The Essential
INVESTMENT GUIDE
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Biotechnology and Life Sciences Sector
The Essential
BIOTECH
INVESTMENT GUIDE
This page is intentionally left blank
The Essential
BIOTECH
INVESTMENT GUIDE
How to Invest in the
Healthcare Biotechnology
& Life Sciences Sector
Chilung Mark Tang, Ph.D.
World Technology Investment Group Corporation, USA
V^fe World Scientific
wl
Jersey London* Sim
New Jersey'London'Singapore
• Hong Kong
Published by
World Scientific Publishing Co. Pte. Ltd.
P O Box 128, Farcer Road, Singapore 912805
USA office: Suite 202, 1060 Main Street, River Edge, NJ 07661
UK office: 57 Shelton Street, Covent Garden, London WC2H 9HE
Library of Congress Cataloging-in-Publication Data
Tang, Mark C. (Mark Chilung)
The essential biotech investment guide: how to invest in the healthcare biotechnology
and life sciences sector/by C. Mark Tang,
p. cm.
Includes index.
ISBN 9812381384 (alk. paper)
9812381392 (pbk.: alk. paper)
1. Biotechnology industries-Finance. 2. Pharmaceutical biotechnology industry-Finance.
3. Investments. I. Title.
HD9999.B442 T36 2002
332.63'2-dc21
2002033070
British Library Cataloging-in-Publication Data
A catalogue record for this book is available from the British Library.
Copyright © 2002 by C. Mark Tang, Ph.D.
All rights reserved. This book, or parts thereof may not be reproduced in any form or by any means,
electronic or mechanical, including photocopying, recording or any information storage and retrieval
system now known or to be invented, without written permission from the Author.
Requests for permission or further information should be addressed to the:
Permission Department, World Scientific Publishing Co.Pte Ltd., 5 Toh Tuck Link, Singapore 596224.
Disclaimer, The materials and opinions herein are based upon publicly available information believed
to be reliable, and may change without notice. The author or Publisher shall not in any way be liable
for claims relating to them, and makes no express or implied representations or warranties as to their
accuracy or completeness or for statements or errors contained in, or omissions from, them. The
information and analyses contained herein are not intended as tax, legal or investment advice and may
not be suitable for your specific circumstances; accordingly, you should consult your own tax, legal,
investment or other advisors to determine such suitability. Any investment returns, past, hypothetical
or otherwise, are not indicative of future performance.
Printed in Singapore by Mainland Press
This book is dedicated to the Tang Family
Gloria
Alexander
Sharon
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Preface
I became interested in investing in biotech in the late 80s while I was a
Ph.D. candidate in the Biochemistry Department at the University of
California, Riverside, in an adjunct molecular endocrinology laboratory of
UCLA School of Medicine. After I finished the doctoral degree, I moved to
New York in 1993 and worked at the prestigious Rockefeller University. I
was a founder and publisher of Bio/Medical Technology Stock newsletter in
1993.
The letter was later acquired in 1996 when I became a
biopharmaceutical investment banker/venture capitalist. During 1993-1996,
I read as many books as I could find on investing and valuation. I became
interested in value investing by Graham and Buffett. Later, I was able to
take finance classes in the part-time MBA program at New York University
and finally obtained an MBA in finance. In 1997, suggested by Michael
Penn, I decided to write a handbook on investing in biotech. Since then,
through Mr. Market's many ups and downs, and my working at different
capacities on Wall Street, I finally finished the assignment in late 2001.
I believe this investment guide is unique in that it aims to have both
breadth and depth. I also endeavored to discuss biotech investing from asset
management and risk management point of, in the hope that it will be useful
for biotech experts, bioentrepreneurs, and individual biotech investors alike.
vii
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Acknowledgements
The author is grateful to the following individuals for their comments and
editorial and proofreading assistance:
Melinda Mingus, M.D. (an NYU Stern Business School alumna), Pascal
Moulin, Calorina Morrillas, Cortney Williams, Fran Bartlett, Mary Miller,
Liz Weston, Don Cooperman, Esq, of Cooperman and Co. (Chapter 14),
Y. Zhu, M.D. Ph.D., of Cornell Medical College (Chapter 2), Z. Yang,
Ph.D. (Chapter 2), and Jonathan Lin of Citigroup (Appendix A).
IX
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Contents
PREFACE
vii
ACKNOWLEDGEMENTS
ix
FIGURES AND TABLES
xviii
INTRODUCTION
1
BIOTECH STOCK FOR WEALTH GROWTH: A N ESSENTIAL PORTION O F ASSET
ALLOCATION
1
Biotechnological Innovation Benefits Society
Biotech Sector Outperforms
Strong Fundamentals and Product Pipelines
Strong Growth of Revenue and Profits
Biotechnology Differs from the Internet
Stock is Essential for Wealth Growth
Stock for Outpacing Inflation
Why Biotech?
Positive Demography: Our Baby Boomer Population
Positive Demographics Trend
Positive Technology Trend
Big Pharma and the Biotech Industry-Complementary
Supply Demand Imbalance?
CHAPTER 1
to Each Other
/
1
2
6
6
7
//
13
75
16
16
16
20
25
THE BASICS OF INVESTING
25
The Case for Equities
The Rule of 72
The Power of Compounding
25
27
28
xi
xii
The Essential Biotech Investment Guide
Opportunity Cost
Relationship Between Risk and Return
Dollar-Cost Averaging
Purchasing Power and Inflation—Is a CD Really Safe?
Holding Period and Risk
Understanding Risks
Diversification-Minimizing Your Investment Risk
Past Reasons for Not Investing
Historic Return and How Much Return One Should Expect
Technical Analysis
Investment Vehicles Available to Achieve Your Goals
Vehicle One: Stocks
Vehicle Two: Bonds
Vehicle Three: Cash
Vehicle Four: Mutual Funds
Vehicle Five: Unit Investment Trust
Vehicle Six: Managed Accounts
Vehicle Seven: Alternative Investment
Asset Allocation
Managing Your Portfolio and Wealth
CHAPTER 2
A N INTRODUCTION TO BIOTECHNOLOGY AND GENOMICS
CHAPTER 3
29
29
29
31
32
33
35
38
39
39
40
40
44
45
45
46
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47
47
48
51
51
63
UNDERSTANDING BIOTECHNOLOGY INVENTION AND THE FDA APPROVAL
PROCESS
Parti: Biotechnology Inventions and Patents
Part II: The FDA Approval Process for Drugs
Stages of the FDA Approval Process
Drug Review Glossary
CHAPTER 4
INTRODUCTION TO BIOTECH INVESTING
Value Investing
Growth Investing
The Industry Life Cycle
Characteristics of Investing in Biotech
Value Investing
Biotechnology Investment Trading Rules
Winning Biotechnology Company Attribute List
63
63
67
67
75
79
79
79
79
80
81
82
86
89
Contents
CHAPTER 5
How TO VALUE AND INVEST IN A BIOTECH COMPANY
Step One: The Economic and Business Cycle
Step Two: Industry Sector Analysis
Biotech Industry Sector Analysis
Step Three: Biotech Company Analysis
Valuation: Should I Buy This Biotech Stock Now?
Method 1: Relative Valuation
Comparisons ofP/E Ratios
Method 2: Discounted Cash Flow (DCF) Analysis
Method 3: Sum-of-the-Parts Valuations
Method 4: Dividend Discount Model (DDM)
Method 5: Subscriber-Based Valuations
Method 6: Economic Value Added (EVA)
Method 7: Yield-Based Valuations-Valuing Market as an Example
Qualitative Component of the Valuation
Risks of Biotech Companies
Summary: Which Model Is Best for Valuing Biotech Companies?
Part II: Investing in Undervalued Healthcare Biotech—Proactive
Value Investing in Healthcare™
CHAPTER 6
INVESTING IN BIOTECHNOLOGY MUTUAL FUNDS
Don't Put All Your Eggs in One Basket
Purchasing Power
Professional Management
Asset Allocation
Liquidity
Discipline
Dollar-Cost Averaging
The Case for Index Funds
Why Stock or Stock Mutual Funds?
The Cost of Delaying
The Benefits of Investing in Biotech Mutual Funds
CHAPTER 7
xiii
91
91
93
95
95
97
98
100
102
116
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779
720
720
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727
723
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757
732
733
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735
735
735
736
736
739
739
145
HEALTHCARE BIOTECH INDEX INVESTING: STRATEGIES USING EXCHANGETRADED-FUNDS (ETFs), BIOTECH ISHARES, AND BOXES
The Case for Index Funds
1. Exchange-Traded Funds (ETFs)
145
145
746
xiv
The Essential Biotech Investment Guide
Advantages ofETFs
Options Strategies for Suitable Clients
Index-Linked ETFs
II. Index Investing
III. Strategies Using Biotech and Pharmaceutical BOXES
CHAPTER 8
147
149
150
151
152
155
RISK MANAGEMENT CONSIDERATIONS FOR BIOTECH INVESTORS WITH
CONCENTRATED EQUITY POSITIONS
Alternative I: Retention of the Position and Associated Risks
Alternative 2: Liquidation of the Position and Reinvestment of
Net Proceeds
Alternative 3: Hedging, Monetizing, and Diversification Strategies
Conclusion
Glossary
CHAPTER 9
MANAGING BIOTECH STOCK OPTIONS: YOUR EMPLOYEE BENEFITS
Non-Qualified Biotech Options
Incentive Biotech Options
Your Biotech Option Plan
Alternative Biotech Stock Acquisition Programs
83(b) Election
CHAPTER 10
155
156
158
158
159
162
163
163
165
166
167
170
171
175
AN INTRODUCTION TO HEALTHCARE BIOTECHNOLOGY HEDGE
FUND INVESTING
Hedge Fund Investment Styles
Three Ways to Participate Healthcare-Biotech Hedge Funds
Conduct Necessary Due Diligence Prior to Investing in Healthcare
Hedge Fund
Conclusion
CHAPTER 11
175
776
177
178
779
181
AN INTRODUCTION TO HEALTHCARE BIOTECHNOLOGY PRIVATE EQUITY
INVESTING
I. Healthcare Venture Capital
Four Investment Stages of Health Care-Biotech Venture
Capital Funding
77. Healthcare Buyout Funds
181
182
783
785
Contents
///. Special Situations in Healthcare
Key Considerations
How to Participate in Private Equity Investing
Five Basic Ways To Participate in Healthcare Private Equity Investing
Measuring Performance of Healthcare Biotech Private Equity Funds
Conclusion
CHAPTER 12
xv
184
784
185
186
187
188
189
RETIREMENT PLANNING CONSIDERATIONS FOR BIOTECH EXECUTIVES AND
INVESTORS
Changing Careers: Affecting Your Retirement Savings
Direct And Indirect Rollovers: Spinning Your IRA
The Tax-Deferred Rollover
Retirement: Strategy
CHAPTER 13
CHARITABLE DISPOSITION OF APPRECIATED BIOTECH STOCKS
I. Private Foundations
77. Charitable Remainder Trusts
Conclusion
///. Alternative Charitable Gift Program Through National
Philanthropic Trust (NPT)
CHAPTER 14
189
789
790
792
792
195
195
796
797
798
799
201
MANAGING YOUR BIOTECH WEALTH-ESTATE PLANNING FOR BIOTECH
INVESTORS, EXECUTIVES, AND FOUNDERS
Other Trust Strategies to Minimize Estate Taxes
Conclusion
201
208
213
EPILOGUE
215
APPENDIX A
217
WHAT Is TECHNICAL ANALYSIS?
7. The Dow Theory
77. Four Groups of Technical Indicators
777. Top-Down Technical Analysis
IV Reading Chart Patterns
Patterns Indicating a Reversal in a Stock Price Trend
Patterns Indicating a Consolidation in a Stock Price Trend
217
277
278
222
222
224
224
xvi
The Essential Biotech Investment Guide
APPENDIX B
BIOTECH AND LIFE SCIENCE GLOSSARY
Glossary—Finance
APPENDIX C
RESOURCES AND FURTHER READINGS
Books
WebSites
Newsletters
Newspapers and Magazines
APPENDIX D
SPEAKING ENGAGEMENT REQUEST
INDEX
229
229
240
253
253
253
254
254
254
255
255
257
Figures And Tables
Figure 1-1. Performance ofBTK, SP, Internet, and NASDAQ over the last
3 and 10 Years
Table 1-1. Selected Profitable Biotech Valuation Comparisons
(as of 12/31/01)
Table 1-2. Selected Major Pharmaceuticals Valuation Comparisons
(as of 12/31/01)
Table 1-3. Selected 2001 Biologic Drug Approvals
Table 1-4. Selected FDA Approved Biopharmaceutical Drugs
Table IS. Historic Returns for Different Asset Class
Table 1-6. Effect of Inflation on Investment Growth
Figure 1-2. Hypothetical Growth of a $1 Investment in Four Traditional
Asset Classes
Table 1-7. The "Graying" of America: Americans Over the Age of 65
Table 1-8. Annual Pharmaceutical Expenditures by Age Group
Table 1-9. Drug Patent Expiration Table
Table 1-10. Biotech Added Value for Big Pharma—Biotech Covers
Technologies Outside of Big Pharmaceuticals
Figure 1-3. Patents Granted in the U.S. Rose to Record Highs in the
Late 1990s
Table 1-11. The 20th Century's Greatest Engineering Achievements
Table 1-12. The Leading Biotech Drugs
Figure 1-1. Over Time Equity Outperforms Other Asset Classes
Table 1-1. Average 20-Year Return from 1981-2001
Table 1-2. Number of Years Needed to Double Your Investment
Table 1-3. The Power of Compounding and Cost of Waiting
Figure 1-2. The Power of Compounding-Hypothetical Investment in Stocks
Figure 1-3. The Relationship Between Risk and Return
xvii
J
4
5
8
9
11
11
12
17
17
18
20
22
23
24
26
27
27
28
30
30
xviir
The Essential Biotech Investment Guide
Table 1-4. An Example of Dollar-Cost Averaging
Table 1-5. Annual Average Inflation From 1925 to 1999
Table 1-6. How Much Money You Need to Keep $100 Dollars
Purchasing Power
Table 1-7. Historic Returns of Cash and Equivalent After Inflation and
Taxes (1926-2000)
Table 1-8. Holding Period and Risk
Figure 1-4. Holding Period and Return
Figure 1-5. Investment Pyramid-Relationship Between Risk and Return
Figure 1-6. Asset Allocation Among Classes
Figure 1-7. Diversification Among Stock, Bond and Money Markets
Figure 1-8. Diversification Among Bonds
Table 1-9. S&P 500 Sectors
Figure 2-1. DNA Structure
Figure 2-2. The Central Dogma
Figure 2-3. Protein Translation
Figure 2-4. Growth of Biological Data
Table 2-1. Selected Biotech Stocks and Their Symbols
Table 2-2. Biotech Companies by Type of Technologies or Applications
Figure 2-5. Bio-Technology Chart
Figure 3-1. Stages of the FDA Approval Process
Table 3-1. FDA Review Times
Figure 3-2. Risk Data Analysis of Drug Development and Approval
Table 3-2. Risk of Clinical Trials
Table 4-1. Typical Industry Life Cycle
Figure 4-1. Drug Development Risk
Table 5-1. Summary of General Valuation Methods
Table 5-2. Classic Business Cycle Model
Figure 5-1. S Growth Curve
Table 5-3. PEG Ratios of Big Pharmaceutical Companies in North America ....
Table 5-4. PEG Ratios of Profitable Biopharmaceutical Company in the U.S. ..
Table 5-5. PEG Ratios of Non-north American Pharmaceutical Companies
Table 5-6. Comparative Analysis-IPO
Table 5-7. Comparative Analysis—Genomic Company
Table 5-8. Estimating Net Present Value (Intrinsic Value) of a
Biotech Company
Table 5-9. Estimate of Intrinsic Value of Five Major Profitable
Biotech Company
Table 5-10. Sum of Parts Valuation of Drug Candidate Pipelines
Table 5-11. Business Model and Valuation Differences between Pharma and
Biotech
31
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94
96
105
106
107
Ill
112
117
118
119
121
Figures and Tables
Table 5-12 Pros and Cons of Valuation Techniques
Figure 5-2. Amgen (AMGN)
Figure 5-3. Genzyme (GENZ)
Figure 5-4. Chiron (CHIR)
Figure 5-5. Centocor (CNTO)
Figure 5-6. Cephalon (CEPH)
Figure 5-7. Human Genome Sciences (HGSI)
Figure 5-8. Immunex (IMNX)
Figure 6-1. Stamps and Inflation
Figure 6-2. Risk-Reward Parameter/Pyramid
Table 6-1. The Value of Professional Management in Biotechnology-10-Year
Performance
Figure 6-3. Value Versus Growth
Figure 6-4. Positive Investment Return and Holding Period
Figure 6-5. Cost of Missing Best Months (1970-2001)
Table 6-2. Healthcare-Biotechnology Funds
Figure 7-1. Institutional Strategy Evolves to Core/Satellite
Figure 7-2. Tax Strategy: Loss Harvesting
Table 7-1. How Do Pharmaceutical and Biotech BOXES Work?
Figure 8-1. Systematic Risk and Company-Spcific Risk
Figure 8-2. Risk Management Strategies for Low-cost, Concentrated and/or
Restricted Biotech Stock
Table 8-1. Hedging and Monetizing Strategies
Table 8-2. Risk Management—Summary of Strategic Outcomes
Table 9-1. How Do Biotech Options Work?
Table 9-2. Biotech Stock Options Vesting Methods
Table 11-1. The Pros and Cons of Private Equity Investing
Figure 12-1. Retirement Sources
Figure 12-2. Tax Deferring Advantage
Table 13-1. Tax Benefit of Depositing Appreciated Biotech Stocks
Through NPT
Table 14-1. Comparison of Four Alternatives
Figure 14-1. Tax Saving through Estate Planning
Figure A-I. Down Trend
Figure A-2. Support and Resistance
Figure A-3. Head and Shoulder
Figure A-4. Round Bottom
Figure A-5. Double Bottom
Figure A-2 to A-5. Chart Patterns
xix
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726
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727
128
128
129
729
132
133
134
138
142
742
143
148
154
154
756
157
767
767
767
765
182
797
193
200
204
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225
226
226
227
227
227
Introduction
Biotech Stock For Wealth Growth:
An Essential Portion Of Asset
Allocation
Biotechnological Innovation Benefits Society
T
hroughout history, biotechnological innovations have produced
enormous improvements to-and benefits for—society. Since ancient
times, people have used simple fermentation to produce and preserve foods.
The Chinese use moldy soybean curd to cure infection. To build on the
discovery of traditional genetics in the 1850s and cracking the gene code in
the 1950s, scientists sequenced the genetic codes of human beings in 2000.
Now the biotechnology industry is studying genes involved in disease by
using genomic tools so that drugs can be designed to cure illnesses. With
more than 350 drugs in late-stage clinical trials, the biotech and life sciences
industry leads the way in medical innovation and revolution.
Biotech Sector Outperforms
During the 12 months ending in December 2001, the AMEX Biotech Index
lost about 8% of its value, and NASDAQ Biotech Index was down 16%,
while the NASDAQ dropped 2 1 % and the market index (S&P 500) fell
1
2
The Essential Biotech Investment Guide
13%. However, biotech stocks on average retained their past three years'
gains. As a group, biotech stocks performed better than many high tech
stocks (see Figure 1-1). Perhaps the most important message was the belief
that there was value in biotech stocks. Table 1-1 and Table 1-2 summarize
recent valuations comparisons of profitable biotech companies and major
pharmaceutical companies.
Strong Fundamentals and Product Pipelines
The FDA approved 16 new biotechnology-based drugs and vaccines in 2001
(see Table 1-3), as well as eight new indications for previously approved
biotech products, according to an analysis by the Biotechnology Industry
Organization (BIO). The new products include treatments for leukemia,
congestive heart failure, rheumatoid arthritis, and life-threatening sepsis, as
well as a new combination vaccine for hepatitis A and B. Even though the
number of approvals declined from the record of 32 in 2000, more than half
of the 133 biotechnology medications available today have been approved in
the last five years, and another 350 products are in late-stage development.
That is a consistent record of new therapeutic development from
biotechnology, and more much-needed therapies are coming. The U.S.
biotech industry currently includes some 400 public companies and more
than 1000 private companies. Since Genentech was founded in 1976, about
120 FDA-approved biotech products are on the market (see Table 1-4) and
more than 300 active biotech drug candidates are in Phase III or late clinical
trials, while another 1000 plus drugs candidates are in clinical trials.
Biotech drugs in the pipeline for heart disease and cancer, the two
biggest killers in the United States, may signal even greater success for this
sector. Revenues of biotech companies have increased an average of 11%
per year since 1995. Revenue growth should remain strong through the next
10 years. Contrary to pharmaceutical companies that face patent expirations
and generic competition, biotech products are generally free from this
pressure.
