Swindlers, saints and spruikers: A life-science health guide

Finding the best life science or biotech companies is more about analysing human nature than science.

Summary: Australia’s life-science sector remains immature, but there’s no shortage of investors willing to buy into stocks promoting their miracle cures – and promising massive investment returns if their products succeed. The problem is that some of these companies are more about marketing hype than actual substance, and there are effectively no industry standards of conduct.
Key take-out: When examining life-science investment opportunities carefully screen the management team and take a close look at their public announcements, especially in relation to clinical trials and other key milestones.
Key beneficiaries: General investors. Category: Shares.

As a long/short manager, I look to invest in life-science companies where the science is strong and the risk-reward balance is skewed to the latter.

However, generally across the industry, there is clearly too much hype factored into valuations where the risk of failure is not adequately captured. I have short-selling positions on a number of these names. The following article talks broadly about some of the themes I pursue in short-selling, keeping in mind I also have a number of investments in the space where I view the risk-reward as compelling.

Life-science is a highly speculative sector which presents a lot of blue-sky hype to investors, offering exciting prospects but equally challenging paths to commercialisation. Emerging health care companies are tricky to value given the complexity of clinical programs and approvals, the expensive cost of conducting trials, the difficulty in anticipating market take-up of the product, and frequent slippages in timelines. Australia is not home to a sophisticated biotech market, with blood products group CSL being the only stand-out. This is in contrast with the NASDAQ, which incorporates the best of European, North American and Israeli health care companies.

Australian investors tap in

What first drew my attention to the sector was the numerous US emerging health care companies electing to raise capital from Australian investors. To date, I struggle to find a satisfactory answer to the following question: “Why are US companies, which have access to the most sophisticated and developed health care and biotechnology capital market – the NASDAQ – opting to raise capital from Australia?” My conclusion is that Australian investors do not fully appreciate the risks.

As a consequence of the depth of the NASDAQ, the market in North America is highly specialised, with industry experts’ scrutinising scientific data to estimate the likelihood of success and financial prospects of highly complex clinical programs. Australia is a relatively immature market by comparison, where investors are much more reliant on management’s predictions and media releases.

Probably the most important consideration when investing in a biotech is management credibility. There are numerous early stage biotech companies in Australia with what locals view as high-calibre management teams, some of which I believe are taking investors for a ride. The most astounding thing is that some have done it all before, having spruiked a story and then failed miserably in the trial and/or on commercial launch. Some of these executives have a history of failure. This is not to say they all operate this way, but my point is that a lot of money can be saved by spending as much time researching the people as the science. As the below table illustrates, fortunes can be both made and lost in short amounts of time.

Australian Life-science Companies Share Price Performance

CodeCompanyPrice3 Month % Change12 Month % ChangeMarket Cap ($m)
NEUNeuren Pharmaceuticals 0.106%178%157
NANNanosonics 0.83-2%72%221
OSPOsprey Medical 0.7013%71%89
CSLCSL Limited65.360%20%32,017
GIDGI Dynamics 0.65-27%8%268
RVAREVA Medical0.50-18%-7%166
MSBMesoblast 5.57-4%-8%1,755
SRXSirtex Medical 11.02-17%-9%622
POHPhosphagenics 0.1228%-17%122
QRXQrxpharma 0.60-23%-23%95
ACRAcrux 2.22-33%-24%371
SPLStarpharma Holdings 0.77-24%-32%218
UBIUniversal Biosensors0.46-40%-48%86
PRRPrima Biomed 0.04-49%-58%50
PXSPharmaxis 0.11-22%-91%31

One early stage investment I have is in Neuren Pharmaceuticals. Science aside, I would never have invested in Neuren if not for the credibility of its management – the same talented people who created significant value at Acrux. Yes, the science has to be compelling, the market opportunity real, but the comfort I needed to invest in such an early-stage company was drawn from the careful evaluation of management, who refrained from overselling the company’s story.

Beware of management spin

Management of early stage life-science companies are determined to keep their programs funded. The necessity of funding allows chief executives with strong sales skills to thrive. Unlike large profitable health care companies with disciplined research and development programs, the incentives for early stage companies to fund trials are not always aligned with shareholder interests. There are some culprits on the ASX which announce price-sensitive programs in disease indications, yet never follow up with results. Some management teams survive on their abilities to swindle investors onto the next indication after current trials hit dead ends. Unlike JORC (the Australasian Code for Reporting of Exploration Results, Mineral Resources and Ore Reserves) standards for early-stage mining companies, there are no such equivalent standards for life-science companies. Disclosure of trial results is optional, and easily manipulated.

Another chapter in the play book is to announce continuous collaborations or licensing arrangements. Often these deals are subject to high levels of confidentiality, and are therefore hard to value from an investor’s perspective. While some deals are legitimate and indicate value, such as Eli Lilly’s deal with Acrux (ACR), or Cephalon with Mesoblast (MSB), others have little substance. One method to track the value of these deals is to assess whether the local company’s enthusiasm is matched by their international partners.

One major company I follow announced collaborations with up to 20 international companies, with none involving upfront payments, and no follow-up announcements. I view these companies as marketing firms, with management spitting out price-sensitive announcements on a monthly basis, paying themselves high salaries, promising new areas of growth, and continuously moving the goalposts.

Conduct proper screening

When screening for life-science investments, I encourage investors to seek companies with greater transparency. Companies should be forthcoming with clinical results regardless of whether they are positive or not. Having trial results published in high-impact journal articles, which are preferably peer-reviewed, is one safety check investors should look for. Another check is to closely analyse media releases and see how clearly management relate clinical results to pre-defined primary end-points. In other words, did the company achieve what they set out to achieve?

It is quite common to find companies with failed trials spinning them in a positive light, talking about new measures of success and possible benefits in areas in which they weren’t previously looking.

Justin Braitling is a principal of Watermark Funds Management at www.wfunds.com.au.

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