Perception vs. Reality in the Biotech World, Part 1

Most folks shake their head when they look at the price action in biotechnology stocks. One stock may soar, another swoon, but neither movement is due to any news or milestone in the product development process. At best, these stocks mimic the driving technique of the typical New York City cab driver. Why?

The reason is that biotech stock prices are governed by the disparate forces of perception and reality. A proponent of this theory is Joseph Edelman, portfolio manager of Perceptive Life Sciences, a New York-based hedge fund specializing in biotechnology.

Joe's an old-timer in this field, having been a senior biotechnology analyst at Prudential Securities from 1990 to 1994, and a senior analyst at Paramount Capital Asset Management from 1994 to 1999. He's had a nice run recently: His hedge fund returned more than 130% between its inception in July last year and year-end, and has returned more than 70% in the year to date.

Edelman's insight is based on the fact that most biotechnology companies have yet to commercialize a product, so a company's market value is based almost entirely on expectations for its lead compound. Even after the lead product is approved, much of the company's future prospects depend on the commercial success of that drug. However, investors have to realize that information is reported about that lead product only at rare intervals, called "reality points."

Those reality points are:

1. The results of a clinical trial
2. An FDA advisory panel meeting reviewing the compound
3. Quarterly financial results -- once the product has been approved and launched.

In between reality points -- that is, the other 99% of the time -- a biotechnology stock trades on perception, not reality. When a biotech stock keeps moving up or down in the absence of any "reality points," it's moving entirely on perception.

For example, in the past 12 months, ViroPharma (VPHM) soared on expectations for its lead experimental compound, Pleconaril, for the treatment of the common cold and viral meningitis. Phase Two data was released for both the common cold and viral meningitis. However, when the disappointing results from the Phase Three clinical trial were released -- another "reality point" -- the stock plummeted.

The theory of perception vs. reality is uniquely suited to biotechnology stocks because they are so inefficiently priced. For instance, if customers are flocking to see Toy Story 2, which means that Pixar (PIXR) is doing well in reality, this will most likely be reflected in the stock price.

In the case of the biotechs, however, the lengthy intervals between reality points mean that shifting perceptions rule share prices the vast majority of the time. In fact, the extreme movements in many biotechnology stocks point out the market's inefficient pricing of those securities.

For more about the "reality points" theory, read Part 2 of this story.

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