3
Introduction
I
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Figure 1-1. Performance of BTK, SP, Internet, and
NASDAQ over the last 3 and 10 Years.
02
Table I-l. Selected Profitable Biotech Valuation Comparisons (as of 12/31/01).
Company
Market
Ticker
Amgen
AMGN
Biogen
Share
Cap
($Mil.)
2002E
EPS
2002
Ratio
2.1
2001
Growth
(%)
19
1.43
39.5
30.2
2.1
14
1.96
29.3
0.95
46.1
1.7
22
1.15
38.1
0.75
72.3
2.4
25
0.91
59.6
PE
Ratio
PEG
Rati
1.19
47.4
57.35
1.90
8,330
43.83
29,295
54.25
58,867
2001
Price
($)
56.44
BGEN
8,545
Chiron
CHIR
Genetech
DNA
2001
EPS
0
Genzyme General
GENZ
12,451
59.86
1.18
50.7
1.8
23
1.48
40.4
IDEC Pharma
IDPH
10,271
68.93
0.59
116.8
1.9
40
0.91
75.7
Immunex
IMNX
15,628
27.71
0.29
95.6
2.3
40
0.30
92.4
Medimmune
MEDI
10,243
46.35
0.69
67.2
1.9
24
1.02
45.4
10,271
54.25
0.75
67.2
1.9
24
1.02
45.4
Median
Source: Analysts reports and company reports.
Table 1-2. Selected Major Pharmaceuticals Valuation Comparisons (as of 12/31/01).
Company
Market
Ticker
Share
Cap
($Mil.)
2001
Price
2001
EPS
($)
($)
PE
Ratio
2001
Growth
PEG
Ratio
2002 E
EPS
2002
Ratio
(%)
Abbott Laboratories
ABT
86,357
55.75
1.88
29.7
13
1.9
2.25
24.8
American Home Prod
AHP
80,627
61.36
2.18
28.1
15
1.6
2.50
24.5
AstraZaneca
AZN
82,762
46.60
1.75
26.6
7.0
3.8
1.75
26.6
Bristol-Myers Squibb
BMY
99,093
51.00
2.41
21.2
12
1.8
2.35
21.7
Eli Lilly
LLY
88,279
78.54
2.76
28.5
12
2.4
2.73
28.8
GlaxoSmithKline
GSK
154,890
49.82
2.06
24.2
12
1.8
2.36
21.1
Merck
MRK
134,828
58.80
3.13
18.8
11
1.7
3.20
18.4
Novartis
NVS
95,776
36.50
1.60
22.8
11
1.9
1.74
21.0
Pfizer
PFE
251,573
39.85
1.31
30.4
19
1.3
1.59
25.1
Pharmacia
PHA
55,488
42.65
1.74
24.5
20
1.1
1.93
22.1
Schering-Plough
SGP
52,390
35.81
1.63
22.0
20
1.0
1.86
19.3
87,318
50.41
1.97
25.6
12
1.8
2.30
23.3
Median
Source: Company Reports and Analyst Reports.
6
The Essential Biotech Investment Guide
Strong Growth of Revenue and Profits
The growth of biotech companies has also been strong. The market cap of
260 publicly traded biotech companies in 1996 was $47 billion. Over the
past two to three years, the Amex Biotech Index has dramatically
outperformed the Dow Jones Industrial Average and the NASDAQ
Composite index. The biotech industry has achieved an aggregate market
cap of about $400 billion with 40 companies over $1 billion and 15
companies achieving profitability. This industry is rapidly gaining critical
mass and is here to stay. In addition, there is increasing number of
legitimate intersections between information technology (IT) and the life
sciences.
Biotechnology Differs from the Internet
Internet companies and biotech companies differ in a fundamental way.
Biotech companies have a high barrier of entry, whereas Internet companies
the barrier of entry is low. While tech stocks have been suffering from
decreased revenue and earnings growth, the fundamentals of biotechnology
remain strong.
Biotech Companies
Internet Companies
Barrier of Entry
High
Low
Earnings Growth
Strong
Decreasing
Demand
Strong
Less Strong
Demographics Needs
Strong
Strong
Products
Strong
Less Strong
7
Introduction
Stock is Essential for Wealth Growth
Why invest in stock? The answer is very simple: outstanding long-term
performance. Ibbotson & Associates, an economic consulting firm, studied
relative rates of return over a 70-year period, beginning in the 1920s. Their
research showed that equity investments have a remarkable long-term record
that weathered the Great Depression, several wars, and recessions, and
fundamental changes in the economy.
As shown in the table below, the unmanaged Standard & Poor's 500
Stock Index, consisting of U.S. stocks from 1925 to 2000, delivered an
average annual return of 11% per year and significantly outperformed U.S.
Treasury bonds and bills. One of the most important factors in evaluating
returns is the time horizon allowed for investments to grow. Solid equity
investment performance is indicative of strategic planning and patience.
Historical Average Annual Returns (12/31/25 to 12/31/2000).
Stocks (Unmanaged S&P 500 Index)
11.0%
Long-term U.S. Government Bonds
5.3%
U.S. Treasury Bills
3.8%
Consumer Price Index (Inflation)
3.1%
As Table 1-5 indicates, historically, more risk has produced a higher
potential return. You will increase your return capacity by adding stocks to
your investment cocktail, but the possibility of losing your initial investment
will also become greater. Therefore, the right mix of investments is
essential, and it's important to point out that stocks are not for everyone.
Assess your risk and loss tolerance with a financial advisor before investing
in any growth vehicle, no matter how "safe."
Table 1-3. Selected 2001 Biologic Drug Approvals.
Company Name
Amgen
Amgen
Amylin
Celltech
Cell Therapeutics
Cephalon
Enzon/Schering-Plough
Genetech
Genetech
Gilead Sciences
ILEC Onology /Schering
Kos Pharmaceuticals
Ligand Pharmaceuticals
Lilly
Nabi
Novartis
OraPharma
SCIOS
Shire Pharmaceuticals
Texas Biotech
QLT
Product
Aranesp
Kineret
Symlin
Metadate CD
Trisenox
Actiq
PEG-1NTRON
Cathflo Activase
Traclear
Tenofovir
Campath
Advicor niacin
Tagretin bexarotene
Xigris
Nabi-HB
Gleevec
Arestin microspheres
Natrecor
Reminyl galantamine
Argatroban
Visudyne
FDA Action
Approved
Approved
Approved
Approved
Approved
Approved
Approved
Approved
Approved
Approved
Approved
Approved
Approved
Approved
Approved
Approved
Approved
Approved
Approved
Approved
Approved
Indication
Anemia (end-stage renal failure pts)
Rheumatoid arthritis
Diabetes
Attention Deficit Disorder
Acute promyelocytic lukemia
Cancer pain
Chronic hepatitis C
Central venous access devices
Pulmonary arterial hypertension
HIV
Chronic lymphocytic leukemia
Cholesterol disorders
Cutaneous T-cell lymphoma
Sepsis
Acute hepatitis B virus exposure
Chronic myelogenous lukemia
Adult periodontitis
Acute congestive heart failure
Acute leukemias
Thrombosis
Subfoveal choroidal newvascularization
Table 1-4. Selected FDA Approved Biopharmaceutical Drugs.
Company
Product
Years Approved
Indication
Amgen/Johnson & Johnson
Amgen/Orthobiotech
Amgen
Armour
Baxter Healthcare
Biogen
Epogen
Procrit
Filgrastim
Monomine
Recombinate/Bioclate
Avonex
Anemia
Anemia
Various, including neutropenia
Hemophilia B
Hemophilia A
Multiple sclerosis
Boehringer Mannheim
Centeon LLC
Centeon LLC
Centocor
Chiron
Chiron
CisBio
Cytogen
Cytogen
Eli Lilly
Eli Lilly
Eli Lilly
Enzon
Galenns Mannheim
Genetech
Genetech
Genetech & Miles
Reteplase
Monoclate-P
Monomine
Myoscint
Proleukin
Basteron
Indimacis-125
Oncoscint
Protascint
Humulin
Humatrope
Humalog
Oncaspar
Ecokinase
Alteplasea
Actimmune
Kogenate
1989 (USA)
1990 (USA)
1991 (USA)
1992 (EU)
1992 (USA)
1996 (USA)
1997 (EU)
1996 (EU, USA)
1987 (USA)
1992 (USA)
1996 (USA)
1992 (USA)
1993 (USA)
1996 (EU)
1992 (USA)
1996 (USA)
1982 (USA)
1987 (USA)
1996 (EU)
1994 (USA)
1996 (EU)
1987 (USA)
1990 (USA)
1992 (USA)
Acute myocardial infraction
Hemophilia A
Hemophilia B
Cardiac imaging
Renal cell carcinoma
Multiple sclerosis
Diagnosis of ovarian cancer
Detection/follow-up of ovarian cancer
Imaging of prostatic carcinoma
Diabetes mellitus
Growth deficiencies
Diabetes mellitus
Leukemia
Acute myocardial infration
Acute myocardial infarction
Chronic granulomatous disease
Hemophilia A
(continued)
Table 1-4 (continued)
Genetech
Genetech
Genzyme
Genzyme
Hoechst
Hoffman La Roche
Immunomedics Inc.
Merck & Co
Novo-Nordisk &
Zymogenetics
Organon
Orthobiotech
Pulmozyme
Nutropin
Ceredase
Cerezyme
Insuman
Roferon
CEA-SCAN
Recombivax
NovoSeven
1993 (USA)
1994 (USA)
1991 (USA)
1993 (USA)
1997 (EU)
1986 (USA)
1996 (USA/EU)
1986 (USA)
1995 (EU)
Cystic fibrosis
Infertility
Gaucher's disease
Gaucher's disease
Diabetes mellitus
Hair cell leukemia
Diagosis of colorectal cancer
Hepatitis B
Coagulation Disorders
Puregon
Orthclone
1996 (EU)
1986 (USA)
Schering Plough
Schering
Serono
SmithKIine Beechman
SmithKline Beechman
SmithKIine Beechman
Intron A
Betaferon
GonalF
Enerix-B
Tritanrix HB
Twinrix
1986 (USA)
1995 (USA)
1995 (EU)
1989 (USA)
1996 (USA)
1996 (USA)
Infertility
Treatment of graft rejection in renal
transplants
Various, including hair cell leukemia
Multiple Sclerosis
Infertility
Hepatitis B
Hepatitis B and DPT
Hepatitis A and B
Introduction
11
Table 1-5. Historic Returns for Different Asset Class.
5 Years
Small Cap Stocks
Large Cap Stocks
Long-Term Corp Bonds
U.S. Treasury Bills
Consumer Price Index (CPI)
18.5%
28.5%
8.4%
5.1%
2.4%
10 Years
20 Years
15.5%
17.8%
10.6%
6.8%
4.0%
15.1%
18.2%
8.4%
4.9%
2.9%
50 Years
14.9%
13.6%
5.9%
5.2%
4.0%
Stock for Outpacing Inflation
Table 1-6 shows the average annual inflation rate for each year since 1971.
It indicates how much more money you will need to equal $100 today in 5,
10, 15, and 20 years assuming various rates of inflation. Therefore, your
investment strategy's targeted growth rate must be in proportion to the
current inflation percentage.
Table 1-6. Effect of Inflation on Investment Growth.
Years
5
10
15
20
3%
4%
5%
6%
$116
$134
$156
$181
$122
$148
$180
$219
$128
$163
$208
$265
$134
$179
$240
$321
Figure 1-2 shows that an investor, who placed $1 in large cap or small cap
stocks at the end of 1925, and reinvested dividends, saw this investment
grow to $7,860 and $2,279 respectively by December 31, 2000 (see Figure
1-2). If you are a more conservative investor, and depending on your needs,
20-year U.S. Treasury bonds and 30-day U.S. Treasury bills offer a
government guarantee of repayment of principal and interest if held to
maturity.
Stocks, Bonds, Bills, and Inflation
1925-2001
$10,000 y
$1,000--
, small Company Stocks
Large Company Stocks
• Government Bonds
» Treasury Bills
Inflation
57,860
12.5%
52,279
10.7%
Ending Average
Wealth Return
S51
$17
510
iSJ«MWi
$.104—
1925
1935
1945
Hypothetical v a l u e of S1 invested at year-end 1925. A s s u m e s reinvestment o l income a n d no t r a n s a c t i o n c o s t s or taxes.
T h i s is for illustrative p u r p o s e s only a n d not indicative ol any investment.
Past performance is n o guarantee of future results. 3/1/2002.
CO 2002 I b b o t s o n Associates. Inc.
Figure 1-2. Hypothetical Growth of a $1 Investment in Four
Traditional Asset Classes.
5.3%
3.8%
3.1%
Introduction
13
Why Biotech?
What Is Biotechnology?
Biotechnology is the application of biological research techniques to the
development of products that improve human and animal health, and as well
as food products. Biotechnology is the identification and management of
disease by developing medicines that use the human body's own elements
(cells, genes, proteins, enzymes, and antibodies), plant cells, animal cells,
and bacteria. Biotechnologists seek to discover how human cells become
cancerous and to identify the disease genes associated with neurological
conditions, such as Parkinson's. Biotechnology is thus yielding new
approaches for the treatment of debilitating conditions. Just as antibiotics
and vaccines have saved countless people from deadly infections since the
1950s, biotechnology leads the way in medical innovation by developing the
first ever treatments for life's most threatening illnesses: heart disease,
cancer, Alzheimer's, Parkinson's, and related diseases.
Bioinformatics is the science of informatics as applied to biological
research. Informatics is the management and analysis of data using
advanced computing techniques. Bioinformatics is particularly important as
an adjunct to genomics research, because of the large amount of complex
data this research generates.
More than 350 biotechnology drugs and vaccines are in human clinical
trials, and hundreds more are in early development. Breakthroughs are being
made in treating cancer, obesity, heart disease, and the a diseases associated
with aging. Millions of Americans are diagnosed with the these major
disease conditions each year. Already some 200 drugs-of which 60 are in
Phase III clinical trials-are under development to fight cancer cells; more
than 30 potential drug treatments for cardiovascular diseases are under
development.
About 300 biotech drugs are in Phase III trials. The historically proven
80% success rate in Phase III trials-and an average development time of six
years from Phase III to FDA market approval-means that as many as 240
new drugs could reach the market by 2007. Biotech drugs in the pipeline for
heart disease and cancer, the two biggest killers in the United States signaled
even greater success for the sector. Biotech companies' revenues have
increased an average of 11% per year since 1995 and revenue growth should
14
The Essential Biotech Investment Guide
remain strong through the next 10 years. Patent expiration and the
competition of their generic drugs do not exert as much pressure on most
biotech companies as they do on pharmaceutical firms. Over the next a few
years, for example, pharmaceutical companies will face patent expirations of
drugs that represent about $100 billion in sales annually.
Successful drug development depends on good science, including a
sound understanding of biological systems, and this can come only from
substantial investment in basic research. Successful medical breakthroughs
depend on understanding the intricate relationships between the variability
among individuals in their susceptibility to disease or response to treatment.
Rational drug design will continue to make inroads as structure-function
relationships and methods of chemistry continue to improve. Use of novel
techniques, such as transgenic and genetic knockout animals, enable
companies to obtain preclinical proof of therapeutic activity in an efficient
manner. Large technology companies, such as IBM, Compaq, Motorola,
EMC, and Palm, have capitalized on biotech by providing venture funding
for e-health and bioinformatics investments.
The human genome sequence, containing some 30,000 to 40,000 genes,
is the beginning, not the end, of the road. Small differences in genetic
structure provide the key to the future of the human condition and the
chance to look at old markets in new ways. Transforming technologies
beyond genomics, such as proteomics, offer both immediate and long-term
growth opportunities. In this industry paradigms are constantly in motion.
Biotech, like IT, exists in a multidimensional universe that stretches to
infinity in every direction.
Servicing the gold rushers has historically proven to be a good business:
selling picks and shovels to miners has long made good business sense. In
biotechnology, those tools are reagents, instruments, and new research
platforms. Wall Street puts the total sales of life science tools at more than
$5.5 billion in 2000, an 18% increase over 1999. A major goal in biotech
research is to dissect the functions and interactions of genes, proteins, cells,
tissues, organisms, populations, and the environment. We are in the midst
of a renaissance in biology, kicked off by the mapping of the human genome
and technological innovation. New research will attempt to understand the
interaction of functions among genes (multigenic diseases), among proteins
(signal pathway), or between proteins and genes (regulation of gene
Introduction
15
expression), and the interaction between molecules in their natural context
(systems biology). Relational information has created a need for new
software products and enterprise systems to better capture, analyze,
visualize, store, and retrieve data. New therapeutic products remain the
greatest value drivers in biotechnology. Although not every drug will
become a personalized medicine, it is estimated that 20% of drugs could
benefit from a specific pharmacogenomics approach.
The next 10 years will likely show a dynamic market as biological
research becomes industrialized. The challenge will be to achieve a true
differentiation and critical mass in market penetration, and to develop a
proprietary product with the right balance in pricing and value to the
research market. Successful companies will make it cheaper and faster to
ask the big questions.
Success in biotechnology can be extremely rewarding. Single products
can build a company worth $10 billion (DDEC), and two products can
produce a $68 billion company (Amgen). Strong market valuations are the
results of high-margin, billion-dollar sales that continue for a decade or
more.
Positive Demography: Our Baby Boomer Population
At the same time that demographics are increasing the demand for drugs,
genomics are creating a new supply of drugs. It is estimated that humans
have 100,000 genes, and virtually all diseases are caused by changes in the
sequences of nucleotides that make up these genes. Very small changes in
these sequences can mean the difference between disease and health. The
U.S. population was approximately 270 million in 1997, consisting of 70
million children, 166 million working-aged adults from ages 18 to 64, and
34 million people over age 65, according to the U.S. Census Bureau (see
Table 1-7 and Table 1-8).
16
The Essential Biotech Investment Guide
Positive Demographics Trend
An Aging Population, Social Security, a Better Quality of Life,
and a Huge Demand for Drugs
By 2025, most baby boomers will have reached retirement, and the number
of people over age 65 will have grown significantly (see Table 1-7). The
framers of the Social Security system designed the program with
contemporary lifespans in mind. When they created the program in 1935
and chose 65 as the benchmark retirement age, the average life expectancy
of a child born in that year was only 61. Today, the average life expectancy
is 76 years, and it is expected to approach 80 years by 2030. As increasing
numbers of Americans claim Social Security benefits and do so for a much
longer period of time than was originally envisioned, and as fewer workers
are available to support those transfer payments, the strain on the Social
Security system threatens to rip the program apart at the seams.
Positive Technology Trend
While demographics are increasing the demand for drugs, genomics are
creating a new supply of drugs. Genomics, the science of gene discovery, is
expected to play an enormous role in treating diseases. The estimated
100,000 genes and the belief that virtually all diseases are caused by
changes in the sequences of nucleotides that make up these genes, provide a
huge resource for gene-targeted treatments. Figure 1-3 shows that patents
granted in the U.S. rose to record highs in the late 1990s. Figure 1-4 shows
the number of new discovered biotech drugs and vaccines approved by the
FDA from 1982-2001.
Big Pharma and the Biotech Industry-Complementary to
Each Other
With most of its blockbuster drug patents scheduled to expire within the
next 15 years (see Table 1-9), Big Pharma needs biotech companies to
supply drug candidates and keep their pipelines competitive (see Table I10).
Table 1-7. The Graying of America: Americans Over the Age of 65.
Year
Population (Millions)
1970
20.1
1980
25.7
1990
31.6
2000
34.9
2010
39.7
2020
53.7
2030
69.8
The aging population will cause a sharp increase in the demand for drugs, especially in the area of chronic diseases, which
require years of ongoing medication. This growing elderly group will likely require the greatest amount of drug therapy.
Source: U.S Department of Commerce.
Table 1-8. Annual Pharmaceutical Expenditures by Age Group.
The fact that baby boomers are getting older and the aged are living longer will fuel the application of genomics for disease
discovery.
Source: Bureau of Labor Statistics.
Table 1-9. Drug Patent Expiration Table.
