A Lesson in Speculation

In spite of the market selloff Thursday and Friday we appear to be in a nascent uptrend. Money is returning to smaller capitalization stocks, meaning that market participants are feeling more confident and are therefore willing to assume greater risk.

And so I arrive at the conclusion that it’s time to take a look at the biotech sector. As you can imagine the sector is out of favor, as it always is during cautious market environments. After all, apart from some profitable large cap companies for the most part the sector is littered with concept companies that have no earnings or sales, but are long on intellectual capital that they hope to turn into profits.

I found what I felt was an interesting company that just came public last year, Accentia Biopharma (ABPI). It trades for less than $3 despite their having a treatment for chronic sinusitis, SinuNase, in Phase III trials.

But the real attraction to ABPI is that they own almost 80% of a Bulletin Board traded stock, Biovest International (BVTI). This company has a follicular non-Hodgkin’s lymphoma drug, BiovaxID, in Phase III trials. And it has been granted Fast Track status by the FDA.

ABPI, which came public at $8, now has a market cap of about $89MM. BVTI, trading at $1, has a cap of about $80MM. This means that if you buy ABPI at the current price, it’s like buying 8/10 of a share of BVTI and getting ABPI for under $1, quite a discount to Friday’s closing price. It seems like an intelligent, well thought out plan that could pay off nicely with a little bit of patience.

What’s wrong with this thinking? Plenty. Bear with me while we review another great opportunity from last year that has now completely played out.

A well respected subscription service submitted a speculative biotech, Corcept Therapeutics (CORT), for consideration on 04 February 2005. At the time it was trading at around $5 a share. The company had come public just the prior April at $12 a share, well below its $15 - 17 target range. Their rationale was thus:

“This week CYBX benefited from a surprise decision by the FDA to issue an approvable letter for a treatment resistant depression indication for vagus nerve stimulation and they expect that other stocks might benefit from what appears to be the FDA's seemingly new and positive stance on alternative depression treatments. CORT is a tiny co engaged in the development of drugs for the treatment of severe psychiatric and neurological diseases. CORT's main drug candidate CORLUX is currently in Phase III trials in psychotic major depression (PMD). With the main treatment option currently being electroconvulsive therapy (ECT or shock therapy), its not hard to see the potential of CORT's offering. Peak sales estimates range from $200 to $500 mln. It is also worth noting that CORLUX is the first psychiatric treatment to receive fast track from the FDA. With a 65% insider ownership and no plans for further dilution, the co has been flying below most analysts’ radars. Mkt cap is $108 mln, which is way below its peers that have candidates in late-stage development.”

On their surface the arguments for ABPI and CORT are cogent. But when being seduced by the anticipated upside what you forget most is the downside potential.

On 25 August of this year Corcept announced that patients in their Phase III study did not respond much better to Corlux than to a placebo. Shares in the company, which had already dipped below $4 a share plunged below $1 during that day’s trading.

This company may not be finished. They may well have other drug candidates. But clearly the reason for the speculation has been invalidated. Your loss on this would have been considerably over 50%, perhaps over 80%, and you would have lost the chance to invest the money elsewhere for almost 20 months, so the return is even worse when you factor in the time value of money.

This is not intended as an affront to the subscription service, for which I have the greatest respect and to which I contribute pieces from time to time. They clearly stated this was a speculation. I am writing this piece because every once in a while we are all attracted to a speculative story like ABPI, and CORT is the poster child for why they should be avoided.

I am a trader and investor. People look at me cross eyed when I tell them how I make a living. They feel what I do is akin to gambling. But it is NOT gambling. I am buying companies with real value. If I have a losing trade there is downside risk, to be certain. But the cost of losing a gamble is 100% of your money, and the odds are never in your favor. The odds of losing more than 10% percent due to adverse news in a well chosen trade in a profitable or at least cash flow positive stock are small.

And so on Monday I will NOT be buying ABPI. The stock may quadruple on good news if it ever comes. But I’ll look elsewhere for my living, in places where the downside cost of investment is a lot less than 100%.