How to Build a Better Biotech Stock Portfolio

Biotech investors have questions. The Motley Fool has answers. In this mailbag episode of The Motley Fool's Industry Focus: Healthcare, host Shannon Jones and Motley Fool healthcare investor Todd Campbell offer insight to biotech investors wondering how to build a better portfolio. In the show, investors learn:

  • Five items that ought to be on every biotech investor's checklist
  • Whether it's better to invest in a biotech stock following phase 2 or phase 3 data
  • How investors should think about management when picking biotech stocks to buy or sell
  • If pushback on drug prices makes this an industry to avoid

A full transcript follows the video.

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This video was recorded on March 20, 2019.

Shannon Jones: Welcome to Industry Focus, the show that dives into a different sector of the stock market every single day. Today is Wednesday, March 20th, and we're talking Healthcare. I'm your host, Shannon Jones, and I am joined via Skype by healthcare guru Todd Campbell. Todd, how are you?

Todd Campbell: I'm doing all right. I've got a little bit of that cold that's going around. If people think my voice sounds a little bit off, I apologize. But I'm really happy to be here today because we'll be talking about ways to build better portfolios. I just think that's a really, really exciting and useful topic.

Jones: Yes, and that applies whether you're a brand-new investor to the biotech space or if you're a more seasoned investor. Today's episode is really about diving into Q&A. We recently had an investing group, Talbot, stop by Fool HQ recently, and they brought along some awesome questions. It just made sense, let's actually take these questions, let's actually share these questions to all of our listeners out there. I'm excited to dive into these because I really do think they apply no matter whether you're seasoned or a newbie.

Todd, let's dive right in. Let's kick things off with the first question. The question is: Considering a potential investment in a small company with no earnings, but a promising pipeline of new drugs -- for example, like a Regeneron -- what does The Motley Fool actually look for?

Campbell: Wow, that's my wheelhouse! I love that kind of stock! I tend to invest in companies that are up-and-comers. I boil it down to five things. I look for management. I look for whether or not the technology, the therapy that they're developing is disruptive. I look to see whether or not the company is in the later stages of development, rather than early stages. I look to see how healthy the balance sheet is. And I like to know whether or not there's a well-heeled partner for whatever it is they're developing. Those are the five key things that I think are worth looking for.

Jones: Let's just briefly dive into those, Todd. I think that really captures the gamut of what you should be looking for, especially if it's a clinical stage company that is up-and-coming. The first, and I'm so glad that you said this first because this is really a true tenet of Foolish investing and something that all analysts here truly believe in. It's diving into management. We're going to get into it in more detail a little bit later on in the show. What do you look for when it comes to management, Todd?

Campbell: I really like "been there, done that" leaders. I want to know, have they successfully developed a drug in the past that's gone through clinical trials and won regulatory approval? I want to know whether or not those drugs were commercial successes. I want to know about the exit for that company they were at previously -- was it an acquisition? Those are the kinds of things I want to see with management. Proven leaders who have shown that they can take a drug from clinic to commercialization.

Jones: Even more importantly is getting past the regulatory hump, making it to market. What's becoming even more important, Todd, is whether this drug is potentially a commercial success. To see a management team that has experience not just getting through the regulatory hurdles, but also bringing a drug to market that actually makes money is certainly a plus in that category.

Let's talk about the idea of a disruptive drug. How would you define that, and what do you look for there?

Campbell: I want to know whether or not the therapy is going to be a game changer. Can it reshape the treatment paradigm so that it can win market share away from established larger competitors? One example of that that we talked about on the show not that long ago was Spark Therapeutics and its one-and-done treatment for hemophilia A. Theoretically, if that drug, which addresses a multibillion-dollar indication, makes it across the finish line, it could transform treatment, because currently, patients with hemophilia A receive two or three infusions of the missing clotting factor per week. A disruptive therapy would be one that truly changes how doctors treat patients.

Jones: I would add to that, and really it's kind of inherent in being a disruptor, you want to see at least one drug in that pipeline that does have the potential to become a blockbuster indication. That basically means you're looking at over a billion dollars in annual sales. That's one thing I like to look for. Is there potential there? Then, more importantly with many of these smaller companies, do they have multiple drugs in their pipeline? I'd like to know that they have multiple shots on goal and that they're not placing all of their bets on just one drug in particular.