2001
American Home Products (AHP)
AstraZeneca
2002
Lovenox
Cipro
Taxol-(expired but has limited
protection until 2004), Paraplatin
Pravachol
Flonase
Wellbutrin,
Energix-B
Combivir,
Paxil
Bristol-Meyers Squibb (BMY)
Prozac
Axid
Augmentin,
Flovent
Glaxo SmithKline (GSK)
Hoffman-LaRoche
(ROHHY)
Accutane
Floxin,
Ortho-Novum,
Ortho-Tri Cyclin
Duragesic, Xenical, Procit (compound
patent- manufacturing patent-2012)
Johnson & Johnson (JNJ)
Terazol
FloxinOrthoNovum
Ortho-Tri Cyclin
Duragesic, Procit (compound patentmanufacturing patent- 2012)
Merck (MRK)
Mevacor
Prinivil
Novartis
Pfizer (PFE)
Schering-Plough (SGP)
2005
Zoladex
Prilosec, Zestril
Aventis SA (AVE)
Bayer (BAYZY)
Eli Lilly (LLY)
2004
2003
Primaxin
Singulair
Accupril
Cardura
Zocor
Lamisil, Aredia
Claritin
(composition),
Intron A/ Rebetron
Diflucan
Zithromax
Zoloft
Fareston
(continues)
Table 1-9 (continued)
2006
2007
2008
2009
2010
2011
Zosyn/Tazocin,
Effexor
American Home Products (AHP)
AstraZeneca
Aventis SA (AVE)
Bayer (BAYZY)
Bristol-Meyers Squibb (BMY)
Eli Lilly (LLY)
Glaxo SmithKline (GSK)
Hoffman-LaRoche (ROHHY)
Johnson & Johnson (JNJ)
Zerit
Gemzar
Regranex
Regranex
Propulsid
Levaquin,
Risperdal
Fosamax
Merck (MRK)
Novartis
Pfizer (PFE)
Schering-Plough (SGP)
Zyprexa
Zofran
Norvasc
K-Dur
Cozaar/Hyzaar
Rezulin
Trovan
Lipitor
Viagra
The Essential Biotech Investment Guide
20
Table 1-10. Biotech Added Value for Big Pharma—Biotech Covers
Technologies Outside of Big Pharmaceuticals.
Basic
Discovery
Research
and
Development
Sales and
Marketing
Big Pharma
Yes
Yes
Yes
life science biotechnologies
Biotech type 1
Biotech type 2
Biotech type 3
Yes
Yes
Yes
Yes
Yes
No
Yes
No
No
life science biotechnologies
distinct from
those of big
Pharma's
Supply Demand Imbalance?
Positive Consumer Trend: New Life Styles and Habits
Lead to More Demand for Biotech Shares
Given the current growth of the U.S. population, by 2005 there will be a
decline in the number of 47-year-olds versus 65-year-olds. By 2020 there
will be more people over 65; giving rise to the "retirement boom." How will
older Americans spend money as their consumer habits change with age?
The marketplace is waiting with bated breath. But even more intriguing than
how much they spend their money is where they place their retirement
savings. Baby boomer investors have already been involved in the stock
market through plans like 401(k)s and IRAs. If the boomers continue to
invest in the stock market, there may be more money chasing fewer shares.
Indeed, there is no way to know whether their interest in stocks will
continue, but monitoring the investment strategy of this group will continue
to be important.
This fact underscores the need for the younger generation to look at the
biotech sector for future investment. In the 20th century, widespread
electrification gave us power for our cities, factories, farms, and homes-and
forever changed our lives. Thousands of engineers made it happen, with
innovative work in developing fuel sources, power-generating techniques,
Introduction
21
and transmission grids. From streetlights to supercomputers, electric power
makes our lives safer, healthier, and more convenient. Seventy-six million
people will be living longer, and consequently wanting to improve the
quality of their lives through innovations in medicine and technology (see
Table I-11 and Table 1-12).
The Essential Biotech Investment Guide
22
U.S. Patents Granted (1790 to1999)
1790
1810
1830
1850
1870
1890
1910
1930
1950
1970
1990
U.S. Ritcnl and Trademark Oiiice
Figure 1-3. Patents Granted in the U.S. Rose to Record Highs in the Late
1990s.
New Biotech Drug and Vaccine Approvals/New Indication
Approvals by Year
»
«
•e HI
E
h
n
n
'
ii','
.v1.
If<
:i
CT: £
<t— JRS
rK
F, F,
Vm — a t — H i — S I .™~JMB
rr<
'X' *'
M™'
O'J
•""•'
n.
^
'."• 'J: f
HfWtl
rr!
?'
Yoar
Ifr
Mi'
mB
.-V.
SJ '/'
,4!
'T.'
.ri,
K
-S'
£i ' i : £.' ' i ?-'
Source: BIO.
Figure 1-4. New Biotech Drugs and Vaccine Approved by the FDA (1982-2001)
Introduction
23
Table I - l l . The 20th Century's Greatest Engineering Achievements.
1. Electrification
2. Automobile
3. Airplane
4. Water Supply and Distribution
5. Electronics
6. Radio and Television
7. Agricultural Mechanization
8. Computers
9. Telephone
10. Air Conditioning and Refrigeration
11. Highways
12. Spacecraft
13. Internet
14. Imaging
15. Household Appliances
16. Health Technologies
17. Petroleum and Petrochemical Technologies
18. Laser and Fiber Optics
19. Nuclear Technologies
20. High-performance Materials
Source: American Association of Electronic Engineers.
24
The Essential Biotech Investment Guide
Table 1-12. The Leading Biotech Drugs.
Drug Brand Name
Developer/Company
2001 Rev
(US$MM)
1. Epogen/Procrit
Amgen/Johnson & Johnson
5700
2. PEG-Intron/Rebetron/Ribavirin
Schering-Plough /Ribapharm
1450
3. Neupogen
Amgen
1350
4. Avonex
Biogen
970
5. Rituxan
Genentech/Idec
820
6. Enbrel
Immunex/Wyeth-Ayerst
760
7. Engerix-B
Genentech/GSK
740
8. Remicade
Centacor
720
9. Ceredase/Cerezyme
Genzyme
570
10. Betaseron
Berlex Lab
530
11. Synagis
Medlmmune/Abbott Lab
520
12. ReoPro
Centocor/Eli Lilly
430
13. Gonal-F
Serono Lab
430
Sources: Annual Reports.
Chapter 1
The Basics of Investing
The Case for Equities
Tbbotson & Associates, an economic consulting firm, studied relative rates
-"-of return over a 70-year period, beginning with the 1920s. Their research
showed that equity investments have a remarkable long-term record that
weathered the Great Depression, several wars, recessions and fundamental
changes in the economy (see Figure 1-1).
Why invest in stocks? The answer is simple: long-term performance.
Based on a 20-year return (1981-2001), a dollar investment:
•
•
•
•
If you had invested a dollar in Treasury bills 20 years ago, your money
would have grown to $3.26.
If you had invested one dollar in long-term government bonds 20 years
ago, it would have grown to $9.81.
If you had invested one dollar back in 1981 in large-company stocks,
your dollar would have grown to $17.06 at an annual rate of return of
15.2%.
And if you had invested one dollar 20 years ago into small-company
stocks with a 13.8% annual rate of return, your one dollar would have
matured to $13.17.
25
Stock and Bond Market Performance
1925-2001
5 iu,uuu-r
s,ocks
• Corporate Bonds
S1 000 -•
1925
Ending
Wealth
Average
Return
S2.279
10.7%
$70.90
- ^ $50.66
S22.99
S 17.19
5.8%
5.3%
4.2%
3.8%
* G o v e r n m e n , Bonds
• Municipal Bonds
Treasury Bills
1934
1943 1952 1961
1970
1979
1988
Hypothetic.i! value ol St invested at year-end 1925
Assumes reinvestment o l Income and no transaction costs or taxes
This Is (or illustrative purposes only and n o ! indicative of any investment.
Past perlormnnce is no guarantee o l future results 3/1/2002.
<Q 2002 Ibbotson Associates. Inc.
Figure 1-1. Over Time Equity Outperforms Other Asset Classes.
The Basics of Investing
27
Table 1-1. Average 20-Year Return from 1981-2001.
Annual return* (%)
Present worth of $1
T-bill
6.1
3.26
LT Government Bond
9.81
12.1
Large-Cap Stocks
17.06
15.2
Small-Cap Stocks
13.17
13.8
Asset Class
Source: Ibbotson Associates, Inc.
As this chart indicates, historically, more risk has produced a higher
potential return. You will increase your return capacity by adding stocks to
your investment cocktail, but the possibility of losing your initial investment
becomes greater. The right mix of investments is essential, and it is
important to point out that stocks are not for everyone. Assess your risk and
loss tolerance with a financial advisor before investing in any growth
vehicle, no matter how "safe." Let's start with some basic concepts and
definitions.
The Rule of 72
The Rule of 72 can help you estimate the future value of your investment
based on assumed rates of growth. If you divide the expected rate of growth
into the number 72, the answer equals the hypothetical number of years it
may take for your investment to double in value. Formula: Number of years
to potentially double your investment = 72/the growth rate.
Table 1-2. Number of Years Needed to Double Your Investment.
$10,000
6%
(Growth Rate)
9%
12%
6 years
8
12
16
18
$40,000
$20,000
$40,000
$20,000
$20,000
$40,000
24
$80,000
$80,000
$160,000
28
The Essential Biotech Investment Guide
For instance, if your expected growth rate was 6%, divide that into 72
and estimate 12 years (see Table 1-2 above). This formula, however, does
not account for the fluctuation of securities, prices, investment returns and
yields due to unpredictable market conditions. On this table, you can see
how long it hypothetically would take $10,000 to double according to the
Rule of 72. With a 6% expected growth rate, it would take 12 years to
double and another 12 years to double again. Finally, at a 12% rate of return,
it would take just six years to reach $20,000 and you can see how many
times your money would have potentially doubled in 24 years. These
statistics are intended to illustrate how long it might take to achieve your
desired investment growth.
The Power of Compounding
Table 1-3 demonstrates the power of compounding, noting the growth of a
$100 monthly investment at a 10% rate of return. Each year you do not
invest, costs you the opportunity to have your investment expand, and in
turn you lose your time to save for retirement. If you waited five years to get
started on this investment, it would cost you $226,470 in possible return.
Similarly, Figure 1-2 demonstrates that by starting early, Investor A
accumulated $123,600 more than Investor B, while still investing $20,000
less because of the effects from compounding.
Table 1-3. The Power of Compounding and Cost of Waiting.
Investment total @
age 65
The cost of waiting
25
$584,222
$0
30
357,752
226,470
40
129,818
454,404
Age starting
Saving*
*Assumptions: $100 invested monthly at a 10% annual growth rate.
The Basics of Investing
29
Opportunity Cost
Investors have choices, and certain alternatives can prove to be more
profitable than others. An individual making 2% in a money market, even
though a higher return in the equity market fund is available, would be
subject to an opportunity cost by having selected the investment vehicle
with the lower return. If the equity market were yielding an average of 10%
per year, the opportunity cost for the money market participant would equal
8%. However, do not forget the correlation between risk and return.
Choosing a higher yield instrument introduces more risk to your portfolio.
Relationship between Risk and Return
This chart (see Figure 1-3) demonstrates the relationship between risk and
return. You can increase return potential by adding stocks to the mix, but
you also increase risk. Of course, where you need to be on this curve
depends on your personal situation, which your financial advisor can help
you determine.
Dollar-Cost Averaging
Dollar-cost averaging is a method of investing that requires you to invest a
fixed dollar amount in chosen securities at set intervals. Buying more shares
when the price is low and fewer shares when the price is high reduces the
overall cost of the purchase. Dollar-cost averaging does not assure a profit
and does not protect against a loss in declining market. However, it can help
you set emotions aside and make regular investments regardless of the
market direction. As you can see, for six periods of investing a fixed amount
of $100, the number of shares purchased will vary depending on the price
per share (see Table 1 -4).
However, studies have shown that if the stock market has a positive
expected risk premium, lump-sum investing is superior to dollar-cost
averaging. As a general rule, averaging down is only recommended only if
there is a good reason to continue to own the stock. Averaging up in a good
30
The Essential Biotech Investment Guide
Y e a r - E n d 1980-2000
Y e a r - E n d 1990-2000
5229,300
$20 000
Z//M7/2:
Investor A
Total A m o u n t Invested
C o m p o u n d e d Value at Y e a r - E n d 2000
Years Contributing:
Annual Amount Contributed:
Investor A
Investor I
10
10
$2,000
$4,000
Source: Ibbotson Associates.
Figure 1-2. The Power of Compounding-Hypothetical Investment in
Stocks.
Understanding Risk
Return
Cash. Equivalents
Figure 1-3.
The Relationship Between Risk and Return.
31
The Basics of Investing
stock works better than averaging down, since you are building wealth on a
successful investment.
Table 1-4. An Example of Dollar-Cost Averaging.
Period Purchased
Amount
Contributed ($)
January
February
March
April
May
June
Totals
100
100
100
100
100
100
600
Average Price/Share
Average Cosl/Share
Price Per
Share ($)
Number of
Shares
11.00
12.00
14.50
14.00
9.00
10.00
70.50
9.09
8.33
6.90
7.14
11.11
9.09
51.66
$ 11.75 ($70.50 divided by 6)
$11.61 ($600 divided by 51.66)
Purchasing Power and Inflation—Is a CD Really Safe?
Purchasing power can be reduced by inflation. Table 1-5 shows the average
annual inflation rates from December 31, 1925 to December 31, 1999. In 5,
10 and 20 years (assuming various rates of inflation), how much money will
you need to equal the value of $100 today? The answer is listed in Table
1-6.
Table 1-5. Annual Average Inflation From 1925 to 1999.
Year
%
1
10
20
2.8
2.9
4.0
50
4.0
65
4.0
32
The Essential Biotech Investment Guide
Table 1-6. How Much Money You Need to Keep $100
Dollars Purchasing Power.
Years
3%
4%
5
10
20
$116
$134
$181
$122
$148
$219
Inflation is not the only culprit reducing your purchasing power; taxes
factor in as well. Table 1-7 demonstrates the historic return of $10,000 cash
and equivalent investments' value after a 75-year growth period. Note how
your return would have been reduced after accounting for inflation and
taxes.
Table 1-7. Historic Returns of Cash and Equivalent After Inflation and
Taxes (1926-2000).
Cash $10,000
Cash equivalent
Minus Tax
Minus Tax and Inflation
Ending Balance ($)
Return (%)
36,072
21,384
10,601
6.6
3.9
0.3
Holding Period and Risk
The longer your time horizon, the greater the chance for your investments to
produce positive returns (see figure 1-4). As indicated by the Table 1-8
below, the 74 year period ending in 1999 saw 54 years of upward
movement. Therefore, as the holding periods increase, the degree of risk
taken by you, the investor, may decrease.
Table 1-8 also shows the years 1926 to 1999, in which stocks posted
positive returns 63 times and negative returns only seven times for five
years' holding period. By extending the holding period to 10 years, stocks
posted positive returns 63 times and negative returns only twice. And
moreover, if an investor extended the holding period to 15 years, the returns
The Basics of Investing
33
would have been positive in every one of the 60 fifteen-year holding
periods.
Table 1-8. Holding Period and Risk.
Years
(1926-1999)
1 year
5 years
10 years
15 years
UnmanagedSP500
Ups (+)
54
63
63
60
Downs (-)
20
7
2
0
This table portrays the volatile results of short-term investing. The
information above draws a clear lesson that long-term investing with a
savvy plan will be beneficial to your financial future. However, no matter
how fool-proof your strategy, there are factors that cannot be ignored or
controlled: inflation and taxation.
Understanding Risks
Every type of investing-whether it is cash instruments, stocks or bonds does
come with some form of risk (see Figure 1-5). Market sentiment, inflation or
a consistent decline in the stock or bond markets can affect levels of risk.
Yet, because investing is ultimately the best way to meet your monetary
goals, there are ways to participate in the markets and limit your risk. One
way is through a strategy known as asset allocation (see Figure 1-6).
Types of Risk
The main risks associated with a single biotech stock are of two kinds (see
Figure 8-1): systematic and non-systematic risks.
34
The Essential Biotech Investment
Guide
Holding Period Risk for Annual Real Returns
Historical Data and Random Walk (Dashed Line)
1802-2000
2C>:
1 • Aciual Slocks
1
1,„
a Actual Bonds
• Aciual Bills
16%
\ 16*
14°
12%
Risk
"
8V
.1il l l l l l . l
10°,
-
Holding Period
..
Stocks for the long Rim rj Jeremy J. Sie^el
Figure 1-4. Holding Period and Return.
Typical Investment Portfolios
Aggressive (iitmih
C a p i t a ] \|>pr.viiilii»n
I Onfgfl MIKLHOIW PBrtfiiHu*
Mtdtam m l j r , r ' fp $4rjdl •
! Total Return
i IfitiflnXl r<lflllj«r.
I A-wl U l n . m » a i
IlllUin
Figure 1-5. Investment Pyramid-Relationship Between Risk and Return.
The Basics of Investing
35
Systematic risk, or "market risk," which relates to the economic situation in
general. It cannot be eliminated.
Non-systematic risk, or "firm-specific risk," which relates to a particular
biotech firm. It can be eliminated. One way to eliminate it is by diversifying
(that is holding 40 or more diversified stocks). Eliminating non-systematic
risk reduces the volatility of the overall portfolio compared with the average
individual biotech stock. This action preserves accumulated wealth.
Diversification-Minimizing Your investment Risk
Since there are a wide variety of investment vehicles available, you should
make financial diversity your top priority. Stocks and bonds are perhaps the
most common, and a good place to start. However, diversity is possible
within an investment class such as corporate and government bonds,
domestic and foreign stocks, and companies with different market
capitalizations. Your advisor is there to help you construct a well-balanced
program (see Figures 1-6 and 1-7).
By Risk Level
There are a variety of securities that you can invest in. Not only are there
stocks and bonds, but there are different kinds of stocks and bonds such as
corporate and government bonds, both domestic and foreign (see Figure 18).
By Sector and Industry
The S&P 500 includes over 100 industry groups, which are generally
categorized into 10 market sectors (see Table 1-9). Ideally all sectors should
be represented in each portfolio. However, depending on market condition,
it may be advisable to overweight some sectors more than others. Major
investment firms have recommendations from time to time and usually have
their preferences.
3G
The Essential Biotech Investment Guide
Figure 1-6. Asset Allocation Among Classes.
The Investor's Investment Pie
^^m
BONDS
^ ^ ^ us so%
M
•B
M
STOCKS
...
value
Growth
CASH
International 20%
Figure 1-7. Diversification Among Stock, Bond and Money Markets
The Basics of Investing
37
Figure 1-8. Diversification Among Bonds
Table 1-9. S&P 500 Sectors.
S&P 500 Market Sectors
Representative Industries
Consumer Discretionary
Auto, Consumer Durable, Hotel Restaurant,
Media, Retail
Food, Beverage &Tobacco, Drug Retailing
Oil, Gas
Banks, Insurance, Real Estate, and Financials
Pharmaceuticals & Biotechnology, Health Care
Equipment & Services
Capital Goods, Transportation, Commercial
Services
Software & Services, Technology
Hardware/Equipment
Metals, Mining, Paper & Forest Products
Consumer Stable
Energy
Financial
Health Care
Industrials
Information Technology
Materials
Telecommunication Services
Utilities
Wireless, Telecom Services
Gas and Electric Utilities
38
The Essential Biotech Investment Guide
By Geographic Region
Stocks can also vary as to their geographical location. For example, these
two figures compares different styles of investing in stocks, foreign stocks
and small companies. Diversification is critical and offsets changes in
company leadership and unpredictable economics, (see Figure 1-6 and 1-7).
By Market Capitalization
The stocks of the companies with different sizes tend to perform differently.
Traditionally, large-cap stocks have less risk than small-cap stocks. Smallcap is typically defined as stocks with a market cap of less than $500
million. Mid-cap is between $100 million to $5 billion and large-cap is a
stock with a market cap more than $5 billion. Again, the historic returns of
different caps are different.
Past Reasons for Not Investing
1950
1958
1963
1978
1982
1990
Korean War
Recession
Kennedy Assassinated
Vietnam War Spreads
Interest Rates Rise
Worst Recession in 40
Years
Persian Gulf Crisis
1993
1994
1997
1998
Health Care Reform
Fed Raises Interest
Rates 6 Times
Asian Financial
Crisis
Russian Financial
Crisis, Clinton
Impeachment
The power of compounding, getting started on your investments now
are essential. Unfortunately, all too often people find reasons not to get
started. Here are only a few of them listed above. Governmental affairs,
politics, healthcare reform and plain procrastination are valid excuses for
delaying the investment process. Year after year, people think of reasons
why they should not invest in the stock market. And year after year, the
stock market has outperformed virtually all other investment opportunities.
We'd all agree an unstable economy is certainly frightening. However, why
The Basics of Investing
39
not look at the statistics? Over time, investing has been profitable. Though
past performance cannot absolutely guarantee a future result, time costs
nothing, and patience is valued.
Historic Return and How Much Return
One Should Expect
Mean Reversion. In the long run, there appears that, there is a tendency for
the overall growth rate of a company and industry sales to regree to the
overall mean growth rate of the economy. Therefore, one should expect
normal annual equity return to be 7-12%.
