[Editor's Note: This guest post was submitted by Michael Fishman, MD, MBA. He started his post-graduate training as a surgery resident, where he saw the light on the other side of the curtain. In transitioning to Anesthesiology, he took a year off and did an accelerated MBA at Drexel University’s LeBow College of Business. After anesthesia residency at Yale, he is now a Multidisciplinary Pain Medicine fellow at Stanford. This Pro/Con series started out like most of them, with a guest poster submitting a guest post I disagree with. I almost just flat-out rejected this one, but since I frequently hear doctors, both in real life and online, advocating similar methods, I thought it was worth a discussion here. We have no financial relationship.]
Pro: Physician Investors: Stick to your Core Competency
I first got involved in biotech trading by sheer luck – I was made aware of a company that had an upcoming reporting of phase III results and started to become more aware of the significance of the Food and Drug Administration’s (FDA) calendar. There are a number of binary events that have known dates. As a physician scientist, we have journal access and knowledge to interpret published data. There are Advisory Committee (AdComm) panels that meet typically one month or so prior to a decision date, on which a panel of independent experts vote on safety, efficacy, and other concerns regarding drugs and devices. The briefing documents from the FDA and the sponsor company are available two business days prior to that event. They are public knowledge and published free of charge on the FDA website. Interpretation of AdComm data has proven to be highly lucrative for me.
Sources of Information
I subscribe to a few sources, which I rely on for four main resources: a database of companies with upcoming catalysts, analytical articles, a current FDA calendar, and real-time Twitter updates on events. I do not endorse any particular resource and have no conflict of interest. Subscription sites I have used in the past include BioRunUp and Chimera Research Group. An excellent free resource is Bio Pharm Catalyst. The resource I use most heavily is the FDA AdComm Calendar. This is difficult to navigate (it is the Federal government, after all), but if you put in thirty minutes or so you will start to realize that it has a great deal of information. This is where AdComm briefing documents are released. You can also subscribe to receive update e-mails whenever new information or events are posted.
My personal approach involves correlating medical data with market sentiment around binary events. I use several different trading strategies to profit from the common patterns that surround these events. There are a few main timeframes that I trade. First is the run-up. Typically, there is a run-up to the event starting 3-4 months prior to the binary event. In some cases, there is an AdComm prior to the approval date, and this can be treated as a binary event in and of itself. Next is the actual approval event. Last is the sell off, as traders sell the stock after approval. This is important because typically companies lack the ability to immediately monetize their new approval. Cash flow may be months or years away, and could require partnership deals and/or raising a sales force. This is highly tradable and predictable. It is also an opportunity to pick up shares of these companies with promising approved drugs at a discount. Trading is just trading, but as a physician with insight and foresight you can use traders’ frivolity to value invest.
There are no hard and fast rules, and not all companies fit these patterns. It is important to never put all your proverbial eggs in one basket. These trends have proven to be true for a majority of trades over the past two years, but there are always exceptions. Pigs turn into bacon. Don’t get fried on one trade. Make rules for yourself and limit risk in any one idea to an amount that stings if you lose it but doesn’t make you wretch or file Chapter 11. Options are an excellent way to have a fixed, tolerable downside with an unlimited upside. They can also be used to hedge.
Without further adieu, I will present my general framework for evaluating small- and medium-cap biotech stocks with near- and medium-term catalysts. I do not take all these steps for every company.
General Approach to Biotech Investing
- Catalyst Date
- For this I typically rely on the FDA calendars at subscribed sites. I look a few months ahead and then research the companies and pipelines.
- Summary of disease
- As a physician, this is obvious. Incidence, prevalence, impact, chronicity, severity are all factors to consider.
- Competitive landscape
- What other drugs are on the market? Do they work? Is this a new formulation of an existing drug (frequently the case)? Are there generics?
- Most important question – is this a disruptive technology (i.e. an oral formulation of a therapy previously only available as injectable)?
- Downside (Market cap – net cash)
- Use your brokerage site or Google finance to look at the company’s financials. How much cash do they have? How much cash do they spend? What is the market valuing them at (market cap = share price x number of outstanding shares)? This is typically the downside potential.
- Upside (industry comps)
- Difficult to gauge, but you can look at the prevalence of disease, competition, and predicted drug cost and make a reasonable guess as to the revenue expected from the drug or device. Once you have this figure, you can predict a new market cap based on commonly used Price/Earnings multiples (average for biotech is 10X), but you can look at direct competitors of your company for more accurate analysis.
- Many companies have partnerships and debt obligations. These should be disclosed in shelf filings, financial statements, annual reports, and general news. Know the deals they have, know the associated milestones, and adjust accordingly. I find comfort in small companies who have multiple deals with Big Pharma, it means that these major players have done due diligence.