Campbell: Absolutely, 100% agree with that. I also think it's important to keep track. We're kind of moving on now to the third point -- is it a late-stage drug? I think there's a lot of excitement that comes out with therapies in phase 1 data. Everyone is pounding the table, saying, "This is going to be the next big thing!" But the reality is that about 10% of the drugs that go into clinical phase 1 trials actually make it to pharmacy shelves. The failure rate is highest in phase 2. Always, in my opinion, better to wait a little bit longer and make sure that you've got positive efficacy in phase 3 trials. That should at least maybe inform a little bit of phase 3. But even in phase 3 -- and we're going to talk about this later on in the show, I know -- roughly half of the drugs that are in phase 3 end up falling short. Just because it's a late-stage drug doesn't mean you're guaranteed success. But I prefer later-stage drugs than earlier-stage.

Jones: Yeah, same here. I like to know that they've got a relatively clean safety profile as well. You want to know that the drug works, but if there's already a standard of care out there, will the drug work at least better, if not the same with the potential for less side effects overall? That's something that I'm looking at.

With that, let's move on to the other part. Financials also matter, even for clinical-stage companies. Todd, what do you look for there?

Campbell: We have to remember that since it's a clinical-stage company, there's no revenue coming in to handle the expenses. You've got the money from your initial investors, you've got money you raised maybe from your IPO, and then maybe money that you've raised through secondary offerings of shares, etc. But you do have plenty of expenses. You don't have a lot of cash to play with, but you've got a lot of expenses because clinical trials, especially late-stage clinical trials, can cost a lot of money. You want to take a look at the balance sheet and say, "How much cash is there today? What's their cash burn?" Take a look at their operating expenses and see how much of their operating expenses they're burning through of that cash.

Then, take a look and see, is management giving guidance as to how long that cash runway can last them before they would have to go back out and dilute me as an investor by issuing more shares? Oftentimes you'll see management talk about that on their conference calls or in their press releases. They'll say, "OK, we have enough cash on deck to be able to get us through that phase 3. Then maybe we'll have to raise more money if we're going to try and commercialize it on our own."

Jones: Exactly. For new investors, you're not necessarily looking at cash in terms of "Do they have enough cash to get them all the way through to approval?" But to your point, Todd, you're looking to see, do they have enough cash on hand until their next inflection point? Whatever that may be, whether that's a new study readout that's coming. You want to know they can at least get through that next inflection point.

Another thing that I look at with these small companies in particular, it's a red flag for me when I see them take on massive amounts of debt. It's already risky because this is a smaller company, no approved products. When you see them taking on a lot of debt, that increases the risk exponentially.

Let's talk about the next checklist item, and that is partnerships. Todd, what do you look for there?

Campbell: To try and avoid having to dilute shareholders, a lot of these small clinical-stage companies will license the rights to these drugs that they're developing to much larger companies. I always want to find out whether or not there is a partner that is deep-pocketed and especially has experience within the indication that is being targeted. As an example, you've got bluebird bio, which is working on a gene therapy for multiple myeloma. That gene therapy is partnered up or licensed to Celgene, which happens to get most of its money marketing drugs for multiple myeloma. That would be, in my mind, a good example of a strong partnership.

Jones: Speaking of Celgene, you've seen them do this multiple times, I do like to see partners that make large upfront stakes. I think the larger the stake the better because then you know that this large biopharma partner actually believes in what this company is doing. They did this back in 2015 when they took a 10% equity stake in Juno Therapeutics and also $150 million in upfront cash for the company before they ended up acquiring them in 2018. I do like to see good partnerships, strong leaders, and that they're making significant upfront investments into these companies as well.

Campbell: Don't get too excited, right, Shannon, about a $10 million upfront payment that's really back-end loaded, right? [laughs]

Jones: Exactly. The back-end-loaded payment structures give me pause. It's something for you to be mindful of. Again, not every partnership deal actually turns out. Many of them end up being terminated. But it certainly does help to see large partners coming in and helping to fund development and actually bring that expertise that you mentioned.

All in all, you've got a number of different points that you can look at as you're evaluating investments. These are the things that we like to look at here at The Fool. Ultimately, it comes down to management, it comes down to competitive advantage, the sustainability of those competitive advantages, partnerships, and then, of course, the financials, too.

Todd, let's dive into the second question: If a biotech company has had some success and is developing a new drug which has passed the FDA's second stage, or phase 2 trials, as we know them, would The Motley Fool recommend investing then, or wait for phase 3?

Campbell: How risk tolerant are you?

Jones: Question of the hour.

Campbell: That's really the question. The Motley Fool does have recommendations of companies that have early-stage programs. It's not like I think you shouldn't invest in early-stage programs. But if you were going to stop me on the street and say, "Hey, Todd, would you rather have phase 2 data in hand or phase 3 data?" Well, I'd rather have phase 3 data in hand. Again, that speaks to what we were talking about before with the success rate of clinical trials. There's a very, very high failure rate. That failure rate occurs at each one of these different stages, and the failure rates are not insignificant.