If you invested your first dollar in the stock market after October 1990,
you may respond differently to a market decline than an investor who
started in the 1970s. The 1990s bull market had an uncharacteristic and
continual ascent until very recently. From January of 1990 to December 31,
1998, the unmanaged Dow Jones Industrial Average jumped from 2,810 to
9,181 points. This steady rise explains why recent investors have unrealistic
expectations of market returns. After all, four out of every five dollars in
equity funds have never seen a 20% correction (crash). Conversely, history
dictates that in one out of every three years, the market has experienced a
down year. Since 1900, the stock market has posted positive annual returns
for 69 years, advancing two out of every three years with an average annual
gain of 22.49%; the other 31 years were met with negative returns at the
year's end. Fifty-five of those sixty-nine years have had double-digit returns
recorded in year-end performance tallies. These statistics pose a great
argument for long-term investing. However, market volatility can
significantly impact short-term performance. Results of an investment made
today may differ substantially from the historical performance shown.
Technical Analysis
When combined with sound fundamental analysis, technical analysis can be
helpful in stock selection, when it comes to timing purchases and sales.
Reading stock charts may seem a daunting and the terminology of the
technicians intimidating. Appendix A may give you some guidelines for
40
The Essential Biotech Investment Guide
your own chart interpretation and the basis for understanding. You need to
learn to interpret when the trend of a specific stock or market. As someone
in the Wall Street once said: "Never go against the trend."
Investment Vehicles Available to Achieve Your Goals
One has to ask the following questions: As an investor, what do I want to
achieve? Investors' long-term financial goals have not changed much over
the years: buying a home, for example, maybe two, putting your children
through college and retiring when you want, the way you want, are the most
common goals. What has changed is the way in which adults prepare to
meet these monetary challenges. Low-interest savings accounts are no
longer providing people with the necessary returns they need. There are a
vast array of investment instruments from which to choose and they can be
overwhelming, however, the following should make it easier to navigate
among them and make the appropriate choice.
Vehicle One: Stocks
If You Don't Own a Biotech Business, Here Is a Way
to Own a Fraction of One
Corporations raise capital through the sale of stock. Buying stock in the
corporation gives you a fractional ownership in the business.
Understanding Biotech Initial Public Offerings (IPOs)
For example, ABC Biotech Inc. needs to raise 10 million dollars to help
finish the development of its product, the "cancer drug." For the first time,
the company decides to issue stock through an initial public offering, or
IPO. The company's board of directors, working with an investment bank,
issues 1,000,000 shares of common stock. That means that each share is
priced at $10.
You, as a biotech investor, like the idea of a cancer drug that cures the
disease, so you decide to invest in ABC Biotech by buying 100 shares. Now
The Basics of Investing
41
you own $1000 worth of ABC Biotech Inc. Consequently, these shares of
ABC Biotech start to trade in the Over the Counter (OTC) market. You're
hoping, as the news of the company's product spreads, the value of the
company's stock will rise.
Any biotech company's stock price tends to react to news about its
product and profitability. For instance, if the company issues a report that
says it anticipates a strategic alliance with a major pharmaceutical giant to
fund and market the cancer drug candidate, more investors will want to
invest in ABC Biotech. This news increases demands for the shares, driving
up the price. As a result, your shares of ABC Biotech are now trading at a
price of $80 each, as opposed to the initial $10. Now you will have two
alternatives: one, you could sell your shares, at a $70 profit. Or secondly, if
you believe that one day there will be this "cancer drug" in every hospital
and in every house in America, you could hold on to your shares of ABC
Biotech and see whether its value will continue to increase.
Buying and Selling in the Markets
Keep in mind that there is always risk when buying or selling stock.
Companies may encounter obstacles, a poor economy or bad press, and this
will ultimately affect their stock price. If ABC Biotech started to sell its
cancer drug, and discovered that it has unexpected side effects, the value of
the company and your shares will simultaneously decline. Your shares may
now trade below $10.
Tracking the Stock: Be Sure to Compare Your
Performance with Biotech or S&P 500 Benchmarks
It can also be useful to compare the performance of stocks against certain
broad stock market indices. The most well known index is the Dow Jones
Industrial Average. It is important to keep in mind that the Dow Jones
Industrial Average is composed of only 30 stocks. These particular stocks
are large-capitalization, "blue chip" stocks that represent a selected
sampling across industrial sectors. Their performance, and therefore that of
the Dow, may not accurately reflect the performance of other stocks.
Perhaps your portfolio more closely mirrors the Standard & Poor's 500. The
42
The Essential Biotech Investment Guide
S&P 500 is an index that includes 400 industrial, 40 utility, 40 financial and
20 transportation companies across all the major exchanges. If your
portfolio is heavily weighted in technology, you should track the NASDAQ
Composite Index, which is generally composed of smaller-capitalization
stocks. Depending upon the types of stocks or equity funds you own, you
may have to look at more than just the major indices for an accurate
assessment of your portfolio's performance.
Buy-and-Hold Investing vs. Tactical Stocks
Buy and hold stocks.
These are the stocks in your portfolio for the long haul. They are onedecision stocks: to buy and hold. There are good reasons for this approach,
(1) No other strategy has beaten this one including transaction costs and
taxes. (2) Longer holding period decreases vitality. (3) Timing the market
has been difficult. (4) Historically bull markets last 3-4 times longer than
bear market. (5) Over time, then stocks have rebounded to historical high.
Bought to be sold.
Some stocks can also play a role in a diversified portfolio. They are two
decision stocks: to buy and sell at a foreseeable point in the future. Cyclical
stocks are a prime example—bought to be sold. Your ability to identify
economic cycles and the industrial sectors likely to perform well is very
critical here.
The Basics of Investing
43
Useful Definitions and Terms
Stock is a fractional portion of ownership in a company, priced by the market.
Blue-chip stocks usually have a steady history of paying dividends, and tend to be less
volatile due to the established nature of the companies.
Growth stocks have an above average level of capital appreciation, are often volatile,
and usually don't pay dividends.
Income stocks have historically paid above-average dividends and have potential for
capital appreciation.
Value stocks can be purchased for low prices relative to their perceived value.
Market capitalization equals the number of outstanding shares of a company's stock
multiplied by its market price.
Large-, mid- and small-cap stocks are defined in terms of their market capitalization.
Small-cap companies have a market cap below $500MM and typically have a higher
level of volatility. The Mid-cap range is $500MM to $5B.
Cyclical stocks are sensitive to changes in the economy. When the economy is
growing, they tend to do well. When economy falls, they fall as well.
Defensive stocks are stocks that are not sensitive to the economic cycle. Their prices
tend to remain stable or even rise when the economy slows down.
52-Week High/Low is a stock's highest and lowest daily closing prices reported during
the preceding 5 2-week period plus the current week.
Dividend is the annualized dividend rate for each share of stock based on the most
recent declaration.
Yield, or return per share of stock, is calculated by dividing the annual dividend per
share by the current market price.
P/E Ratio the price/earnings ratio, calculated by dividing the closing market price by
the company's per share earnings for the trailing 12 months.
Sales 100s trading volume, or sales, is printed generally in 100-share increments.
High/Low indicates the trading price range on that day.
Close indicates the closing price on that day.
Net Change is net change, or the dollar amount by which the closing price per share
advanced or declined from that of the previous trading day.
44
The Essential Biotech Investment Guide
Vehicle Two: Bonds
Bonds, another basic class of investment, offer a different situation. You are
now the lender, and the corporation, government or municipality is
borrowing from you. Essentially, a bond is an IOU from a corporation, a
government or a municipality. These entities issue bonds to raise funds.
When you buy a bond, the issuer of the bond promises to pay you a certain
amount of interest, usually each month, based on the bond's interest rate.
For that reason, a bond can be a good way to help assure a steady—or fixed
stream of income.
Bonds generally offer higher current income with less volatility than
stocks, but have less potential for capital appreciation. People who buy
bonds are often referred to asfixed-incomeinvestors and bonds are referred
to as fixed-income securities. The value of a bond will fluctuate in response
to a variety of factors including changes in interest rates and the financial
condition of the issuers.
Bonds have three important components:
Coupon Rate: The fixed amount of interest the bond issuer promises to pay
to you, the lender, over a fixed time period.
Maturity Date: The date on which a loan or bond comes due and is to be
paid off by the issuer.
Par Value: The face value or principal value of a bond, typically $1,000.
There are three types of bonds:
Corporate Bonds: While most major corporations issue bonds, the greatest
portion of corporate debt is issued by public utilities.
Government Bonds: There are three major classifications. The first
includes Treasury bills, Treasury notes, and Treasury bonds. The second
classification includes securities issued by U.S. federal agencies. The third
are issues of federally authorized agencies.
Municipal Bonds: These are issued by states, territories and possessions of
the US, as well as other political subdivisions (counties, cities, school
districts, sewer authorities, and other public bodies).
The Basics of Investing
45
High-Yield Bond Fund
A high-yield fund typically seeks to maximize total return by investing in a
diversified portfolio of high yield fixed income securities that offer a yield
above that generally available on debt securities in the four highest rating
categories of the recognized rating services. To mitigate these risks, the
fund can diversify its holdings by issuer, industry, and credit quality. Since
this type of bond fund has high risk, one should invest a small portion of
noe's assets in bonds of corporations with the strongest industry positions
and favorable outlook for growth of cash flow and asset value.
Vehicle Three: Cash
The third general category of investments is cash. Cash can be in the form of
money market securities, Treasury bills, or short-term certificates of deposit.
Because these debt securities have shorter maturaties, they typically provide
a more stable investment value along with current-interest income. A
general "rule of thumb" is that you should have at least three months' worth
of living expenses in cash, but this amount has to be determined by looking
at your specific needs for liquidity and risk tolerance.
Vehicle Four: Mutual Funds
Professionally Managed Investment Portfolios
In addition to asset allocation, there are a number of professionally managed
vehicles that offer the opportunity for diversification. Mutual funds,
investment companies that are professionally managed and pool large
amounts of investors' assets together, are often appropriate for many people.
Each fund has a professional money manager who manages the fund
according to its own objective: Long-term growth or high current incomes
are just a few of the possibilities.
Mutual funds offer:
46
The Essential Biotech Investment Guide
Diversification: Portfolios have risk spread among different securities,
sectors, and markets.
Professional Management: Professional managers and teams of research
analysts, who have in-depth knowledge of the financial markets, securities
and companies in which they invest, handle investment decisions within the
fund.
Regulation and Disclosure: A mutual fund cannot be issued without a
prospectus, and must adhere to its published objectives.
Choice: Investors have access to a multitude of financial markets through
mutual fund investing.
Liquidity: Shares can be sold on any business day to provide funds to meet
unexpected emergencies.
The value of individual investments within a portfolio fluctuates on a
daily basis and can be affected by numerous circumstances:
•
Changes in interest rates
•
General market conditions
•
Political, social, and economic developments
•
Matters relative to the securities in which the fund invests.
If you redeem your shares when their value is below that for which you
bought them, you will suffer a loss. In addition, when purchasing a mutual
fund there is often a sales charge, load or fee associated with the sale.
Mutual funds are sold only by prospectus. This document discusses the
fund's risks, charges and expenses. Before investing in a mutual fund, read
the prospectus carefully.
Vehicle Five: Unit Investment Trust
A unit investment trust (such as healthcare and pharmaceutical UITs) is a
registered investment company that buys and holds a relatively fixed
The Basics of Investing
47
portfolio of stocks, bonds, or other securities for a stated amount of time.
Units in the trust are sold to investors who receive a share of principal and
interest or dividends.
This type of investment company is established under an indenture or
similar accord instrument, and trustees supervise the management of the
company. UIT issue only redeemable securities, each of which represents an
undivided interest in a unit of specific securities. Unit holders receive a
proportionate share of net income from the underlying investments. The
portfolio generally remains fixed for the life of the trust-the securities do
not change. Also, UITs are not managed; therefore, securities in the trust are
not sold to take advantage of various market conditions to improve the
trust's value. UITs are sold by prospectus only.
Vehicle Six: Managed Accounts
You Select the Manager and They Manage Your Money
For the individual investor, professional management has often proven to be
a sensible way to navigate the complexities of the financial markets.
Management money is a full time job. The right manager can relieve you of
daily and burdensome investment decisions. A mutual fund may be a good
place to start when considering this kind of investment.
Vehicle Seven: Alternative Investment
Alternative investments include venture capital, private equity and hedge
funds. There are only for qualified accredited investor and institution only.
We shall have more detailed discussion later.
Asset Allocation
An asset allocation strategy should be based on diversity, time horizon,
investment goals, and risk tolerance. This strategy involves dividing your
savings among different asset classes (usually stocks, bonds, and cash
48
The Essential Biotech Investment Guide
equivalents). Since no single asset class performs well in all economic
environments, a diversified portfolio may help offset losses, reduce your
overall portfolio risk, and potentially achieve a more consistent long-term
performance (see Figure 1-6).
Proper asset allocation involves diversifying within each asset class as
well. Hypothetically, the stock portion of your portfolio might include small
and large capitalization stocks, value and growth stocks, and domestic and
international stocks. As different types of equities have varying levels of
performance dependent upon economic and market factors, asset allocation
helps to smooth out or potentially increase a portfolio's return.
Nonetheless, true diversification is only achieved within a portfolio
when it includes international and domestic securities. Long-term,
international investments can form a valuable part of a plan to help reduce
overall portfolio risk. International investing does involve some additional
risks such as currency fluctuations, political and economic developments.
You may want to consider using a professionally managed instrument to
incorporate international securities in your asset allocation mix.
Managing Your Portfolio and Wealth
A Three-Step Process
Which investments are appropriate for you, and how can you create a longterm program? The three steps listed below serves as a guide to the process
to help you achieve your goals.
1. Establish a plan that considers your goals, objectives, and risk tolerance.
Assess your constrain(s) such as asset levels, income, debts and
expenses. Determine the difference between your immediate and longterm goals. You must determine your investment styles, which can be
value, growth, blend of growth and value, GARP (growth at a
reasonable price, or PEG/PEGY), and Core Holding (Buy and Hold).
Have a written investment policy statement and maintain realistic
expectations.
The Basics of Investing
49
2. Select investment to develop the actual plan to fund your goals.
Determine the appropriate asset allocation—the percentage in the stock,
the bond, and the cash. A good rule of thumb to follow is: % of Cash
and Bond = your age. For example, thirty-year olds would place 30% in
cash plus bond, and 70% in stocks. One can minimize risk through
diversifying your portfolio by risk level, sector, geographic region, and
market capitalization.
3. Review and adjust your portfolio periodically. Allow your situation to
evolve. Most goals are dynamic and will change over time. Revisit your
strategies often, and as necessary. Review the asset allocation, stock
performance, check, and re-balancing the dollar and sector weighting.
Know when to sell, sell to take tax loss, when it is wise to use stop-loss
discipline and dollar-cost averaging.
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Chapter 2
An Introduction to Biotechnology
and Genomics
\ \ T h a t is a gene? A simple definition is that a gene is a sequence of
™ » nucleotides that specifies the sequence of an RNA or protein. A more
complicated definition is that a gene is a physical and functional unit of
heredity, which carries information from one generation to the next. In
molecular terms, it is the entire DNA sequence-including exons, introns and
noncoding transcription-control regions that are necessary for production of
a functional protein or RNA. In essence, a gene is pure digital informationsequences based on a four-letter code (A, T, G, C).
A gene is a portion of chromosomal material that potentially lasts for
enough generations to serve as a unit of natural selection. Chromosomes are
made up of deoxyribonucleic acid (DNA). Two chromosomal strands bind
and wrap around each other, giving the bound chromosomal strands the
"double-helix" shape that biophysicists James D. Watson and Francis H.C.
Crick discovered in 1953 (Figure 2-1). Weak hydrogen bonds, which
resemble rings on a ladder, hold the strands together. Most human cells
have 46 chromosomes, including one pair of sex chromosomes and 22 pairs
of autosomes, which have no role in sex determination. Each chromosomal
strand is made up of four DNA bases, or nucleotides: Adenine (A), thymine
(T), guanine (G), and cytosine (C). Although there are about 2.9 billion base
pairs on the 46 human chromosomes, only three percent of these base pairs
51
52
The Essential Biotech Investment Guide
encode for genes, while the rest are usually labeled as "junk DNA" because
of no known function. The human genome is estimated to contain about
30,000 to 40,000 genes. Gene expression is defined as the process by which
genetic information stored in DNA is used to direct the synthesis of RNA
and proteins.
The Central Dogma was proposed by Francis Crick in 1957. The main
idea in the central dogma is that genetic information flows from DNA to
RNA to proteins. The crucial point is that once the information passes into
proteins, it cannot get out. The current version of the Central Dogma
diagram includes reverse transcription and protein folding. The discovery of
reverse transcriptase, an enzyme that uses the RNA template to make a
complementary DNA strand, completed the cycle by adding an arrow from
RNA back to DNA (see Figure 2-2).
Figure 2-1. DNA Structure.
An Introduction to Biotechnology and Genomics
53
Diagrams of the Central Dogma
^
Circa
DNA
i;;;!iii;;;;;;ii;;;jjj|l?>
RNA.
— "
: :
' ^
Protein
1957
O
v
—DNA
-^ *• t
- RNA
•
A
Protein
Circa 1970, solid arrows=transfers that occur in all cells,
Dotted arrows=transfers that occur in special cases
Figure 2-2. The Central Dogma.
The complete genetic makeup of an individual is known as its genotype.
The way in which the genotype expresses itself (physical traits) is called its
phenotype. The genotypes of all humans are 99.9 percent identical, while
the remaining 0.1 percent difference in an individual's genetic makeup
accounts for their uniqueness (phenotypes).
These genetic differences often come in the form of Single Nucleotide
Polymorphisms (SNPs), because a single nucleotide in a base pair can be
different between two individuals. Some SNPs are linked to certain
diseases, making them excellent genetic landmarks for disease gene hunting.
Genetic variations might also explain why a given drug works well with
some patients, but not with others. The science associated with customizing
treatments to individual genetic variations is known as pharmacogenomics
(personalized medicine).
54
The Essential Biotech Investment Guide
Genes express themselves by forming proteins, which are large
molecules that give the body structure and carry out its functions. Examples
of proteins include enzymes (which catalyze chemical reactions in cells);
antibodies (produced in the immune system to fight infection when antigens
invade the body), and hormones (which regulate functions such as growth
and reproduction).
Genes produce these proteins via transcription process. During
transcription, two strands of DNA are separated, allowing the RNA
polymerase to move along a DNA strand and copy nucleotides that make up
the gene to form a molecule of messenger RNA (mRNA).
When this transcription process is complete, mRNA then migrates
outside the nucleus and into the cytoplasm of the cell. Here, the string of
bases is exposed to the ribosome, an organelle that carries out the work of
translation—the process of carrying out the nucleotides' instructions to form
a protein (see Figure 2-3).
Each string of three bases (known as a codori) of mRNA codes for a
specific amino acid—the molecules that form proteins. As the bases perform
this coding function, a molecule of transfer RNA (tRNA) carries the
appropriate amino acid bases to the ribosome. The various amino acids
(each of which was coded for by a different set of codons) are then strung
together by the ribosome to form a protein.
Drugs sometimes work by inhibiting or amplifying the function of a specific
protein target. Therefore, analysis of gene products, the proteins, can
drastically improve the process of drug discovery. With the near-finished
sequence of the human genome, it is now possible to identify proteins
rapidly. In time, the number of potential drug targets will be closer to 5,000
than the 500 of today. And in some cases, these newly discovered proteins
could serve as the drugs themselves.
Today, genomics companies are racing to take advantage of these advances,
developing platform technologies to identify genes, the SNPs associated
with disease, and producing drug candidates that attack these newly
discovered targets.
An Introduction to Biotechnology and Genomics
55
Human Genome Program. U.S. Department of Energy. Genomics and Its Impact on Medicine and Society: A 2001 Primer. 2001
Figure 2-3. Protein Translation.
When Celera Genomics Group announced last June that it had sequenced
nearly all of the human genome, it sparked new interest in a field that
promises to transform health care. The sequencing—which Celera and
publicly funded Human Genome Project have nearly completed—could
allow scientists to one day defeat the most defiant disease and tailor
treatments to individual patients. The real race in genomics today, a race in
which Celera, Human Genome Sciences, and Millennium participate, is to
find ways to use this data to diagnose disease and develop new drugs.
Recent advances in genomic sequencing and research accumulated a large
amount of biological data measured by size and complexity. The Fletcher
law postulated in 1974, a functional equivalent of Moore law received
recognition recetly as the growth of Genbank sequences and data doubles
every 18-24 months (see Figure 2-4).