- Projected market valuation
- Multiply the projected earnings per share by the average P/E and compare to the current market cap. The difference can be extrapolated to suggest upside on approval.
- Projected Market Cap (favorable/unfavorable)
- Just to reiterate, it is best to model the upside and downside. This is especially useful when creating an options strategy. My favorite options strategy is the ‘strangle’ or ‘modified strangle’. This operates on the premise that the stock price will move up or down based on the binary event.
- Google news or brokerage site should be used to have news on your watchlist forwarded directly to you.
- FDA Comparisons/AdComms
- Look at how similar drugs (by class or mechanism) have fared with the FDA in the past. Pay attention to the AdComms – these are highly tradable and the briefing documents have a great deal of information.
- Twitter sentiment
- Twitter has a tight group of biotech investors who I have followed for some time. There is a lot of information and news that can be gleaned in this fashion. I do not post often, but typically use Twitter to ‘listen’. News travels fast on Twitter, and I have made several profitable quick trades as a result. Log in to Twitter and look at who I follow. (Follow me at @MFMDMBA.)
Con: Buying Individual Stocks is a Loser's Game, Even Biotech Stocks
Dr. Fishman's initial email to me said he tangentially followed my blog. I figured it must be REALLY tangential for him to send me a post suggesting that picking individual stocks was a good idea. His follow-up emails noted that he invests 20% of his portfolio in biotech stocks and 80% in dividend stocks. While I will readily admit there are dozens and dozens of reasonable portfolios, I don't see his as one of them. It is a bit difficult to know exactly where to start with this one, but I was able to come up with a five point list about why investing as Dr. Fishman has suggested isn't a great idea.
1) Uncompensated Risk
According to well-known investing theory, any time you can diversify away a risk, that risk is uncompensated, meaning you will not, on average, receive additional return for running that risk. By its very nature, investing in individual stocks, which are easily diversified by purchasing a very low cost index fund, is uncompensated. The data is very clear that thousands of professional mutual fund managers can't beat the index funds despite their best efforts. What makes you think you're so special? If you're really that smart, why are you practicing medicine for chump change instead of running your own mutual fund or hedge fund? Going to medical school does not give you enough of a leg-up that you're going to beat the pros at picking biotech stocks, much less beating a passive fund.
2) Competing with Experts
But I'm a doctor! Surely I know more about biotech companies than the analysts some mutual fund has hired. Guess what? Those mutual funds can hire doctors, and MBAs, and CFAs and MD/MBA/CFAs. These guys spend all day, every day analyzing these health care companies. Every time you buy and sell, guess who the guy on the other end of the trade is? It's not Joe the Plumber.
3) The Value of Your Time
Dr. Fishman has listed out an 11 step process to aid you in knowing when to buy and sell biotech stocks. How much time do you suppose those 11 steps will eat up? All of a sudden I have to read all kinds of financial news and follow a bunch of people on Twitter? I have to learn how to analyze earnings statements? I have to read shelf findings? I have to know what an AdComm is? I have to spend time on the FDA website? To make matters worse, many of these companies are making products that aren't even used in my specialty. That means more research for me. So, let's be conservative and say you're going to spend 5 hours a week doing this stuff. That's 260 hours a year. Let's say your time is worth, pre-tax, $200 an hour. That's $52,000 per year if you spent that time at work instead of researching biotech companies. Now, I have no idea how large Dr. Fishman's portfolio is as a fellow, but I suspect it is not very many multiples of $52,000. But even with my presumably larger portfolio, I would need to be able to beat the market by about 10% a year in order to be worth spending 260 hours on it, and that's assuming my entire equity allocation is invested in these individual stocks. Call me skeptical, but I don't see that happening. If I could do that, I'd be running a hedge fund. Far better for me to be contributing an extra $52K into my portfolio each year than spending 260 hours a year on Twitter and the FDA website.
4) Vanguard Health Care Fund
If I really thought biotech and other healthcare stocks were a smart sector to overweight, there are far better ways to do that than trying to purchase individual stocks. Vanguard's health care fund has an excellent long-term record, almost 18% per year since 1984, all for just 30 basis points. There are dozens of other passively managed ETFs as well. Otherwise, I'll content myself with knowing that I already own every single stock Dr. Fishman has bought in the last 10 years.