If you look at phase 1, the probability of success, so phase 1 getting to phase 2, the probability of success is pretty high, 63%. That's because phase 1 isn't designed to prove out the efficacy of a therapy. It's more of a dose-ranging study, get some safety information. Phase 2 to phase 3, only 30% probability of advancing into phase 3. So phase 2, a lot of drugs end up failing. So now you're saying, what if they've successfully made their way through phase 2? In phase 3, your probability of success is quote-unquote 58%. Slightly better than a coin flip, but still better than phase 2. And there's always the risk that even if you put up good phase 3 numbers, it will fail to win regulator approval.

Regardless, I like to have the odds in my favor. I would prefer to have the phase 3 data, if push came to shove.

Jones: Yeah, same here. Now, with the FDA trying to push through more of these innovative products, sometimes you'll see a combined phase 2/phase 3 study under way, especially for areas with high unmet need. You can look at that data as well, especially if they plan to use that data to actually register for approval. But just like you said, phase 2 is riddled with failures. As a matter of fact, the FDA even put together a document back in 2017 entitled 22 Case Studies Where Phase 2 and Phase 3 Trials had Divergent Results. So it's not uncommon to see pretty good phase 2 data, but you have to remember, phase 2 is only allowing the drug to be exposed to maybe several hundred patients in most trials. Really, you're getting early signs of efficacy oftentimes on lab values or biomarkers. You're not necessarily looking at clinical outcomes, that comes in phase 3. So while you get some early signs of efficacy in phase 2, it's really phase 3 when it's expanded to a much wider patient population, often hundreds to thousands of patients with some of these larger trials. Then you really see, does this drug actually work, and is it safe?

My bet is always, I'm going to wait until phase 3 unless there's something really compelling or really disruptive or innovative. Then I might take my chances on phase 2. But generally I will wait for phase 3.

Campbell: The other thing that's important to mention, Shannon, is that you can look at this on an indication-by-indication basis, too. They do have data out there that allows us to see the success rates from phase 2 to phase 3, or phase 3 to approval. Are they better for some indications than they are for other indications? And the answer to that is yes, absolutely. In some indications, you may feel more emboldened by the probability of success than you would with other indications. For example, hematology drugs tend to have a very high probability of success relative to all other drugs, while oncology drugs tend to have some of the worst probability of success. So maybe you're willing to take a little bit of risk earlier stage with companies researching hematology, but not really wanting to take too much risk when it comes to cancer.

Jones: Great point there, Todd. And we're The Motley Fool, so obviously we have this long-term, buy-and-hold approach. Waiting to phase 3, and even waiting for actual approval, is not a bad thing, especially if you plan on holding on to a stock for three to five years plus. It's OK to wait to see, does this drug actually work? What's the commercial strategy? Oftentimes, you're not going to get that until a drug is very close to approval or right after approval. It's certainly OK to wait on the sidelines until you get a clear picture of that, for sure.

Todd, let's move on to the next question here: How does The Motley Fool evaluate management, other than sales and earnings track record?

Campbell: There are a few different things. As I said earlier, I like "been there, done that" leaders. I like people who are demonstrating to me that they've got the chops and the success in the past that they can leverage to be successful again today. I think one of the ways to evaluate management from a clinical stage perspective is to say, Have they been successful in the past? Maybe that will help you have some confidence that they're going to be successful again. Then, with commercial stage companies, how successful have they been in designing trials and translating those trials into regulatory approvals and commercial-stage successes? And how much are they willing to commit in R&D spending to protect that moat? Or have they made missteps?

Shannon, you and I on the show have talked plenty about different missteps in the past that companies have made. One that jumps out to me if you're evaluating management is Bristol Myers Squibb, and what happened with Opdivo in 2016. Bristol Myers Squibb's management decided to enroll a very aggressive population of people in a first-line lung cancer study. Basically, they were looking for patients who didn't express a lot of a particular biomarker in their cancer that the drug was designed to target. They were hoping for the broadest label possible. Their competitor, Merck's Keytruda, didn't do that with their first-line study trial. Keytruda succeeded, Bristol Myers failed. That's a knock. Now, you look at Bristol Myers' management, you say, OK, that was a bad decision on their part, so I'm evaluating them a little bit on the strategy of how they're designing their clinical trials to set them up to succeed best. I think that's something to keep in mind as well.

Jones: Bristol has certainly been under the gun more recently in terms of their management with the Celgene deal. We won't talk about that on today's show, but I'm sure we will get to that very soon.