56
The Essentia/ Biotech (nvesfmenf Guide
Bioinformatics, a new field in biology that emerged after the human genome
project, has attracted unprecedented attention from investors in this postgenomic era. Often referred as Computational Biology, Genomics, or in
silico Biology, Bioinformatics deals with computer archiving, accession,
manipulation, dissemination, and analysis of biological data with computer.
For instance, the annotation of the human genome, which means to discover,
describe, and assign sequence structures, functions, disease relation,
expression patterns, protein structures, variations, and gene interaction, to all
known and unknown genes, requires sophisticated mathematics algorithms
and superb computational power. Celera Genomics and its competitor,
Incyte Genomics, claim that they both have arguably the most powerful
computer systems in the world besides NASA. Pharmaceutical and biotech
companies in the United States and around the globe almost all have their
own propritary genomics/bioinformatics divisions. In this new century, the
rush to hunt down each disease-related gene and genes that cause aging or
intelligence, and to develop drugs and cures for all human diseases and
overall improve human life, is the challenge that bioinformatics would
provide the answer to. Symbols for US public traded biotech companies are
listed in Table 2-1. Table 2-2 breaks biotech companies by type of
technologies and applications. Figure 2-5 depicts a simplified version of
inter-relationship of life sciences technologies and their relationship to
commercialization/drug discovery and development processes.
Protein as Drugs. Proteins are biologic macromolecules that carry out
almost all of the activities of cells. Proteins can be used as therapeutics, drug
targets, diagnostics, marker and vaccines. Proteomics is the study of
proteins. Amgen's blockbuster lead product is a protein drug.
Antibody
and light
produced
antibodies
antibodies
as Drugs. Antibodies are Y-shaped proteins composed of heavy
chains with antigen binding and constant regions. They are
by B-cells. Each B-cell makes a unique antibody. A few
have been approved as drug in the past, and the market of
as drugs is immense.
An Introduction to Biotechnology and Genomics
57
Genetic Therapy Drugs. With four products in Phase III trials, genetic
therapy could be the next wave of biotech commercialization with the help
of cloning the right gene and using the right vectors.
Enabling Technology Platforms. These are toolbox technologies
companies that can sell technology and services to other biotech and
pharmaceutical companies. These novel technologies can produce a
database relating to structure, function, and drug candidates or can be used
to analyze a variety of diseases for potential cures.
Growth of GenBank
15000
13(500
12000
10500
9000
7000
eooo
4600
3000
1S00
0
19S2
1985
1988
1991
1994
199T
2000
Figure 2-4. Growth of Biological Data.
<=
£
The Essential Biotech Investment Guide
58
Table 2-1. Selected Biotech Stocks and Their Symbols.
Company
3D Pharma
Abgenix
Aclara Biosci
Adv Tissue Sci
Affymetrix
Alberny Mol
Alexion Pharma
Alkermes
Alliance
Amgen
Amylin
Antigenics
Aphton
Arena
ArQuIe
Array
Atrix Labs
Avant Immuneo
AVI BioPharm
Avigen
Aviron
Biogen
BioMarin
Biomira
Biopure
Bioreliance
Bio-Tech General
Biotime
Biotransplant
Celera
Celgene
Cell Genesys
Cell Therapeutics
Cellegy Pharma
Cephalon
Cepheid
Cerus
Chiron
Cholestech
CIMA Labs
CollaGenex
Collateral Thera
Connetics Corp
Cor Thera
Corixa
Corvas
Crucell
Symbol
Company
DDDP
ABGX
ACLA
ATIS
AFFX
AMRI
ALXN
ALKS
ALLPD
AMGN
AMLN
AGEN
APHT
ARNA
ARQL
ARRY
ATRX
AVAN
AVII
AVGN
AVIR
BGEN
BMRN
BIOM
BPUR
BREL
BTGC
BTX
BTRN
CRA
CELG
CEGE
CT1C
CLGY
CEPH
CPHD
CERS
CHIR
CTEC
CIMA
CGPI
CLTX
CNCT
CORK
CRXA
CVAS
CRXL
Immunogen
Immunomedic
Incyte Genomecs
Inhale Ther System
Inspire Pharm
Integra LifeSci
InterMune
Interneuron
Introgen
Invitrogen
Isis Pharm
Kosan
La Jolla Pharma
Lexicon
Lifecore Bio
Ligand
LION Biosci
Martek Bio
Maxygen
Medarex
Medlmmune
Millennium
Mirivant
Myriad Genetics
NABI
Nanogen
NaPro Biother
NeoPharm
Neose tech
Neurocrine Biosci
Neurogen
Northfield Labs
Novavax
NFS Pharm
Onyx Pharm
OraSure Tech
Orchid
Organogenesis
Ortec Intl
OSI Pharma
Paradigm Genetics
Pharma Prod Dev
Pharmacopeia
Pharmacyciics
Progenies Pharma
Protein Design Lab
Qiagen
Symbol
IMGN
IMMU
INCY
INHL
ISPH
IART
ITMN
IPIC
INGN
IVGN
ISIS
KOSN
UPC
LEXG
LCBM
LGND
LEON
MATK
MAXY
MEDX
MEDI
MLNM
MRVT
MYGN
NABI
NGEN
NPRO
NEOL
NTEC
NBIX
NRGN
NFLD
NVAX
NPSP
ONXX
OSUR
ORCH
ORG
ORTC
OSIP
PDGM
PPDI
PCOP
PCYC
PGNX
PDLI
QGENF
(continues)
An Introduction to Biotechnology and Genomics
59
Table 2-1 (continued)
Company
Cubist Pharm
Curagen
CV Therapeutics
Cygus
DeCODE
Dendtreon
DepoMed
Digene
Diversa
DUSA Pharma
Dyax
Embrex
Emisphere
Entremed
Enzo Biochem
Enzon
Epix Medical
Esperion
Exact Sciences
Exelixis
Gene Logic
Genelabs
Genetech
Genome Therap
Genta
Genzyme
Genz Mol OncI
Geron
Gilead Sciences
Guilford Pharma
Human Genome Sci
Hyseq
ICOS
IDEC Phama
Idexx Lab
IGEN
ILEX Oncology
ImClone Sys
Immtech
Immucor
Immunex
Symbol
CBST
CRGN
CVTX
CYGN
DCGN
DNDN
DMI
DIGE
DVSA
DUSA
DYAX
EMBX
EMIS
ENMD
ENZ
ENZN
EPIX
ESPR
EXAS
EXEL
GLGC
GNLB
DNA
GENE
GNTA
GENZ
GZMO
GERN
GILD
GLFD
HGSI
HYSQ
ICOS
IDPH
IDXX
IGEN
ILXO
IMCL
IMMT
BLUD
IMNX
Company
Regeneration
Regeneron
Ribozyme
Rigel
Sangamo
SangStat Med
Scios
Sepracor
Sequenom
Sicor
Supergen
Synaptic Pharma
Tanox
Telik
Texas Biotech
Third Wave Tech
Titan Pharma
Transgenomic
Transkaryotic
Trimeris
Tripos
Tularik
United Thera
UroCor
V.I. Tech
VaxGen
Versicor
Vertex Pharma
Vical
Viropharma
Visible Genetics
Vysis
XOMA
Symbol
RTIX
REGN
RZYN
RIGL
SGMO
SANG
SCIO
SEPR
SQNM
SCRI
SUPG
SNAP
TNOX
TELK
TXBI
TWTI
TTP
TBIO
TKTX
TRMS
TRPS
TLRK
UTHR
UCOR
VITX
VXGN
VERS
VRTX
VICL
VPHM
VGIN
VYSI
XOMA
60
The Essential Biotech Investment Guide
Table 2-2. Biotech Companies by Type of Technologies or Applications.
Type of Biotech Companies
Examples of Public companies
Angiogenesis
Antibodies
EntreMed
Antisense Drug Discovery
ISIS Pharmaceuticals
Autoimmune/Inflammation
Bioinformatics
Abgenix, Celgene Corp., ICOS,
Biopharmaceuticals
Alkermes, Genzyme General, Human
Genome Sciences
Blood Products
Biopure Corp.
Cancer
Ligand Pharmaceuticals, Gezyme Molecular
Oncology,
Carbohydrate Chemistry
BioMarin Pharmaceuticals, Neose
Pharmaceuticals
Cardiovascular
Sangamo Biosciences, Genzyme Biosurgery
Adv. Tissue Sciences
Cell Therapy
Abgenix, Cambridge Antibody Technology,
Medrex
Curagene Corp., Hyseq Inc., ZymoGenetics
Chemistry-combinatorial
ArQules, Ribozyme Pharmaceuticals,
Tripos Inc.
Computational Chemistry/Biology
Dermatology
Cubist Pharmaceuticals, Tripos
Connetics Corp, Ligand Pharmaceuticals
Diagnostics
Drug Delivery
Alliances Pharmaceuticals,
Alkermes, Cell Therapies, Inhale
Therapeutics, Target Genetics.
Drug Discovery
ArQules, Inc., ISIS Pharmaceuticals,
Tularik Inc.
Enhanced Peptide Drugs
ConjuChem Inc.
Functional Genetics
Lexicon Genetics Inc., Sangamo
BioSciences, Inc.
Functional Genomics
Paradigm Genetics
Gene/Cell Therapy
Target Genetics Corp, Geron Corp., Cell
Genesys, Inc.
(continues)
An Introduction to Biotechnology and Genomics
Table 2-2 (continued)
Genomics
Diversa Corp., Exelixis, Genome
Therapeutics., LION Biosciences,
Genomics Drug discovery
High Throughput Screening
Tularik Inc.
3-Dimentional Pharmaceuticals,
Pharmacopeia, Inc.
Immunology
Antigenics Inc.
Immunotherapy
Biomira
Infectious Disease
Cubist Pgarmaceuticald, Inc., InterMune
Pharmaceuticals.
Lipids
Liposome
Metabolic
NPS Pharmaceuticals, Telik, Inc. Paradigm
Genetics
Caliper
Microfluidics
Natural Products
Cubist Pharmaceuticals
Neurological
Guilford Pharmaceuticals, Neurogen Corp.
Nucleo tide-based
Gilead, Isis
Nutraceuticals
Pain
Progenies Pharmaceuticals
Neose Technologies, Orapharma, Inc.
Pharmacogenetics
Orchid BioSciences, Inc.
Pharmacogenomics
Protein Glycosylation
Variagenics
Neose Technologies
Proteomics
Lyns Therapeutics
SNPs
Orchild BioSciecnes Inc.
Structural Biology
BioCryst, Vertex
Gezyme Transgenics Corp., LION
Biosciecnes
Services
Transplant
Therapeutic vaccines
Dendreon
BioTransplant Inc.
Vaccines
Cytovax Biotechnologies Inc.
(h
Undertandlng Life SctenceJBlotechnologyTechnologies
GenoSequencfng. Hlgti-ttirouohput, DataBase and Mining
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CTQ
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Single Nucleotides, Resfrlctfon Enzyme analysis
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Chemistry, Parallel Systhasls, Splitamf Pool Syathasls
I
Chapter 3
Understanding Biotechnology
Invention and the FDA Approval
Process
Part I: Biotechnology Inventions and Patents
A
patent is a grant from the federal government that entitles the patent
owner to prevent others from practicing an invention for a limited
period of time. Practicing an invention includes making, using, or selling the
patented product or process. For U.S. utility and plant patents, the protection
expires 20 years after the application is filed.
The counterpart for such protection is that the public gets access to the
information in the patent and is able to practice the invention, once legally
entitled to do so. There may be some restrictions to the practice of an
invention. For example, it may hamper another patent owner's rights, or it
may require a federal approval (i.e., the FDA approval).
Benefits of Patents
When a patent is issued, society is able to learn about the invention. This is
so because, at that time, publication of the patent is mandatory. Patent
63
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The Essential Biotech Investment Guide
owners have several opportunities to take advantage of the commercial
value of the patent:
1. They can sell the patent outright.
2. They can produce and sell the products themselves, thus benefiting from
the monopoly rights derived from the patent.
3. They can license or grant their rights to a third party.
Patents allow the development of products that otherwise could not be
invented because they require a very expensive research process. Through
the protection granted by the patent, the owner can recover the costs
involved in bringing the product to market. Patents are a motivation for
others to invent more around the patent, thus further benefiting society as a
whole. When a patent expires, society still benefits from the invention as
products continue to be commercialized by the original developer and other
manufacturers.
Patentable Inventions
A patentable invention is "any new and useful process, machine,
manufacture, or composition of matter, or any new and useful improvement
thereof." Examples are. chemical processes, methods of making and using
genetically engineered products as well as the products themselves, and
plants or new life forms.
Three Criteria for Patentability:
1. Does the invention have utility? It need not be superior to other means or
have commercial value. However, the usefulness of the invention cannot be
only for academic study.
2. Is the invention novel? No one has done the same thing before.
3. Is the invention obvious? It must not be obvious. A person having
ordinary skill in the art-that is a person with general knowledge in the field
of the invention-does not find the invention obvious at the time the
invention is made.
Biotech Invention and the FDA Approval Process
Three Parts of a Patent Application:
1. A Specification
The specification comprises one or more claims for the invention, which
describe the essential elements and the specific features of the invention.
Claims are important because they provide a basis for legal enforcement of
the patent. Approval of the patent owner is required to practice the claims.
2. A Drawing (if necessary)
3. An Oath by the Inventor
Inventorship and co-inventorship: Inventship must be distinguished from
authorship. An "independent conceptual contribution" to the invention is
required in order to qualify as an "inventor" or "co-inventor" if there is more
than one inventor. More specifically, one should concentrate on the claims
to see whether the person has made an original, conceptual contribution to
any element of the claim (co-inventor) or to all claims (inventor). Patent
law defines conception of the invention as "the formation in the mind of the
inventor of a definite and permanent idea of the complete and operative
invention as it is to be applied in practice thereafter." An invention is
complete and operative "if the inventor is able to make a disclosure which
would enable a person of ordinary skill in the art to construct or use the
invention without extensive research or experimentation." Only inventors
or co-inventors may file an application to have a patent issued in their
names. It is important to specify accurately all legal inventors since failure
to do so may be a basis for invalidating the patent or even be qualified as
fraud against the Patent Office.
Three Ways to Recognize Personal Contribution to an Invention:
1. By designation as one of the legal inventors in whose names the patent
will be issued.
2. By participation through sharing in any income from commercialization
of the invention.
65
66
The Essential Biotech Investment Guide
3. By recognition through publications and presentations. Whereas law
strictly regulates the title of "inventor," financial returns can be freely
attributed by the owner or by university policy to reward other meritorious
contributors. University policy may assign only a share of the income to the
inventor.
Invention recognition and disclosure: An invention may be recognized at
the end of an experiment or inquiry. The presentation of a manuscript is
usually accepted as recognition of the invention. Once the invention is
divulged to the public, patent rights may be lost. Consequently, it is
recommended that whenever researchers believe that the discovery meets
the three invention criteria, they should file a disclosure form to preserve
their future rights to commercialize the patented product(s).
Loss of patent rights by publication: Once an invention is disclosed to the
public, the inventor may still file a U.S. patent application within the year
following the release. Failure to do so implies that the inventor surrenders
the patent rights. Most foreign countries exclude any filing of a patent
application after public release.
Preservation of patent rights: It is important for companies to protect their
patent rights. Therefore, they should file a US patent application before the
public has access to the invention. Market exclusivity granted by the patent
is the only way companies can recoup the money they spent to develop the
product. A special foreign patent application can be filed within a year of
the date of the U.S. application in order to preserve foreign patent rights.
Records can win or lose patents: Participants should carefully keep all
records in notebooks in order to avoid any potential dispute over who
qualifies as inventor. Records are decisive to determine:
•
The date the invention originated: The Conception
•
The date the invention was put in practical form: The Reduction to
Practice
The U.S. Patent and Trademark Office conducts interference
proceedings in which parties not only have to prove that they first made the
invention but also that they have taken diligent steps between conception
and reduction to practice. A contending inventor should keep records on a
Biotech Invention and the FDA Approval Process
67
daily basis and have them confirmed by witnesses who have knowledge in
the field of the invention but have no interest in it. Peers of the inventor(s)
are preferred as witnesses rather than subordinates. Whereas record keeping
for industrial researchers is done routinely on a daily basis, it may not be so
for academic researchers. However, record keeping is important because it
is ultimately the legal document used to recognize the inventor's rights.
Part II: The FDA Approval Process for Drugs
The U.S. biotech industry currently includes some 340+ public companies
and 1050+ private companies. About 120 biotech products approved by the
FDA were on the market, and more than 300 active biotech drug candidates
war in late clinical trials. The U.S. biotech industry spends $13.8 billion
annually on research & development. Furthermore, the cost associated with
bringing a drug to market has been estimated to be approximately $500
million.
Even though the FDA has dramatically decreased the approval time over
the last 5 to 10 years (Table 3-1), the overall length of time for developing
drugs has not been significantly shortened—it still takes approximately 10
years to bring a drug to market, from research through approval. Successful
drug development still depends on good science, including a thorough
understanding of biological systems.
The Federal Drug Agency sets regulations for new drugs, medical
devices and diagnostics intended for the public in order to protect public
health. Figure 3-1 summarizes the drug development stages and the approval
process.
Stages of the FDA Approval Process
Preclinical Testing
The preclinical testing period revolves around laboratory and animal studies
(one to three years). Its purpose is to prove efficacy of the compound and to
assess potential toxicity.
68
The Essential Biotech Investment Guide
Investigational New Drug (IND) Application
The company files an IND application with the FDA to start testing the
compound on humans. The IND goes into effect unless the FDA rejects it
within 30 days. The IND reveals scientific data relative to the compound
and logistics of the studies performed. It must be reviewed and approved by
an Institutional Review Board (IRB), which ensures that the patients in
clinical trials are protected and that the rules of informed consent are
followed. Progress reports must be presented at least every year.
Phase I Clinical Trials
Tests are conducted for approximately a year with 20 to 80 healthy
volunteers and are aimed at determining a safety profile (dosage, absorption,
metabolization, and excretion by the body and time of effect). Phase I is
usually a lab bench study, with its main purpose to rule out liver toxicity.
Phase II Clinical Trials
Tests are conducted for one to two years with 100 to 300 volunteers with the
targeted disease and are aimed at evaluating the effectiveness of the drug
using different dosing regimens based on animal data.
Biotech Invention and the FDA Approval Process
Preclinical X Biological effects
Testing
J
and toxicities
Safety and
pharmacokinetics
Efficacy, dosing
Statistics of
significance of
safety and
efficacy
Standard cor
Acct elerated
Riview
Figure 3-1. Stages of the FDA Approval Process.
69
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The Essential Biotech Investment Guide
Phase III Clinical Trials
Tests are conducted for approximately two years with 500 to 3,000 patients
in different clinics and hospitals. Physicians and clinical research trial
specialists monitor strictly patients regarding possible adverse reactions and
critical incidents to the drug. Phase II is always a prospective, randomized,
placebo-controlled multicenter trial. The main purpose is to determine the
safety and efficacy of the drug compared to a placebo control (an inactive
substance that looks like test drug). The FDA uses the data from these trials
to assess whether it should grant drug approval.
Phase IV Clinical Trials
These postmarketing trials compare the drug in question to competitor drugs
and/or treatments. They are used to enhance the efforts of pharmaceutical
marketing and to help encourage sales.
New Drug Application (NDA)
After the three phases of clinical trials have been completed, the company
files an NDA application with the FDA. An outside advisory committee
usually reviews the NDA and recommends whether or not to approve the
drug. The final decision rests with the FDA, which usually follows the
advisory board's recommendation. The average time to review an NDA is
24 months.
Accelerated Review
For serious diseases, that is, those for which no effective treatment presently
exists, the FDA has a special procedure to accelerate the NDA review. In
such cases, approval can be granted prior to the results of the Phase III trials.
Biotech Invention and the FDA Approval Process
71
Approval
After the drug has been approved, physicians can prescribe it for their
patients. For some drugs further clinical trials, known as postmarketing
surveillance studies, may be required (Phase IV) to determine the long-term
effects.
The Risk of Clinical Trials
As shown in Table 3-2 and Figure 3-2, of 100 drugs for which INDs
applications are submitted to the FDA, about 70 will successfully complete
Phase I trials and go on to Phase II; about 33 of the original 100 will
complete Phase 2 and go to Phase III; and 25 to 30 of the original 100 drugs
will clear Phase III, On average, about 20 of the original 100 will ultimately
be approved for marketing.
Notes for Investors
•
Companies that advertise that they have made their IND application
should be analyzed with caution since application is just a routine
procedure.
•
Investors should select companies that have proved clinical efficacy and
are cost-effective.
•
Companies with products in the late stages of development are less
risky.
•
Investors should focus on drugs that are fulfilling significant medical
needs.
•
Investors should continue to follow up on drug companies, monitor their
studies, and be aware of any warning signs.
