by Josh Levine
Editor, Levine's MicroCap Investor
Small, emerging life science companies have an insatiable appetite for cash. This is why Wall Street firms prefer to embrace biotechs early in the game, which is critical in their efforts to ensure multi-million-dollar fees from future raises.
The starting point for the banks is usually the biotech IPO, in which a group of investment banks team up to raise money for an R&D outfit built upon a single drug in the early stages of clinical trials.
The way this game works is presented in a recent Street.com article by Nathan Sadeghi-Nejad who uses the story of recently IPO'd Verastem (VSTM) to reveal the flaws and conflicts in Wall Street's research model. He also makes this point: “Investment bankers always win, which is why investors who rely heavily on sell-side research and don't do independent work too often lose.”
It’s hardly surprising that analyst opinions too often lack objective reflection on corporate fundamentals and biological science. Sadly, what often happens is the willful manipulation to hike the perceived and thus real market value of the company. In the case of the UBS analyst covering Verastem, his “adjustment” makes Verastem's pre-clinical drugs 3 to 4 times more likely to reach approval than the industry norm, resulting in the doubling of his price target.
(Note: Another reason I rarely ever read sell-side research is because the most reliable information in the reports is either pruned from SEC filings or directly from a company's web site or background data supplied by management).
Biotech companies are especially ripe targets for investment bankers since management is virtually guaranteed to keep coming back for raises in the future. Small life science companies typically have high cash-burn-rates and this condition lasts for years. The investment banks, to ensure they are first in line for the next round of lucrative fees, will do absolutely nothing to alienate themselves with management.
The Street.com article explains why Verastem's IPO, which raised $59 million, stands out even more than the usual biotech offering:
“Biotech IPOs are relatively rare these days, but Verastem's offering was even more unusual and risky because the company's drug development program is based on research into cancer stem cells still in preclinical stages. Verastem won't initiate Phase l studies, which test a drug's safety in humans, until next year. Proof-of-concept efficacy data will not available until late 2014 at the earliest.”
World Class R&D on Sale
What really blows my mind is the $250 million market valuation for Verastem. Compare this to 3 biotech companies in the MicroCap Investor portfolio which are involved in Phase I and II clinical trials and developing world-class therapies.
1) A radically innovative cancer therapy that acts like a grenade and wipes out everything in the target region, all with minimal side-effects. The developer “travels light” as a virtual company yet has accomplished what most comparable firms can't manage to do on budgets 10- or 20-times bigger. Market cap: $62 million.
2) This leading developer of DNA vaccines has three Phase II trials in progress, one Phase I completed, and five more ongoing Phase I trials. As the best pure play in the field, its achievements represent a potentially new paradigm for the pharma industry. Market cap: $76 million.
3) This developer is another virtual company that is unique among stem cell developers due to its novel proprietary neural stem cell lines derived from fetal tissue -- from both a therapeutic and an ethical standpoint. Market cap: $58 million.
The reality is these microcaps are a different and superior breed. According to Wall Street's worldview, the incentives aren’t enough to support these microcap firms. The managements of these firms can choose to change the calculus, but it would come with a huge cost -- particularly to shareholders.
While these companies sell stock incrementally they have succeeded at raising cash through alternative channels, too. The DNA vaccine firm has funded much of its R&D with the aid of prestigious government grants, and the other two have also raised non-dilutive funds this way.
I believe they lose nothing by playing the game according to their own rules, and not by those dictated by investment banks. The founders of these companies take a long-term view knowing that successful clinical trial results will lead to partnerships and licensing agreements with major pharmas, consequently propelling stock valuations to big multiples.
Most importantly for investors, we have an opportunity to buy shares in world-class biotech R&D at discount prices.
It's no contest between investing in undervalued biotechs with phenomenal potential and proven track records in human clinical trials, versus one like Verastem, which is still a year away from initiating its first trial and already has a bloated price. If you’re going to play the biotech game you should play to win!
If you would like to learn more about the 3 exciting biotech companies in my MicroCap Investor portfolio, download Josh Levine's Special Report.