Another thing that I think is really important when it comes to biotech is management transparency. Because of the changing nature, because there's still so much that we don't know about the human body and how these drugs will work, you want a management team that's going to be very upfront about its challenges. Even when it comes to trial design, if they have to change an endpoint, you want to know that management is being upfront about it and why. What you don't want to see -- one of the tools I highly recommend that any biotech investor use is to go to, and you pull up the trial design and you compare the edits. You literally can compare what they have changed. Then, all of a sudden, you notice that they actually changed some of the endpoints that they were evaluating this drug on. Those are things you don't want to see. You want management to be up front.

Also, you want to make sure that management doesn't use a lot of buzzwords that have very little meaning. "Successful FDA meeting" is one of those that's my pet peeve, Todd. I don't know what that means. Oftentimes, it just means you had a meeting. I don't know if the FDA actually just told you to go ahead and put that drug on the shelf because it's not going to work, and you decided to proceed anyway. I want to know that I can trust management, trust what they're telling me, and also that they're not being coy about what's actually happening with their drug.

Campbell: Yeah, what's successful? Right, Shannon? "I actually made it to the meeting!" [laughs] "I didn't pass out while I was talking to the FDA!" Yeah, that's a very valid point. You don't want to invest in a hype factory. If you feel like you're investing in a management team that's more interested in press releases than research, that might be a company to avoid.

Jones: Yeah. We could probably do a whole show just on biotech red flags.

Another thing I like to evaluate with management is the board of directors. Are they bringing relevant experience? Do they have expertise in the areas that the company is focused on? What I don't like to see is a board that is full of politicians that have no medical experience. I shall not talk about the company that did that, but I'm sure many of our listeners will know. I want to see a board of directors that brings that scientific and clinical expertise. The commercial expertise, too, is another important point for me.

Let's go to our final question here: There's been much negative press about biotech companies dramatically increasing prices. Should we avoid companies which are aggressively raising prices? Todd, I love this question.

Campbell: It's an awesome question and it's really relevant right now because, you know, you just know, that the 2020 presidential election, that's going to be heating up from here. You know drug prices are going to be something that these politicians will be pounding on the table about, because it works. It resonates with people. People are frustrated about how much their medicine costs, and that could translate into headwinds for some of the stock prices of these companies.

I think the era of unchecked price increases on mature drugs is over. From here, I think that as you're modeling and thinking about how much can we grow revenue at XYZ Company, if you're a shareholder, you should be modeling 5% to 10% max per year for the existing drug, unless, of course, it gets approved for new indications. As a result, Shannon, I think that investors need to be focused more on innovative companies. I don't think they should be focusing as much on these companies that have a quote-unquote "track record" of serial price increases that have driven a significant amount of their sales success. Instead focus on innovative companies that are working on therapies that actually may save the healthcare system over time. Although they cost a lot up front, if it's a one-and-done treatment, that keeps you out of the healthcare system and maybe saves the system money over time. Maybe focus on those kinds of things -- rare diseases, late-line treatment, so maybe third- or fourth-line cancer treatments where there are a few other treatment options.

Jones: You mentioned the 5% to 10% price hike increases. Generally, many of the larger biopharma companies are targeting that range. It's kind of laughable to me because you do see some companies come out with a 9.9% increase. They just refuse to go above 10%. But, to your point, innovation is, I think, really where you can unlock a lot of value as a shareholder. For many of these companies, you want to know that they're developing drugs that are serving a high-unmet-need area, that are actually contributing to the long-term quality of life for many of these patients. I think those are much safer bets overall. Granted, the price tags may be a lot higher, but you are starting to see a lot of these biopharma companies come out with value-based pricing contracts to make sure that they can gain some sort of reimbursement for these drugs. Those are the types of things that I at least like to see.

All in all, I won't say avoid the companies that have these 5% to 10% price hikes. I will say, avoid the worst offenders. If you've got a drug that you've taken off the shelf and you increase the price by 5,000% with very little innovation going into it, very little R&D going into it, and you're just repackaging it and selling it for much more, those, I would say, avoid. But generally speaking, just look for those companies that are truly innovating.

Campbell: Right. Shannon, that's a great point. It made me think of this other point, which is that if you're trying to separate the wheat from the chaff, and you look at it, you say, How much is a particular company -- say it's a commercial stage company -- how much are they plowing back into R&D? If it's 10% or less of sales, probably not going to be an innovative company that'll have a lot of blockbusters in the wings. These companies are going to have to invest in their future to offset their patent risk. They just can't rely on price increases alone.

Jones: Great points, and a great way to wrap up today's show. Thank you, listeners, so much for tuning in! As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is produced by Austin Morgan. For Todd Campbell, I'm Shannon Jones. Thanks for listening and Fool on!

Shannon Jones owns shares of Merck and Spark Therapeutics. Todd Campbell owns shares of Bluebird Bio and Celgene. The Motley Fool owns shares of and recommends Bluebird Bio and Celgene. The Motley Fool has a disclosure policy.