Table 3-1. FDA Review Times.
Year
1985
1986
1987 1988 1989 1990 1991
1992 1993 1994 1995
1996
Mean Approval Times
(Months)
31.9
34.1
32.4
31.3
32.5
27.7
30.3
29.9
26.5
19.7
19.2
17.8
20
21
20
23
23
30
20
23
22
28
53
Total # of new drugs
30
approved in each year
Note: A six-month reviewing time is the statutory standard.
Source: U.S. Food and Drug Administration.
Biotech Invention and the FDA Approval Process
73
3 »
„ « = ! &
(2-10 years)
50,000 to 10,000 compound screened
250 lead candidates i n
preclinical testing
S drug condidates
entering clinical
testing
Preclinical
Testing (lab and
^ animal testing)
Piasel
(safety and
dosage, 20-30
healthy
volunteers)
80%passPhaseI
30 9£ pass
Phase II
80% pass
Phase HI
Phase II
(efficacy and
side effects,
100-300
patients)
Phase III
(long-term
effects, 10005000 patients)
\^
One drug
approved
FDA Reviewed
Approval
FDA
Post-marketing
Testing
Figure 3-2. Risk Data Analysis of Drug Development and Approval.
74
The Essential Biotech Investment Guide
Table 3-2. Risk of Clinical Trials.
Testing in
Humans
Phase I
Phase II
Phase III
Number of
Patients
20-100
Up to several hundred
Several hundred
to several
thousand
Length
Several months
Several months to 2
years
1-4 years
Purpose
Mainly safety
Some short-term safety
but mainly effectiveness
Safety, dosage,
effectiveness
Percentage of
Drugs
Successfully
Tested
70 percent
33%
25-30%
Source: The FDA.
Biotech Invention and the FDA Approval Process
75
Drug Review Glossary
Abbreviated New Drug Application (ANDA): A simplified submission
permitted for a duplicate of an already approved drug. ANDAs are for
products with the same or very closely related active ingredients, dosage
form, strength, administration route, use, and labeling as a product that has
already been shown to be safe and effective. An ANDA includes all the
information on chemistry and manufacturing controls found in a new drug
application (NDA), but does not have to include data from studies in
animals and humans. It must, however, contain evidence that the duplicate
drug is bioequivalent (see Bioequivalence) to the previously approved drug.
Accelerated Approval: A highly specialized mechanism intended to speed
approval of drugs that promise significant benefit over existing therapy for
serious or life-threatening illnesses. It incorporates elements aimed at
making sure that rapid review and approval are balanced by safeguards to
protect both the public health and the integrity of the regulatory process.
This mechanism may be used when approval can be reliably based on
evidence of a drug's effect on a "surrogate endpoint" (see Surrogate
Endpoint), or when the FDA determines an effective drug can be used
safely only under restricted distribution or use. Usually such a surrogate can
be assessed much sooner than such an endpoint as survival. In accelerated
approval, FDA approves the drug on condition that the sponsor studies the
actual clinical benefit of the drug.
Action Letter: An official communication from the FDA to an NDA
sponsor that informs of a decision by the agency. An approval letter, which
allows commercial marketing of the product, lists minor issues to be
resolved before approval can be given. A letter of non-approval describes
important deficiencies of the drug or data that preclude approval unless
corrected.
Advisory Committee: A panel of outside experts convened periodically to
advise FDA on safety and efficacy issues about drugs and other FDAregulated products. The FDA is not bound to follow committee
recommendations, but it usually does.
Amendment to an NDA: A submission to change or add information to an
NDA or supplement not yet approved.
Bioavailability: The rate and extent to which a drug is absorbed or is
otherwise available to the treatment site in the body.
Bioequivalence: Describes the scientific basis on which generic and brand
name drugs are compared. To be considered bioequivalent, the
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The Essential Biotech Investment Guide
bioavailability of two products must not differ significantly when they are
given in studies at the same dosage and under similar conditions. Some
drugs, however, are intended to have a different absorption rate. The FDA
may consider a product bioequivalent to a second product with a different
rate of absorption if the difference is noted in the labeling and doesn't affect
the drug's safety or effectiveness or change the drug's effects in any
medically significant way.
Clinical Studies: Human studies designed to distinguish a drug's effect
from other influences-for example, a spontaneous change in disease
progression or in the effect of a placebo (an inactive substance that looks
like the test drug). Such studies conducted in this country must be under an
approved IND (see Investigational New Drug Application), under the
guidance of an institutional review board and in accord with FDA rules on
human studies and informed consent of participants.
Drug Product: The finished dosage form (tablet, capsule, etc.) that contains
a drug substance-generally, but not necessarily, in association with other
active or inactive ingredients.
Drug Substance: The active ingredient intended to diagnose, treat, cure, or
prevent disease or affect the structure or function of the body, excluding
other inactive substances used in the drug product.
Effectiveness: The desired measure of a drug's influence on a disease
condition. Effectiveness must be proven by substantial evidence consisting
of adequate and well-controlled investigations, including human studies by
qualified experts, that prove the drug will have the effect claimed in its
labeling.
Investigational New Drug Application (IND): An application that a drug
sponsor must submit to the FDA before beginning tests of a new drug on
humans. The IND contains the plan for clinical trials and is supposed to give
a complete picture of the drug, including its structural formula, animal test
results, and manufacturing information.
New Drug: A drug first investigated or proposed for marketing after 1938
(when the Federal Food, Drug, and Cosmetic Act was passed)-that is, the
drug was not generally recognized as safe and effective before that date.
New Drug Application (NDA): An application requesting the FDA
approval to market a new drug for human use in interstate commerce. The
application must contain, among other things, data from specific technical
viewpoints for FDA review-including chemistry, pharmacology, medical,
biopharmaceutics, statistics, and, for anti-infectives, microbiology.
Parallel Track Mechanism: A U.S. Public Health Service policy that
makes promising investigational drugs for AIDS and other HIV-related
Biotech Invention and the FDA Approval Process
77
diseases more widely available under "parallel track" protocols while the
controlled clinical trials essential to establish the safety and effectiveness of
new drugs are carried out. The system established by this policy is designed
to make the drugs more widely available to patients with these illnesses who
have no therapeutic alternatives and who cannot participate in the controlled
clinical trials.
Pharmacology: The science that deals with the effect of drugs on living
organisms.
Post-Marketing Surveillance: The FDA's ongoing safety monitoring of
approved or marketed drugs.
Preclinical Studies: Studies that test a drug on animals and other nonhuman test systems. They must comply with the FDA's good laboratory
practices. Data about a drug's activities and effects in animals help establish
boundaries for safe use of the drug in subsequent human testing (clinical
studies). Also, because animals have a much shorter lifespan than humans,
valuable information can be gained about a drug's possible toxic effects over
an animal's life cycle and on an animal's offspring.
Raw Data: Researcher's records of patients, such as patient charts, hospital
records, x-rays, and the attending physician's notes. These records may or
may not accompany an NDA, but they must be kept in the researcher's file.
The FDA may request their submission or may audit them at the researcher's
office.
Safety: No drug is completely safe or without the potential for side effects.
Before a drug may be approved for marketing, the law requires the
submission of results of tests adequate to show the drug is safe under the
conditions of use in the proposed labeling. Thus, "safety" is determined case
by case and reflects the drug's risk-versus-benefit relationship.
Safety Update Reports: Reports that an NDA sponsor must submit to the
FDA about any new safety information that may affect the use for which the
drug will be approved, or draft labeling statements about contraindications,
warnings, precautions, and adverse reactions. Safety update reports are
required four months after the application is submitted, after the applicant
receives an approval letter, and at other times upon the FDA request.
Supplement: A marketing application submitted for changes in a product
that already has an approved NDA. FDA must approve all important NDA
changes (in packaging or ingredients, for instance) to ensure that the
conditions originally set for the product are not adversely affected.
Surrogate Endpoint: A laboratory finding or physical sign that may not, in
itself, be a direct measurement of how a patient feels, functions, or survives,
but nevertheless is considered likely to predict therapeutic benefit. An
78
The Essential Biotech Investment Guide
example would be CD4 cell counts, used to measure the strength of the
immune system.
Treatment IND: A mechanism that allows promising investigational drugs
to be used in "expanded access" protocols-relatively unrestricted studies in
which the intent is both to learn more about the drugs, especially their
safety, and to provide treatment for people with immediately life-threatening
or otherwise serious diseases for which there is no real alternative. But these
expanded access protocols also require researchers to formally investigate
the drugs in well-controlled studies and to supply some evidence that the
drugs are likely to be helpful. The drugs cannot expose patients to
unreasonable risk.
User Fees: Charges to drug firms for certain NDAs, drug products, and
manufacturing establishments. The FDA uses these fees to hire more
application reviewers and to accelerate reviews through the use of computer
technology.
Source: The FDA.
Chapter 4
Introduction to Biotech Investing
Value Investing
B
enjamin Graham is widely regarded as the father of value investing. The
first to develop analytical methods of security analysis, his goal was to
find companies selling for less than they were really worth. He examined a
company's net current assets, debt-to-equity ratio, dividend record, earnings
growth, and price relative to net current assets. His thinking was that the
dividends would provide a sufficient return until the market recognized the
true value of the shares. The conventional way implies buying low pricebook value or low price-earnings ratio stocks.
The generic way implies buying at a price lower than the value of the
assets. Some indicators such as price-book value, price-earnings, and pricesales ratios seem to guarantee high returns which may reward a long-term
investment or risk taking.
Growth Investing
Classic definition implies investing in companies with high P/E ratios. A
growth stock is defined as a company whose sales and profits are expanding
at a much faster rate than the overall economy. Current definition implies
79
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The Essential Biotech Investment Guide
investors paying a price for growth that is less than the value of that growth.
Many pay little or no dividends to shareholders, since they usually reinvest
their earnings into the company to help keep the growth alive. This type of
investing is based on the belief that growth is systematically undervalued
and requires being able to assess future growth. It also involves a certain
degree of risk. An activist growth investing strategy implies investing in
businesses that have potential for growth but are constrained in their
development. Such investors need a good understanding of the business and
must be ready to take the risk involved in trying to ease the constraints.
While some growth stocks do double or triple in value, this does not
usually happen for a number of years. Growth stock investors attempt to
identify companies early in their development, to create diversified
portfolios, and to stick with the shares through years of rapid earnings
growth. Some of the best examples of value stocks today were growth
stocks at one point in their history. A company with a great product and
terrific track record can suddenly be knocked out of the game by a new
competitor or substitute technology. Moreover, growth stocks usually do not
offer dividends, which could support the share price in times of uncertainty.
Therefore, growth stocks are generally appropriate for risk-tolerant investors
who can hold firm through periods of volatility.
When looking at P/E ratios or price-book ratios, value stocks appear to
be more profitable, over the long term, than growth stocks. However,
growth stocks outperform value stocks when the overall growth rate of the
market is good or when long-term rates are higher than short-term rates.
The Industry Life Cycle
The automobile industry is a good example of a market life cycle (see Table
4-1). Automobiles were introduced in the early 1900's, and the
INTRODUCTORY stage developed with the growth of new technology.
With the concept of the assembly line and an increasingly affluent society,
the GROWTH stage began. Many different products (automobiles) were
introduced during this stage with varying success. The TURBULENCE
stage is a period of competitive "shakeout." During this stage, models such
as the Studebaker, DE Sotos, and others like them could no longer stay in
Introduction to Biotech Investing
81
business owing to competition. The shakeout makes available more market
share, and its acquisition by the remaining competitors represented the
transition to a MATURITY stage of the market cycle. At some point in time
the final stage, DECLINE, will occur when a more effective means of
transportation than the automobile is introduced, and thus will begin a new
market life cycle. The automobile industry represents an unusually long
market life cycle. The biotech industry might be viewed as the beginning
Stage 2, or the rapid growth stage.
Table 4-1. Typical Industry Life Cycle.
Stage 1
Stage 2
Stage 3
Stage 4
Stages
Introduction
Rapid Growth
Turbulence
Maturity
Decay/Decline
• market being
defined
• sales
sporadic
• sales grow
rapidly
• competitor
joining
market
• sales growing
slowly
• competitive
shakeout
• sales holding
steadily
• major
competitor
established
• price as a
competitive
weapon
• sales decline,
profit margins
erode
• product
efficiencies crucial
• some competitor
dropout
Characteristics of Investing in Biotech
Small Cap Investing
Investing in small firms is often more profitable than investing in bigger
firms for the same risk. This is true although transaction costs of investing in
smaller stocks are higher. However, small-cap investing requires a longterm strategy in order to offset the costs of transactions. The Capital Asset
Pricing Model (CAPM) may not be the best model to assess risk since it
does not take into account the additional risk involved in investing in
smaller stocks.
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The Essential Biotech Investment Guide
Public Venture Investing
Very few (about 3%) of publicly traded biotech companies are profitable.
Biotech investing in most cases entails risk very similar to that of venture
capital investing.
Value Investing
I. The Passive Value Investor
Passive value investing relies upon screens that are meant to identify value
stocks. Ben Graham developed screens that have since been refined and
extended. First and foremost, value investing concerns itself with the
internal financial dynamics of a company rather than with the larger
economy. Furthermore, it is a strictly 'by the numbers' approach. You can
not 'measure' the quality of management or a company's ability to develop
new products, so the pure value investor does not consider these criteria.
Ben Graham's Screens
Some of Ben Graham's screen criteria:
•
•
•
•
•
•
•
•
•
•
P/E of the stock has to be less than the inverse of the yield on "AAA"
corporate bonds
P/E of the stock has to be less than 40% of the average P/E over the last
five years
Dividend yield > 2/3 of the "AAA" corporate bond yield
Price < 2/3 of book value
Price < 2/3 of net current assets
Debt/Equity ratio < 1.0
Current assets > twice the current liabilities
Debt < twice the net current assets
Historical growth in EPS (over the last 10 years) > 7%
No more than two years of negative earnings over the previous 10 years
Introduction to Biotech Investing
83
Price/Book Value
If the price-to-book ratio is low, it shows that the firm is undervalued. In
practice we notice that, in the long run, low price/book value stocks have
outperformed high price-book value stocks and the overall market. Research
findings show that there is a negative relationship between returns and
price/book value ratios. Also, it has been established that price-book value
ratios may be a tool to measure risk: Firms with prices well below book
value are riskier and may be driven out of business. It is for investors to
assess whether higher expected returns are worth investing in higher risk
profile firms.
Price/Earnings Ratio
It has been found and confirmed that firms with low price/earnings ratios
reveal under valued stocks and earn excess returns. Studies show that the
average return for firms with the highest PE ratios vary from 6.64% to
16.26% for firms with the lowest PE ratios. This is true even on
international markets. Note that most biotech companies have negative P/E
ratios.
Price/Sales Ratio
Studies show that portfolios with low price/sales ratios outperform the
markets; however, low price/sales ratio portfolios do not outperform low
price/earnings ratios portfolios. Additionally, a strategy that favors low
price/sales ratios will not earn returns that are as consistent as one that
favors low price/earnings ratios. This strategy is also more inclined towards
selecting smaller firms. Nevertheless, price/sales ratios remain a useful tool
in order to understand excess returns.
Success Factors at Value Screening
1) Have a long time horizon. All studies mentioned above are reliable only
in sofaras they are carried out over the long run.
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The Essential Biotech Investment Guide
2) Choose your screens wisely. If screens are not properly selected, it may
lead investors to miss stocks that were going to create the positive excess
returns.
3) Be diversified. It is recommended to hold a large portfolio because a
small portfolio incurs more risk and undercuts excess returns.
4) Watch out for taxes and transactions costs. The use of screens may lead
one to select stocks that are low-priced, but have increasing transaction
costs. Note that the excess returns mentioned above are pre-tax returns.
Also, note that screens may expose the investor to high tax strategies.
II. The Activist Value Investor
Investors buy undervalued stocks from companies, which are not properly
managed. They then try to confront and influence the management team to
improve the company's efficiency and create value. Such strategy requires
large capital and expertise in business and corporate finance.
Spin-Offs, Split-Offs, Divestitures on Value
The decision to push for breakup takes place when the components of a
company are worth more than the company as a whole. Research shows
that spin-off announcements result in an increase of the average excess
return. Also, the increase is more for bigger entities or if the motive is tax
evasion or regulatory concerns. For example, Affymatrix is an excellent
example of a successful spin-off.
Leverage Increasing and Decreasing Transactions on Firm Value
The decision to increase leverage takes place when companies are being too
conservative with the use of debts. Effects: Increase of leverage usually
increases the firm's value, and decrease of leverage usually decreases the
value of the firm. Unprofitable biotech companies that issued debt could
increase their equity risk as well as bankruptcy risk.
Introduction to Biotech Investing
85
Management Changes on Firm Value
The decision to change management or to have the firm acquired takes place
when the company is not run efficiently. Effects: Markets usually react
positively to such news. A biotech company that has bad news or trouble in
clinical trials, for example, tends to have management changes.
Hostile Acquisitions on Target Firm
The decision to push for a merger or an acquisition usually takes place for
firms that are not well managed. If gains are to be expected from, such
strategies, it should be pursued even if hostile.
Effects: It is in the best interest of stockholders.
Success Factors at Active Investing:
1) Have high capital. It is necessary to make significant investments to
confront/influence the management team in charge and force it to make the
desired changes.
2) Have good knowledge of the company. Compared with the screening
model, much more information is required because the strategy involves a
smaller portfolio.
3) Understand corporate finance. Investors need to identify the weaknesses
of the firm.
4) Be persistent. To take over the current management team is no easy task
since incumbent managers will fight back to keep their position.
5) Organize and create change. The major part of the job is to actually set
up conditions and, in particular, form the proper coalitions, in order to bring
up the necessary changes.
III. The Contrarian Value Investor: Buying the Losers
This strategy relies on the belief that markets overreact to bad news and
push prices down below real value. Such strategy implies investors can
sustain short-term losses. All value investors are contrarian investors, but
not all contrarian inventors are value investors.
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The Essential Biotech Investment Guide
Evidence That Markets Overreact to News Announcements
It is interesting to notice that markets reverse themselves over the long-term.
For example, the serial correlation is more negative as time goes by and also
for smaller stocks.
Good Companies Are Not Necessarily Good Investments
Conventional ratings of company quality and stock returns appear to be
negatively correlated.
Success Factors of Contrarian Investing:
1) Self-confidence. This is necessary because investments are made in
companies that have low ratings.
2) Clients who believe in you. Clients, whether they have the same views as
the investors or they are ready to take high risk.
3) Patience. Such strategies can only be successful in the long run.
4) Ability to withstand short-term volatility. Short-term volatility and high
profile failures directly result from the nature of the investment.
5) Watch out for transactions costs. As previously mentioned, investors may
end up holding portfolios of low-priced stocks, held by few institutional
investors, thus increasing transaction costs.
Biotechnology Investment Trading Rules
In this case, I am not referring to day trading, but to surges in stock price
over weeks and months. Keep in mind the transaction costs and taxes
involved with the trading the stocks. Apart from having the necessary
experience and intuition, the bio-technology investor should study the theses
rules:
Introduction to Biotech Investing
•
87
Invest in new bio-product cycles.
Stocks should be bought in anticipation of the new bio-product launch cycle,
after the FDA approval.
•
The trend is your friend.
Buy when no one is interested, and sell when everyone is interested. Pick
stocks for which fundamentals are intact; buy when stocks start trading up
after large declines and sell when they start trading down after large rises.
•
Upside earnings surprises can start a trend.
Better-than-expected results typically boost stock prices.
•
Buy franchise growth.
In the long run, it is advisable to buy stocks from solid companies that have
high-franchise growth potential, even if they seem, upon first glance,
expensive.
•
Importance of focus and market share.
Stocks should not be bought from a company that is losing market share,
since the company is likely mismanaged.
•
Margin expansion or great margins.
Do not buy shares of a company that is experiencing a significant margin
decline. This usually happens when competitors catch up, or a key patent
expires.
•
Know the product, like the product, and then own the stock.
It is important to personally understand the product (circle of competence)
or to get reliable feedback regarding it.
The Essential Biotech Investment Guide
88
Bet on the brains.
It is better to buy stocks from a company is run by its founders (or even
better a serial entrepreneur), since they have a passion for their business
and are usually highly skilled people. A good indicator is when stocks
are purchased by insiders (however, selling by insiders is not necessarily
a negative sign). Watch out for ego. There is no need to have huge
headquarters to be successful. A lot of functions can be outsourced to be
efficient. Rather what is needed is focus.
•
Do not fall in love with a company or a industry.
Do not fall in love with the company you bought when it is time to sell. A
stock does not know you own it. Refrain from getting too involved in
biotech or technology companies. If you are not among those who know
how to pick stocks, asset allocation is very important to you.
•
Take notice of January Effect.
