
To end my rant on the short squeeze, when someone tells you something is a good buy because of a potential short squeeze, think about what theyre actually telling you that the stock is a great buy because so many professional traders think its a terrible buy. It makes no sense.
Not all stocks with a high short interest are necessarily a bad long play, though. For example, there are stocks with many large institutional owners that also have an exceptionally high short interest. One specific example is Vivus (NASDAQ: VVUS), a drug developer with both obesity and erectile dysfunction drugs in late regulatory phases of development. This battleground stock, you could call it, has many >5% owners including Chilton, Caxton, Suttonbrook and First Manhattan, but also boasts a short interest of nearly 23% of float, making it one of the top 100 most shorted stock on the NASDAQ. Someone will, of course, be very wrong here, but at least there are big dogs on either side of the fence, rather than squarely against you.
In general, a short interest of as much as 10% of float is typical of smaller biotech companies, but those with a short interest of over 20% usually means danger. Combine short interest with institutional ownership and analyst opinion to get a more complete picture of the particular stock.
Dilution Risk
An ever present risk in holding shares in any biotech company, but especially of that is rapidly approaching a catalyst, is that associated with a surprise dilutive follow-on, or secondary, offering. In these events, new shares are issued by the company in order to raise cash to finance current business operations. The offering increases the number of total shares thereby decreasing the amount of the company each share owns, hence diluting the current shareholders. These events can have serious implications on share price and a drop in excess of 10% is often typical.
The timing of follow-on offerings is notoriously difficult to predict, as they should be. If it were easy to predict the timing of these events, the share price would dip going into the event and the company would then raise significantly less money than they would have otherwise. Managements, therefore, have a sizable incentive to be completely unpredictable about the timing of dilutions.
That being said, there are a couple pieces of information that may help you to predict approximately when a dilution will take place. First, determine how long a company has cash to continue operations as normal. This information can be found most easily in the companys quarterly press release that accompanies a 10Q or 10K SEC filing. The CFO will typically spell out exactly how long the company expects their current cash reserves will last to the nearest quarter. Having more than 24 months of cash will usually lower the odds of a dilution event taking place in the near future, but is certainly no guarantee. You can also take a look at when the last dilutive financing took place, as a company is unlikely to dilute again for some time with scaring away many of its shareholders.
Always expect a biotech company with less than 24 months of cash to dilute sometime in the three quarters leading up to a major catalyst event. Occasionally, someone will state something to the effect of If they dilute before their catalyst, it means they are expecting bad news. Otherwise, why not dilute after at a higher price?. These commentators are squarely wrong. Thats because even the company itself cannot predict with certainty that it will be successful in any high stakes catalyst event, and most especially when the catalyst is an FDA regulatory event. Raising money before the catalyst is the low risk play, and therefore it is the right play. Companies will always bypass the higher risk post-catalyst dilution in favor of the sure thing pre-catalyst dilution.
Once a dilution occurs, the most important piece of information to pay attention to is the price at which the placement occurs. Typically, the company will place the new shares with an institutional investor at a set price. The price gives a lot of insight into what the professional investment community believes is a fair share price. A placement price significantly below the current market values of the shares is an extreme red flag, while a placement price very close to current market levels can make the dilution a non-event, or even a somewhat positive occurrence as institutional ownership is also being increased (see Managing Risk in Biotech Investing: Part 1).
There are several strategies that serve to mitigate the risk associated with dilution events. The first is to simply average in to your positions. Rather than enter a large position all at once. Buy into the position over two, three, or more transactions spaced one to two weeks apart. This way, if the company does dilute, it will only adversely impact a part of your holdings, rather than the entire position if the company dilutes, say, the day after you made your single large order.
The other way to reduce risk associated with a potential dilution is to buy into the depression of share price that results from the dilution event. Assuming the placement occurs at a somewhat respectable price, the share price often tends to recover quickly. This especially true of biotech companies that are quickly approaching a significant catalyst. A recent example of a dilution followed by quick recovery (and rally) is Biosante Pharmaceuticals (NASDAQ: BPAX), which completed a $25 million direct offering in March 2011 at $2.06 per share then rallied to over $3.00 per share less then three months later. After a dilution event can be the perfect time to enter a position, assuming the rest of the investment thesis is sound. If you are already long the now diluted stock, this is one of the rare occasions where the right play may actually be to double down on the dilution loss, rather than exit to keep losses low.
Part 3 of Managing Risk in Biotech Investing, including catalyst risk and summary coming soon!
