Perception vs. Reality in the Biotech World: Part 2

Editor's Note: On Wednesday, biotech columnist Gabe Hoffman discussed how biotech stocks trade around "reality points," the dates when actual news is released. Today he shares how this insight can help time purchases of specific stocks.

How can you use the theory of perception vs. reality to make money? One way, according to biotech portfolio manager, Joe Edelman, is to look for a biotechnology stock that shows a strong chart, and whose lead drug is set to go before a review with a Food and Drug Administration advisory panel.

Buy such a stock at least two months before the review, and sell it a couple of weeks before the panel. Think of it as buying a stock while it is steadily rising on perception -- and then selling it before the reality point. The risk is lessened because nothing bad can happen to the company before then -- at least not in terms of its reality points. This method also applies to other reality points.

Look, for example, at the meteoric rise in ViroPharma's (VPHM) stock price following the release of the Phase 2 data for Pleconaril on July 13, 1999. The market began assuming, albeit slowly, that the Phase 3 results for the drug would also be positive, and that it would subsequently be approved and successfully commercialized. In other words, by the time the clinical data was released on April 11, "perfection" for Pleconaril was already priced into ViroPharma's stock.

If the data were good, the stock would probably open 5 or even 10 points higher. If the data were bad, the results would be catastrophic because nearly all of the company's value was based on expectations for future earnings derived from sales of that drug. The risk/reward profile obviously dictated that a shareholder holding ViroPharma's stock should sell ahead of the data. With this strategy, if the data turns out good -- you would miss a few points. If the data turns out bad, then you'd avoid a disaster. And, in ViroPharma's case, that happened on April 11.

Edelman also believes that the opportunity for making the most money -- on either the long or short side of a biotech stock -- is when there exists a difference between perception and reality. He cites Enzon (ENZN) as an example of a situation where current perception differs from reality, and believes the market underestimates the prospects for that company's lead product, PEG-Intron. Needless to say, identifying such a gap is a lot easier said than done, and Edelman stresses the need to do a substantial amount of research in order to do this well. (At the time of publication, Edelman was long Enzon, although holdings can change at any time.)

One way I use the perception-vs.-reality theory is to look for companies that have just experienced a positive outcome on their reality point, but aren't covered by many sellside analysts. When a widely covered early-stage biotechnology company reports great clinical data on its lead product, it is not unusual to see that company's stock double or even triple immediately. This huge price movement is actually warranted because at exactly that point, much of the regulatory and commercial risk is removed in the eye of the astute investor. The price movement takes place so quickly because the salespeople at the firms that cover the stock rapidly disseminate the good news to all of their clients.

On the other hand, companies that aren't widely covered could report great data but aren't immediately noticed by the market. To me, this presents a great opportunity to make money. Two such examples in late 1999 were Maxim Pharmaceuticals (MMP) in hepatitis C and malignant melanoma last November:

and Immunomedics (IMMU) in certain forms of lymphoma last December:

(Edelman was also long Immunomedics at the time of publication.)

Purchasing either stock one day, one week, or even a month after the clinical data was presented would have generated great returns.

next, Hoffman discusses handicapping drug marketing and clinical data.

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