Empirical evidence shows that healthcare biotech stocks in general tend to
rise from 5% to 25% during November to March period.
"Does the management have a determination to continue to develop
products or processes that will still further increase total sales potentials
when the growth potentials of currently attractive product lines have
largely exploded?"
-One of Philip Fisher's 15 Points to Look for in a common stock, from
Common Stocks and Uncommon Profits
Introduction to Biotech Investing
89
Winning Biotechnology Company Attribute List
It is important to establish a checklist of attributes that identify winning
companies since winning companies become being winning stocks. Be sure
to read Fisher's 15 points due-diligence list.
1) Large market opportunities (be in a position where there is growth
potential).
2) A good technology/service that offers a significant
proposition to its customers.
value/service
3) A simple, direct mission and strong culture.
4) Passionate founders.
5) Technology magnets.
6) A great management team/board of directors/committed partner.
7) Ability to lead changes and embrace chaos.
8) A Leading/sustainable market position with first-mover advantage.
9) Monopoly or brand leadership, leading reach and market share.
10) Global presence and leadership.
11) Strong customer focus and rapidly growing customer base.
12) Customer loyalty.
13) Extensible product pipelines with a focus on constant improvement (e.g.
Epogen).
14) Clear distribution plans.
15) A Strong business and milestone momentum.
16) An annuity-like business with barriers-to-entry.
17)
High
gross
margins.
Most
drugs
have
high
margins.
18) An effort or plan to improve operating margins
19) A low-cost infrastructure and development efforts (for example,
outsourcing and strategic partners).
A Decision Tree for Drug Development and Investor Risk
Negative
0.975-0.95
Negative
Negative
ko.025-0.05-
Preclinical
Testing
_ni)2*.
I
_>10-0.20~"
0.30
r
(veiy
Negative
^.0.98"^
Phase I
^0.70 -*
V- 0.25-0.30 <-\
Phase m
I — 0.33-P-J Registration
I— 0.80-0.90 « J
FDA
Approval
PostTesting
Data Sources: FDA wi PhRMA
Figure 4-1. Drug Development Risk.
I
Chapter 5
How to Value and Invest in a
Biotech Company
Valuation is part science and part art.
-Warren Buffett Speaks
C
ompany Valuation. Valuation is not an exact science. It is based on
judgement regarding a company's growth prospects and related
financial projections. It is influenced by many factors, including the
company's historical financial performance, perceptions about the
management team, the company's position in the marketplace, and capital
supply and demand. There are many different financial valuation techniques
that are used to give an estimate of a company's value. Some of these
techniques, summarized in Table 5-1, include comparable ratio analysis
(P/E, P/S, BV), and Discounted Cash Flow analysis (DCF, etc.).
91
Table 5-1. Summary of General Valuation Methods.
Valuations
Parameters
Earningbased
Price/Earning (PE)
PE/Growth Rate
Price/Sales
EBITA
Enterprise
Value/EBITA
Discounted Cash
Flow (DCF)
Dividend Discount
Model (DDM)
Cash/per share
BV/per share
Prices Each Piece
Yield
Customer Accounts
X
Revenuebased
Cash flow- Equitybased
based
Sum-ofparts
Yieldbased
Subscriber
-based
X
X
X
X
X
X
X
X
X
X
X
How to Value and Invest in a Biotech Company
93
Step One: The Economic and Business Cycle
The economic environment sets the stage for stock selection. By examining
key economic indicators, economists attempt to predict where we stand in
the business cycle. Some of those indicators include:
1. Interest Rates:
Are they rising or falling?
2. Money Supply:
Is it restrictive or expansive?
3. Fiscal Policy:
What is the direction of taxes and
government spending?
4. Inflation:
Is it stable, rising, or falling?
5. Political Status:
Where are we in the election cycle?
6. Currency:
Is the currency stable? Is it fairly valued?
Of these factors, those with the greatest bearing on stock prices tend to
be interest rates and inflation. As the economy expands, the Federal Reserve
(Fed) often becomes concerned with the prospect of rising inflation. If there
is ample evidence of inflationary pressures, the Fed will raise interest rates
in an attempt to slow growth. Eventually, the economy will contract,
business will slow, and the Fed will lower interest rates. Generally, bond
and stock prices move inversely to interest rates: they tend to fall when
interest rates rise, and rise when interest rates fall. But stock and bond prices
should move in opposite directions during the expansion and contraction
phases of the business cycle. For these reasons, pinpointing the current
stage of the business cycle is crucial for an effective top-down analysis. The
asset allocation model, a guideline for investors to use when deciding how
to divide their assets among stocks, bonds, and cash, is directly influenced
by the expected direction of the economy. Table 5-2 can be used to identify
favorable areas for investment based on the stage of the economic cycle.
Table 5-2. Classic Business Cycle Model.
Stage 1
Recessionary
Stage 2
Recovery
Anticipated
Stage 3
Mid-cycle
Recovery
Stage 4
FuU-Blown
Expansion
Stage 5
Economic
Peak
Stage 6
Economic Decline
Interest Rate
Rising
Flat
Begin to Rise
Rise
Flat
Fall
GDP Growth Rate
Negative
Flat
Rise
Rise
Peak
Negative
Favored Groups
Utilities and
Financials
(interest-sensitive)
Consumer
Cyclicals
Industrial
Stocks
Chemical,
Technology
and Energy
Basic
Materials and
Energy Stocks
Defensive Stocks
such as Consumer
Non-cyclicals
Others
Stock and
Commodity
Prices Fall
Stocks
Bottom
Commodity
Price to rally
Interest
Sensitive
Stock Prices
Peak
Stocks, Bonds and
Commodities are
all falling
How to Value and Invest in a Biotech Company
95
Step Two: Industry Sector Analysis
Top-down analysis also involves an examination of industry sectors.
Companies in each industry react differently during various stages of the
economic cycle and are affected differently by Federal Reserve actions. For
example, when interest rates change, financial institutions and companies
with high debt levels are affected more than debt-free companies. Some
industries, especially commodity industries such as oil and gas, real estate,
and natural resources, may actually see their stock prices rise during periods
of high inflation when most other stocks are reacting negatively. Other
industries (cyclicals, for example) do well during periods of economic
expansions. Rotating in and out of certain industry sectors as the economic
cycle changes may enhance portfolio performance.
Biotech Industry Sector Analysis
The Biotech Industry Life Cycle
Following the automobile industry market life cycle example (S growth
curve, Figure 5-1) discussed earlier, the biotech market cycle can be
described as follows. The biotech market cycle introduction stage began in
the early 1970's. The growth stage, begun in the 1990s, resulted in the
introduction of many different biotech products with varying success.
Currently, the biotech industry experiences rapid growth and vigorous
competition. The five stages of a typical industry cycle may be summarized
as follows:
•
•
•
•
•
Introduction: market is being defined, sales sporadic
Rapid growth: sales grow rapidly, competitor joining market
Turbulence: sales growing slowly, competitive shakeout
Maturity: Sales holding steadily, major competitor established
Decline: sales decline, some competitor dropout
96
The Essential Biotech Investment Guide
Upper asymptote
Lower asymptote
time
Figure 5-1. S Growth Curve
Biotech Stock Index Holds Its Value
During the 12 months ending in December 2001, the AMEX Biotech index
lost about 8% of its value, while the NASDAQ dropped 2 1 % and the market
index (S&P 500) fell 13%. But biotech stocks on average retained their past
three years' gains and on average, biotech stocks as a group performed better
than many high-tech stocks. The biotech industry has achieved an aggregate
market cap of about $400 billion with 40 companies over IB and 15
companies achieving profitability. This industry is rapidly gaining critical
mass and is here to stay.
Biotech Products-Labors Poised for Fruition
The biotech industry in the U.S. currently includes 339 public companies
and 1040 private companies. About 120 FDA-approved biotech products are
on the market and more than 300 active biotech drug candidates are in Phase
How to Value and Invest in a Biotech Company
97
III or late clinical trials (according to BIO). The historically proven 80%
success rate in Phase III trials and an average development time of six years
from Phase III to FDA approval translates to about 240 new medicines
reaching the market by 2007.
Biotech Industry-Ripe for Investment
Biotech companies' revenues have increased an average of 11% per year
since 1995. Revenue growth should remain strong through the next 10 years.
Unlike pharmaceutical companies that face patent expirations and generic
competition, biotech products are generally not under such pressure.
Successful drug development depends on good science, including a good
understanding of biological systems, which can come only from substantial
investment in basic research. Successful medical breakthroughs depend on
understanding the intricate relationships between variability among
individuals and their susceptibility to disease or response to treatment.
Step Three: Biotech Company Analysis
The final step in the process is a rigorous company analysis. This involves
both quantitative modeling and the assessment of less tangible but equally
important factors such as management and customer loyalty.
Biotech Industry-Mixture of Sciences
The human genome sequence, containing some 30,000 to 40,000 genes, is
the beginning, not the end, of the road. Small differences in genetic structure
provide the key to the future of the human condition and the chance to look
at old markets in new ways. Transforming technologies beyond genomics,
such as proteomics, offer both immediate and long-term growth
opportunities.
We are in the midst of a renaissance in biology, kicked off by the
mapping of the human genome and technical innovation. New research will
attempt to understand the interaction of function-among genes (multigenic
diseases), proteins (signal pathway), or between proteins and genes
The Essential Biotech Investment Guide
98
(regulation of gene expression), and the interaction between molecules in
their natural context (systems biology). Relational information has created a
need for new software products and enterprise systems to better capture,
analyze, visualize, store, and retrieve data. New therapeutic products
remain the greatest value drivers in biotechnology. Although not every drug
will become a personalized medicine, it is estimated that 20% of drugs could
benefit from a specific pharmacogenomics approach.
Valuation: Should I Buy This Biotech Stock Now?
Once one has thoroughly examined a company's financial well-being, the
task remains to evaluate whether the stock is currently attractive for
purchase by utilizing a variety of valuation methods.
Intrinsic Value
Intrinsic value, also known as Net Present Value (NPV), can be defined as
the discounted value of the cash that can be taken out of a business during
its remaining life. It is the only logical approach to evaluating the relative
attractiveness of investments and businesses, intrinsic value, is an estimate
rather than a precise figure. Two different people would probably calculate
two different NPVs depending on their own assumptions. The NPV
typically differs from a firm's book value given that NPV is a calculated
number. Book value, or shareholders' equity per share, is an accounting
number and changes quarterly with a firm's earnings (given that earnings
flow into equity). However, the percentage change in book value in any
given year is likely to be reasonably close to that year's change in intrinsic
value. Book value either overstates or understates the intrinsic value of a
company. Therefore, to reach intrinsic value, one needs to estimate future
earnings, future growth, and a discounting factor.
Discounted Cash Flow (DCF) Analysis
In a DCF analysis, the value of a company is computed as the sum of (a) the
forecasted free cash flow of a company out to a valuation horizon,
discounted back to the present at a discount rate and (b) the forecasted value
How to Value and Invest in a Biotech Company
99
of the company at the horizon or the terminal value, also discounted back to
present value at the same discount rate. The free cash flow of a company is
the cash not required for operations or reinvestment. For this analysis, free
cash flow is generally forecasted on an unleveraged or debt-free basis. The
valuation horizon that is chosen typically reflects the time period (about 5 to
10 years into the future) when the company's growth rate will stabilize. See
the table below for a sample free cash flow calculation:
Year
1
2
3
4
5
Sales
- Costs and Expenses
Earnings Before Interest and Taxes (EBIT)
- Taxes (on the full EBIT)
Net Income
+ Depreciation and Amortization
- Capital Expenditures
- Changes in Working Capital
= Free Cash Flow
Based on the forecast of the stream of free cash flow, the stream is
discounted back to the present value. A discount rate is chosen that reflects
expected return and risk. Companies with high risk-return profiles typically
have high discount rates (i.e., 20%). A range of discount rates may be used
in the analysis to test a range of values and create a probability distribution.
Finally, a judgment is made on the terminal value at the horizon or how
much it could be sold for in that year. The terminal value is discounted back
to the present value using the same discount rate used for discounting the
free cash flow.
Comparable Public Companies Analysis
This technique determines a company's value, based on how other similar
companies are trading in the public market. The most difficult aspect of this
technique is finding companies that are truly comparable. There are many
factors to look at when determining comparability, including the company's
target industry, growth stage, size, and financial performance. Once a
100
The Essential Biotech Investment Guide
comparable company is chosen, investors typically look at several different
valuation ratios, such as price/sales, price/earnings, and EBITDA multiples.
These valuation ratios are then applied to the company's Financials to
determine its value. However, private companies are usually discounted
based on the lack of liquidity for investors. In addition, private companies'
valuation could be further discounted based on their stage of development,
market positioning or proven concept vis-a-vis public companies.
Comparable Private Companies Analysis
This technique determines a company's value, based on how other similar
companies are valued in the private market. Two difficult aspects of this
technique are finding companies that are truly comparable and obtaining
information about private companies. Once a comparable private company
is chosen, investors typically look at the sales multiple and EBITDA
multiple paid. These valuation ratios are then applied to the company's
financials to determine its value. The company may be given a premium or
discount, based on how it compares to these private companies and whether
a majority stake (>50%) is being purchased. Investors usually pay a
premium for a majority stake as this allows them to take over the control of
the company.
Method 1: Relative Valuation
In relative valuation, the value of an asset is compared to the value assessed
by the market for similar or comparable assets. To do relative valuation
then, we need to identify comparable assets and obtain market values for
these assets. Prices can be standardized using a common variable such as
earnings, cash flows, book value, or revenues (see table below).
Advantages for using relative valuation method: It saves a lot of
explanations, many of which are qualitative and difficult to measure.
Disadvantages for using relative valuation method: Embedded in every
multiple are all of the variables that drive every discounted cash flow
valuation-growth, risk and cash flow patterns. It is impossible to properly
How to Value and Invest in a Biotech Company
101
compare firms on a multiple, if we do not know the nature of the
relationship between fundamentals and the multiple. Unlike the traditional
analysis, which states that comparable firms are firms in the same sector,
valuation theory suggests that comparable firms are firms that are similar in
terms of fundamentals. It is impossible to find an exactly identical firm to
the one you is valuing, anyway.
Earnings Multiples
Price/Earnings Ratio (PE), variants (PEG and
Relative PE)
Value/EBIT
Book Value Multiples
Value/EBITDA, Value/Cash Flow
Price/Book Value, Value/ Book Value of Assets,
Value/Replacement Cost ("Tobin's Q")
Price/Sales per Share (PS) Value/Sales
Price/kwh, Price per ton of steel
Revenues
Industry Specific Variable
1. Earnings Per Share and P/E Ratios
The most common way to value a company is to compare its price to its
earnings power. Also called net income or net profit; earnings are whatever
money is left over after a company pays all of its bills. To allow meaningful
comparisons across companies, most people look at Earnings Per Share
(EPS), calculated simply by dividing the dollar amount of the earnings
reported from a company by the number of shares outstanding.
The price/earnings (P/E) ratio is a simple comparison of a company's
current share price and its EPS (the "E" in P/E). Analysts compare a
company's P/E ratio with other similar companies, the overall stock market
or relative to the company's historical P/E range. Companies with high
P/E's typically have a high growth rate or are highly regarded. (See PE/G
below for additional information). The P/E ratio is not useful for biotech
investing given that most biotech firms have net losses rendering the P/E
meaningless.
Why Is the P/E Ratio Used So Widely?
It is simple to compute and is widely available, making comparisons across
stocks simple. Potential for misuse: Use of P/E ratios is a way, for some
102
The Essential Biotech Investment Guide
analysts, to avoid having to be explicit about their assumptions on risk,
growth and payout ratios. P/E ratios are much more likely to reflect market
moods and perceptions but this can be viewed as a weakness, especially
when markets make systematic errors in valuing entire sectors.
PE/G-Investment Strategies That Compare P/E to
the Expected Growth Rate (G)
Portfolio managers and analysts sometimes compare P/E ratios to the
expected growth rate to identify under and overvalued stocks. In the
simplest form of this approach, firms with P/E ratios less than their expected
growth rate are viewed as undervalued. In its more general form, the ratio of
P/E ratio to growth is used as a measure of relative value. Tables 5-3, 5-4
and 5-5 show the profitable major pharmaceutical companies in North
America and Non-north America and biopharmaceutical companies in the
US.
Problems with comparing PIE ratios to expected growth (G)
There is no basis for believing that a firm is undervalued just because it has
a PE ratio less than expected growth. This relationship may be consistent
with a fairly or overvalued firm, if interest rates are high, if a firm is high
risk or if investors fear a cut in its growth rate.
Problems with the relative comparison (PE/G)
In its relative form, where firms are ranked on the basis of the ratio of P/E
ratio to expected growth, the rankings will provide a measure of relative
value if, the length of the high growth period, and risk is equivalent for all
firms. Using similar reasoning, if the risk-return model used were the
CAPM, then all firms would have the same betas.
Comparisons of P/E Ratios
Comparisons across countries. Comparisons are often made between
price/earning ratios in different countries with the intention of finding
How to Value and Invest in a Biotech Company
103
undervalued and overvalued markets. It is clearly misleading in these cases
to compare P/E ratios across different markets without controlling for
differences in the underlying variables.
Comparisons across time. Another comparison often made is between P/E
ratios across time. As the fundamentals (interest rates and expected growth)
change over time, the P/E ratio will also change. A more appropriate
comparison is therefore not between P/E ratios across time, but between the
actual P/E ratio and the predicted P/E ratio based upon fundamentals
existing at that time.
Comparing P/E ratios across firms. P/E ratios vary across industries and
across firms because of differences in fundamentals-higher growth
generally translates into higher P/E ratios. When comparisons are made
across firms, differences in risk, growth rates and payout ratios have to be
controlled explicitly.
Using Comparable Firms-Pros and Cons
The most common approach to estimating the P/E ratio for a firm is to
choose a group of comparable firms, calculate the average PE ratio for this
group, and adjust this average for differences between the firm being valued
and the comparable firms.
There are several problems with this approach. The definition of a
"comparable" firm is essentially a subjective one. The use of other firms in
the industry as the control group is often not a solution because firms within
the same industry can have very different business mixes, risk, and growth
profiles. There is also plenty of potential for bias. Even when a legitimate
group of comparable firms can be constructed, differences will continue to
persist in fundamentals between the firm being valued and this group.
104
The Essential Biotech Investment Guide
A Regression Approach Using the Entire Cross-section
In contrast to the "comparable firm" approach, the entire cross section of
firms can be used to predict P/E ratios. The simplest way of summarizing
this information is with multiple regression, with the P/E ratio being the
dependent variable, and proxies for risk, growth, and payout forming the
independent variables.
2. PEG and PEGY Ratios
The PEG ratio is the ratio of market price to expected growth in earnings per
share:
PEG = PE/Expected Growth Rate in Earnings
A simple rule of thumb is that a stock's P/E ratio should be about equal
to its projected long-term earnings growth rate. Thus, a stock trading at a
P/E of 15 with expected earnings growth of 15% annually would appear
fairly valued. A P/E lower than the projected EPS growth rate suggests an
undervalued stock. PEG is simply the P/E ratio divided by the projected
earnings growth rate. So a PEG ratio of 1 would indicate a reasonably
valued stock, while anything below 1 could indicate an undervalued stock
that is attractive for purchase.
PEGY, short for P/E to growth plus yield, adds dividends to the
equation. PEGY is a good proxy for the risk/reward trade-off inherent in a
stock because the numerator of the ratio, P/E, measures the "cost" to
investors of purchasing a stock. The denominator, meanwhile, encompasses
the "benefit" that the investor expects to receive in the form of earnings
growth and dividend yield. The lower the PEGY ratio, the more benefit an
investor should expect to receive relative to the cost of the investment.
As in the case of P/E ratios, analysts compare stocks' PEG and PEGY
ratios to their historical levels, to those of other companies in the same
industry, and to those of the market as a whole.
Table 5-3. PEG Ratios of Big Pharmaceutical Companies in North America.
Company Name
Ticker
EPS
(Last)
EPS
(Current)
EPS
(Next)
GE Region
Long Term
Growth Rate
Market Cap
(USD Mil)
P/E
(Current)
P/E ""pVEto""1
(Next) Growth
Pharmacia Corp.
PHA.N
1.45
1.74
2.01
North America
19.26%
53,166.97
23.49
20.32
1.22
Bristol-Myers Squibb
BMY.N
2.15
2.41
2.56
North America
10.25%
102,741.51
22.03
20.72
2.15
2.43
Pfizer Inc
PFE.N
1.02
1.31
1.57
North America
13.27%
261,677.99
32.20
26.80
Schering-Plough
SGP.N
1.64
1.62
1.90
North America
13.31%
53,858.05
22.71
19.37
1.71
Baxter International
BAX.N
1.53
1.75
2.01
North America
11.00%
28,837.24
28.07
24.33
2.55
1.90
2.22
North America
13.00%
184,008.28
31.04
26.55
2.39
2.14
Johnson & Johnson
JNJ.N
1.63
Medtronic
MDT.N
1.05
1.22
1.42
North America
15.50%
49,563.50
33.10
28.47
Becton Dickinson
BDX.N
1.49
1.63
1.80
North America
13.00%
9,868.60
22.82
20.69
1.76
Eli Lilly
LLY.N
2.65
2.76
-
North America
11.96%
87,549.14
28.25
-
2.36
Merck & Co.