5) Invest, Don't Trade
Dr. Fishman also suggests that you “trade” these stocks. In case the meaning of that is unclear to you, he is saying you should not necessarily hold them very long. You buy them before they go up, and sell them before they go down. The problem with this strategy is that it is extremely difficult to predict the future accurately enough to overcome the costs of the strategy. Every time you buy and sell there are bid/ask spreads, commissions, and tax consequences. If you've held it less than a year, you pay your full marginal tax rate on your gains. I don't know about you, but my crystal ball always seems to be cloudy. Predicting the future always seems so hard to me, even when things seem obvious in retrospect.
The other issue I see traders run into all the time is they don't accurately track their returns and compare them to a reasonable benchmark. I say, “XIRR?” and they say, “Huh?” Or perhaps they don't include the commissions or the extra taxes. Or perhaps they're comparing their returns to the S&P 500 while investing in stocks that aren't in the S&P 500. At any rate, Dr. Fishman didn't reveal his returns to us, and even if he did we don't have an independent audit of them and so would probably be skeptical anyway. But none of that really matters. What matters to you is YOUR returns, not those of Dr. Fishman. So if you're going to trade individual stocks, track your returns meticulously, include all expenses including taxes, subtract out an appropriate value for your time, and compare them to an appropriate benchmark. If you're like most who do this, you will quickly disabuse yourself of the notion that you are any good at picking stocks. While you're at it, write down all your other predictions about the future- currency changes, interest rate changes, which way the indices are going etc. You'll likely be surprised how cloudy your crystal ball is.
Busy physicians don't need to pick individual stocks, much less options, in order to successfully reach their financial goals. Coupling an adequate savings rate with a reasonable, low-cost indexing strategy has worked for thousands of physicians and it will work for you. If you wish to engage in stock-picking as a hobby, limit yourself to a small slice of your portfolio and meticulously track your returns.
Rebuttal – Dr. Fishman
I use the above strategy as a component of a balanced stock portfolio. I have mutual fund positions in my retirement accounts, but did not disclose them as I tend to think of my active and passive portfolios as distinct entities. The investing strategy I use in my trading account is to generate gains using the aforementioned trading strategy, which are then used to purchase dividend-paying stocks, REITs, and ETFs.
I enjoy the process of being informed on emerging companies, technologies, and drugs. I tend to select companies in areas within my specialty, but also enjoy learning about others. Investing and learning and research are fun. The savvy physician investor can use my strategy to identify opportunities where the traders have taken their profits and left a company with an approved drug in an oversold state. Value investing beats the market consistently over time.
Is this riskier than passive strategies? Yes. Have I consistently matched or beaten the S&P for the past several years? Yes. Have I considered leaving clinical medicine to pursue this full-time? Yes, but I enjoy medicine (at least for now).
Rebuttal – White Coat Investor
I've said many times it doesn't matter all that much what you do with a tiny portion of your portfolio. If you enjoy picking stocks, and it is a relatively small portion of your portfolio, then have at it. But I find it interesting that someone who enjoys investing, spends a great deal of time doing it, and apparently can beat the market with his stock picks still invests his serious money in mutual funds. There are two lessons to take from that. First, that informed investors invest their serious money in mutual funds. Second, that even an investor who has (reportedly) beaten the market is humble enough to realize there is a reasonable probability that he beat it by luck rather than skill and smart enough not to bet the farm on that skill. Chances are that readers neither have an MBA nor are willing to spend countless hours researching biotechnology stocks rather than spending time with their kids, mountain biking, or seeing patients.
Dr. Fishman makes a couple of other points in his rebuttal that should be addressed. The first is that value investing beats the market. That is true, as evidenced by Fama and French. However, picking value stocks doesn't beat a passive value investing strategy for most investors, most of the time.
Second, Dr. Fishman compares his returns to the S&P 500, an inappropriate index for someone picking biotech stocks. He should be comparing his returns to a biotech index, such as the Nasdaq Biotechnology Index. This index sat at 791 5 years ago. As I write this (and that is a few months before the post runs) it is at 3583. That represents an annualized return of over 35% per year, not including dividends, whereas the S&P 500 had a 5 year annualized return of just 16%. If Dr. Fishman's annualized after-expense returns are between 16% and 35%, he has made the classic error of mistaking a bull market for brilliance, while actually underperforming the market he is investing in. A 2010 investment in the ETF IBB, which invests in that Nasdaq index, has quadrupled in value over the last 5 years.
Hopefully, Dr. Fishman has a profitable hobby, but even if his stock picking is underperforming an appropriate index, that's okay too as long as he's enjoying it. Readers know that not only do I invest in some weird stuff, but I waste lots of money on hobbies I enjoy too.
What do you think readers? Do you think physicians have an edge over the pros (or even average stock pickers) when it comes to biotech stocks? Why or why not? Comment below!