The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.
NEW YORK (MagicDiligence.com) -- It is one of the fundamental facts of Joel Greenblatt's Magic Formula Investing (MFI) screening methodology: small research pharmaceutical firms almost always show up shortly after receiving one-time windfalls such as hitting development milestones or receiving collaboration payments of some sort.
These huge shots of revenue spike profits, causing trailing 12-month returns on capital to skyrocket. At the same time, human investors realize that these payments are non-recurring, keeping the stock price at a reasonable level but creating what looks like a very low valuation (low P/E ratios, or high earnings yields). Bingo, the perfect formula for getting screened by MFI! I believe it is one of the side effects of the simple screening methodology, and it breaks the strategy's core mission of finding "great companies selling at cheap prices."
It is not just an annoyance, either -- a significant number of these stocks constitute the current small-cap (top 50 over $50 million) screen. Currently, eight of the 50 stocks can be classified as small research pharmaceutical firms -- a meaningful 16%. Some have approved products that pay royalties, some do not. Some have multiple late-stage drug candidates, some do not have a pipeline past Phase II.One thing they all have in common is that it is extremely difficult to value them due to the inherent uncertainties in drug development. MagicDiligence generally recommends taking a "basket approach" if you want exposure to these names -- buy a little of each of them instead of dedicating a full portfolio position to one in particular. We've looked at several recently (DepoMed (DEPO), Pozen (POZN), and SuperGen (SUPG)), and today we'll add another to the reviewed list: Acadia Pharmaceuticals (ACAD). Acadia falls on the high-risk side of this group. Unlike any of the aforementioned three stocks, Acadia does not have any approved products generating royalties. In fact, the company has never had a product approved! Acadia relies on occasional milestone payments, research grants, and issuing new equity to fund its operations. The payment that got the stock into MFI was recognition of about $35 million in deferred revenue from the October 2010 termination of its partnership with Biovail for lead drug candidate Pimavanserin. This occurred after Biovail was merged into Valeant (VRX).
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