MRK.N
2.90
3.13
3.42
North America
9.04%
148,882.15
20.79
19.02
2.30
Forest Labs
FRX.N
1.18
1.72
2.08
North America
25.05%
13,136.54
43.16
35.68
1.72
Abbott Laboratories
ABT.N
1.78
1.88
2.26
North America
13.10%
84,532.27
28.95
24.13
2.21
Boston Scientific
BSX.N
1.03
0.78
1.03
North America
15.00%
9,563.58
30.43
23.18
2.03
19.27%
5,083.88
21.49
17.76
1.12
Watson Pharmaceuticals
WPI.N
1.13
2.23
2.70
North America
|
Table 5-4. PEG Ratios of Profitable Biopharmaceutical Company in the U.S.
Company Name
Ticker
EPS
(Last)
EPS
(Current)
EPS
(Next)
GE Region
Long Term
Growth Rate
Market Cap
(USD Mil)
P/E
P/E
(Current) (Next)
P/Eto
Growth
Amgen
AMGN.O
1.04
1.19
1.58
North America
28.76%
60,424.01
48.57
36.47
1.69
Chiron
CHIR.0
0.86
0.91
0.96
North America
13.62%
10,170.22
59.05
55.59
4.33
Biogen
BGEN.O
1.75
1.91
2.11
North America
14.45%
8,556.77
29.30
26.52
2.03
Medlmmune
MEDIO
0.51
0.68
1.05
North America
27.41%
8,642.46
59.81
38.67
2.18
Genzyme General
GENZ.O
1.13
1.22
1.61
North America
24.92%
10,549.72
44.49
33.79
1.78
Genentech
DNA.N
0.60
0.77
0.90
North America
28.78%
27,699.02
68.41
58.62
2.38
Immunex
IMNX.O
0.28
0.26
0.44
North America
26.93%
12,679.05
88.47
52.67
3.28
Enzon
ENZN.O
0.27
1.00
1.66
North America
63.69%
2,520.59
59.94
36.23
0.94
ELN.N
1.54
1.93
2.34
North America
13.71%
15,491.59
23.86
19.68
1.74
KG.N
0.74
1.00
1.33
North America
18.32%
8,476.29
37.03
27.77
2.02
Allergan Inc.
AGN.N
1.60
1.96
2.35
North America
19.42%
9,432.72
36.53
30.40
1.88
Fisher Scientific
FSH.N
0.98
1.00
1.27
North America
15.00%
1,576.40
28.27
22.24
1.88
Elan Corp.
King Pharmaceuticals
Table 5-5. PEG Ratios of Non-north American Pharmaceutical Companies.
Company Name
EPS
(Current)
Ticker
EPS
(Last)
Roche
ROCZg.VX
5.81
Novo Nordisk
NVOb.CO
8.87
AZN.L
1.64
1.76
AstraZeneca
Aventis
Glaxo Smithkline
EPS
(Next)
GE Region
5.18
5.71
10.80
11.51
1.51
P/E
P/E
(Current) (Next)
Long Term
Growth Rate
Market Cap
(USD Mil)
P/E to
Growth
Europe
9.24%
58,972.70
21.52
19.53
Europe
13.29%
14,337.30
31.49
29.53
2.37
Europe
17.10%
1,207.77
0.39
0.45
0.02
2.33
AVEP.PA
1.50
2.11
2.73
Europe
15.41%
58,758.65
39.53
30.60
2.56
GSK.L
60.96
70.38
85.71
Europe
9.95%
167,359.12
26.82
22.02
2.69
2.23
CCH.L
8.07
14.50
17.50
Europe
29.61%
3,680.73
66.09
54.75
Novartis
NOVZn.VX
2.49
2.67
2.87
Europe
11.49%
98,320.54
22.98
21.39
2.00
Merck KGaA
MRCG.DE
1.69
2.39
2.36
Europe
19.69%
6,082.32
16.41
16.61
0.83
MediGene
MDGGn.DE
-1.10
-3.47
-4.02
Europe
101.92%
192.51
-6.34
-5.47
-0.06
Qiagen NV
QGENF.DE
0.18
0.24
0.42
Europe
37.85%
2,284.39
65.41
37.87
1.73
Banyu Pharmaceutical (p)
4515.T
72.44
87.12
95.84
Japan
10.50%
4,968.72
26.28
23.90
2.50
Chugai Pharmaceutical
4519.T
61.51
73.41
74.21
Japan
5.40%
3,709.46
24.40
24.14
4.52
Celltech Group
Daiichi Pharmaceutical
4505.T
99.36
118.69
119.39
Japan
8.60%
6,509.76
23.30
23.16
2.71
Fujisawa Pharmaceutical
45U.T
63.60
72.60
82.79
Japan
12.28%
7,582.56
39.26
34.42
3.20
(continues)
108
The Essential Biotech Investment Guide
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How to Value and Invest in a Biotech Company
109
Example-Estimating the PEG Ratio for Biogen
If BGEN has a current P/E of 29 and the LT growth rate is 14%, then the
PEG ratio of Biogen is just over 2.
Relative PIE Ratios. The relative P/E ratio of a firm is the ratio of the P/E of
the firm to the P/E of the market:
Relative P/E = P/E of Firm/PE of Market
Although the P/E can be defined in terms of current earnings, trailing
earnings or forward earnings, consistency requires that it be estimated using
the same measure of earnings for both the firm and the market. Relative P/E
ratios are usually compared over time. Thus, a firm or sector that has
historically traded at half the market P/E (Relative P/E = 0.5) is considered
overvalued if it is trading at a relative P/E of 0.7. The relative P/E ratio for
this firm can be estimated in two steps. First, we compute the P/E ratio for
the firm and the P/E ratio for the market separately: Relative P/E Ratio =
8.33/10.45 = 0.80
The relative P/E ratio of a firm is determined by two variables. In
particular, it increases as the firm's growth rate increases relative to that of
the market. The rate of change in the relative P/E will itself be a function of
the market growth rate, with much greater changes when the market growth
rate is higher. In other words, a firm or sector with a growth rate twice that
of the market will have a much higher relative P/E when the market growth
rate is 10% than when it is 5%. Relative P/E ratios seem to be unaffected by
the level of rates, which might give them a decided advantage over P/E
ratios.
3. Price/Sales Ratios (P/S)
The money a company receives for its goods or services is called its
revenues. Whether or not a company has had benefits in the past year, there
are always revenues; revenue-based valuations can therefore be useful to
110
The Essential Biotech Investment Guide
assess companies that are temporarily losing money. The price/sales or P/S
ratio is a measurement companies often consider when making an
acquisition. As with the PEG and PEGY, the lower the Price/Sales ratio, the
cheaper the company is. Table 5-6 and Table 5-7 demonstrate how an
investment banker could calculate price of an IPO of a private genomic
company and a secondary offering of a public genomic company.
Advantages of Using Price/Sales Multiples
Unlike price/earnings and price-book value ratios, which can become
negative and are heavily influenced by accounting decisions on
depreciation, inventory and extraordinary charges, price-sales multiple are
available even for the most troubled firms. They are not as volatile as
price/earnings multiples and are relatively difficult to manipulate. Hence,
they are more meaningful and reliable for use in valuation and provide a
convenient handle for examining the effects of changes in pricing policy and
other corporate strategic decisions.
Price/Sales Ratios and Profit Margins
The key determinant of price-sales ratios is the profit margin. A decline in
profit margins reduces the price-sales ratio directly, and it can lead to lower
growth and hence lower price-sales ratios.
Using Price/Sales Ratios in Investment Strategies
Studies have compared the performance of low price-sales ratio portfolios
with low price-earnings ratio portfolios, and concluded that the low pricesales ratio portfolio outperformed the market but not the low price-earnings
ratio portfolio. Low price-earnings ratio strategy earned more consistent
returns than a low price-sales ratio strategy and the low price-sales ratio
strategy was more biased towards picking smaller firms. When scholars
created undervalued and overvalued portfolios (using price/sales ratios and
profit margins) from 1981 to 1990, the undervalued portfolio outperformed
the S&P 500 by about 6%.
Table 5-6. Comparative Analysis-IPO.
BIOTECH INDUSTRY-Multiple Valuation
Comparative Company Analysis
(J in millions)
Comparable
Company Name
Ticker
Affymetrix
Genomic Solution
Nanogen
Visible Genetics
lncyte Genomics
Human Genome Sciences
Sequenom Corp.
AFFX
GNSL
NGEN
VGIN
1NCY
HGSI
SQNM
Price
(2/9/01)
$
$
$
$
$
$
$
63.88
8.19
9.47
32.50
21.60
51.81
17.81
52 Week
high-low
163.5-42.3
30.1-4.5
101.9-6.1
119.1-19.3
144.5-19.0
116.3-25.0
191.2-11.2
Shares
Total
Debt
55.60 375.00
0.00
25.00
20.90
2.30
0.00
14.80
64.20 203.16
120.70 532.95
1.10
24.40
Total
Enterprise
Value
Equity
Mart«t
Value
3926.45
204.70
200.20
481.00
1583.46
6786.78
435.74
3551.45
204.70
197.90
481.00
1380.30
6253.83
434.64
Total EV Multiples
EMV Multiples
LTM
LTMEV/Net
2000E
LTM
Revenue
Revenue
SPS
BVEQTY
200.80
17.00
200.80
15.00
194.20
22.30
6.40
19.55
12.04
1.00
32.07
8.15
304.34
68.08
3.61
0.68
9.61
1.01
3.02
0.18
0.26
2.97
2.12
5.09
5.86
9.67
4.32
6.20
New Chip IPO condidate
NCHIP
22.00
2.00
10.50
0.48
5.16
Stats for Comparable Firms
(excludes New Chip)
Mean
Median
High
Low
Firm Evaluated:
63.61
19.55
304.34
1.00
22.00
2.00
0)
3
Q.
5"
5
s.
3'
o>
Do
o'
o
301
3
10.50
NCHIP Implied
Implie Equity Valuation
ian
Median
m
Mean Price Per Share
Median Price Per Share
1) Hrm Value = Equity Value + Total Debt - Cash
2) LTM = 12 months/latest 4Qs figures
5.18
5.09
9.67
4.32
Sf
1
New Chip NCHIP
LTM
2.63
1.01
9.61
0.18
£
5
667.85
205.32
30.36
9.33
Table 5-7. Comparative Analysis—Genomic Company.
BIOTECH INDUSTRY-Multiple Valuation
Comparative Company Analysis
(S in millions)
Comparable
Company Name
T icker
CRGN
Curagen
EXEL
Exellxls
GLGC
Gene Logic
GENE
Genome T herapeutlcs
INCY
Incyte Genomics. .
Human Genome Science HGSI
Lexicon Genetics
LEXG
Millenium Pharmaceutic M L N M
MYGN
Myriad geneltcs
Celera Genomics
CRA
Price . 52 Week
(2/9/Ql) Hi-Low
Shares Total
Debt
12820-18.30
50.50-8.10
152.50-13.90
75.30-5.80
14450-19.00
116.30-25.00
49.20-8.00
89.80-23.70
138.O0-J9.O0
43.80
46/0
25.90
22.30
64.20
120.70
48.10
21250
,22.70
41/50 276.00-27.75
68.60
3448
13.69
22.38
8.97
21.50
51.81
13.30
40.94
65.87
,I.o.tal.
Enterprise
Value
Cash
0.00
11.45'
2.64
2.30
1.92
8.93
203.17
2.71
203.17 58220
532.95 837.30
221
4.30
15349 1450.00
,14020
0-QP.
1840
175.00
Eaulty
Market
VfllMS
TotdEVMdtldes
LTM , A I M EV/Net ! 200.0E
Revenue Revenue
SPS
1498.774
634.7812
572.632
400.488:
1001267
5949.4801
637.64,
740324.
1355.049
1510.22
635.12
579 64
200.03
1380.30
6253.83
639.73
8699.75
1495.25
20.80
2140
22.50
26.00
194.20
22.30
13.70
196.30
41.60..
2697.16
2853.76
113:00'
Stats tor Comparable firms
(atduafes CRA)
Mean
Median .
High.. '
Lew .,
Firm Evaluated;
Cetera Genomics Ratio C R A
4160 276.00-27,75
6860
18.40
Celero Genomics, (CR A)
175
72.06 !
0.47
2966 *
046
2545''
0.87
1540 '
1.17
5.16
3.02
266.79!
0.18
46.54=
0.28
37.71 i
0.92
3257; ^ ... J-83
23.87 s "
57.33
35.14
266.79
5.16
64.70
LTM
CR A imgllvd E gultY Valuation,
Mean.
Median
Mean Prlee.Per Share
M ecJan p rice P er 5 hare
Current Priceas of 2/M)l
l)FlrmVdue=EaJtyVdue+Totd Debt-Cash
2) LTM = 12months/latest4Qi fioJes
3709.10
2273.79
54D7
33.15
1.65
0.90.067.
3.020.18:
EMVMlitldes
2001E
LTM
5P5
?VE«TY
067
081
149
148
3.63
064
058
115
J. 00
461
534
224
272
967
432
300
593
1498
' "T26" ;
198
122
1.15
3.63
0.58
557
498
14.98
224
•
:
'
How to Value and Invest in a Biotech Company
113
4. Shareholder's Equity (Book Value)
Book value (BV) is literally the value of a company that can be found on the
accounting ledger and is determined by deducting the book value of
liabilities from the book value of assets. The book value per share is
calculated by dividing the company's shareholder's equity (book value) by
the current number of shares outstanding. Book value is an overall measure
of how much liquidation value a company has if all of its assets were to be
sold off. book value is an especially important measure for valuing financial
companies such as banks, consumer loan concerns, brokerages, and credit
card companies. A strict value investor would consider a price-to-book
value ratio of less than 1.0 as an indication of an undervalued stock.
However, in recent years, price /book ratios have risen far above 1.0 for
most companies. Thus, comparing ratios with peer companies or the market
in general would be a better gauge.
Another use of shareholder's equity is to determine return on equity
(ROE). ROE is calculated by dividing net income by equity, and
multiplying that result by 100 to attain a percentage (the higher the better).
Some investors use ROE as a screen to find companies that can generate
large profits with little in the way of capital investment.
Price/Book Value (P/B)
The market value (stock price times shares outstanding) of an asset reflects
its earning power and expected cash flow. Since the book value of an asset
reflects its original cost, it might deviate significantly from the market value
if the earning power of the asset has significantly increased or decreased
since its acquisition.
Advantages of Using Price/Book Value Ratios
The price/book ratio provides a relatively stable, intuitive measure of a
value that can be compared to the market price. Provided accounting
standards across firms are consistent, price/book value ratios can be
114
The Essential Biotech Investment Guide
compared across similar firms for signs of under or overvaluation. Even
firms with negative earnings, which cannot be valued, using P/E ratios, can
be evaluated using price/book value ratios.
Disadvantages of Using Price/Book Value Ratios
Book values, like earnings, are largely determined by accounting decisions
on depreciation and other variables. When accounting standards vary widely
across firms, the price/book value ratios may not be comparable across
firms. Book value may not carry much meaning for service firms that do
not have significant fixed assets. Book value can become negative if a firm
has a sustained string of negative earnings reports or" write-offs of assets,
leading to a negative price-book value ratio.
Price/Book Value Ratios and Excess Returns
Several studies have established a relationship between price/book value
ratios and excess returns. Firms with high return on equity and low pricebook value ratio could be considered undervalued. All NYSE stocks from
1981 to 1990 were divided into two portfolios-an "undervalued" portfolio
with low price/book value ratios (in the bottom 25% of the universe) and
high returns on equity (in the top 25% of universe) and an "overvalued"
portfolio with high price-book value ratios (in top 25% of universe) and low
returns on equity (in bottom 25% of universe)-each year, and excess returns
were estimated for each portfolio for the following year. The undervalued
portfolio had an average return of 25.6% over the 10-year period compared
to the S&P 500 return of 17.5%. The overvalued portfolio had an average
return of 10.6% annually.
5. Cash and Working Capital Per Share
1) Cash: A company's cash and equivalents and short-term investments
divided by its shares outstanding is a quick measure that indicates how
much of the current share price consists of just the cash that the company
has on hand. Buying a company with a lot of cash, even if it seems to have
How to Value and Invest in a Biotech Company
115
limited future prospects, can yield many benefits: Cash can fund product
development and strategic acquisitions and pay for high-caliber executives.
2) Working Capital: It is determined by subtracting current liabilities from
current assets. Investors compare that amount, which is what the company
disposes of to run its everyday business, with the company's market
capitalization.
Biotech companies, due to bad news and industry or sub-sector
depression can, from time to time, trade near their cash value. If the
company's fundamentals and technology are solid, it still could be an
attractive opportunity for a risk-tolerant investor.
6. EBITDA and Non-Cash Charges
Other than earnings, cash flow is an important indicator of a company's
earnings power. It is normally measured using Earnings Before Interest,
Taxes, Depreciation, and Amortization (EBITDA). Investment bankers also
use cash flow to value companies in much the same way that the P/S and
P/E ratios are used. The advantage of EBITDA, especially when comparing
companies, is that it shows the earnings power of companies regardless of
taxes, debt and charges. Hence, EBITDA allows one to focus on the
company's operating business. Cash flow is most commonly used to value
industries that involve tremendous up-front capital expenditures or
companies like cable television firms that have large amortization burdens.
7. Enterprise Value/EBITDA
EBITDA's version of the P/E ratio is called the EBITDA* Multiple or
EV/EBITDA. EV/EBITDA compares a company's total value or Enterprise
Value to its EBITDA. Enterprise Value encompasses the value of the
company's debt minus cash plus its stock equity market value. Firms with
high P/E, P/S, and P/B ratios tend to have high EBITDA multiples.
116
The Essential Biotech Investment Guide
Method 2: Discounted Cash Flow (DCF) Analysis
A common valuation application of EBITDA is a discounted cash flow
analysis. In effect, DCF analysis projects how much cash flow a company is
likely to generate over an extended period (usually 10 years is common) and
then calculates the value of that cash flow using net present value (NPV) or
Internal Rate of Return (IRR). The NPV method applies an interest rate
based on the company's expected marginal cost of capital (that is what it
costs the company to borrow money) to future cash flows, bringing them
back to present. The IRR method finds the average return on investment
earned through the life of an investment; and it determines the discount rate
that equates the present value of future cash flows to the cost of the
investment.
Table 5-8 shows you how to estimate a net present value (intrinsic value) of
a biotech company. An estimate of intrinsic values of five profitable biotech
companies by DCF is listed in Table 5-9.
Method 3: Sum-of-the-Parts Valuations
A company can sometimes be worth more divided up rather than all in one
piece. This can happen because there is a hidden asset that most people are
not aware of or simply because a diversified company does not produce any
synergies. To value companies that have diverse lines of business, analysts
often measure the worth of each business separately, using the most
appropriate valuation parameters for each industry, and then add the
individual values together. A biotech company can have many drug
candidates in different development stages and clinical trials. The value of
these projects can be estimated by adding them together as shown in Table
5-10 below (assuming the company has 50 million shares outstanding and
40% net margin).
Table 5-8. Estimating Net Present Value (Intrinsic Value) of a Biotech Company.
Year
0
1
2
3
4
5
6
7
8
9
10
11
$
$
$
$
$
$
$
$
$
$
$
$
Cash Flow
Discount Rate Cumulated Discount Factor
10,000,000.00
12,000,000.00
15%
1.15000
14,400,000.00
15%
1.32250
17,280,000.00
1.52088
15%
20,736,000.00
1.74901
15%
24,883,200.00
15%
2.01136
29,859,840.00
2.31306
15%
35,831,808.00
2.66002
15%
42,998,169.60
3.05902
15%
51,597,803.52
15%
3.51788
61,917,364.22
4.04556
15%
74,300,837.07
15%
4.65239
Total Net Present Value
Intrinsic Value Per Share
Assumption:
20%
15%
6%
20000000
Growth rate: Y1-Y10 is
Discount rate
Stable rate is
Total Share Outstanding is
1
$
$
$
$
$
$
$
$
$
$
$
$
$
$
PV
10,000,000.00
10,434,782.61
10,888,468.81
11,361,880.50
11,855,875.30
12,371,348.14
12,909,232.84
13,470,503.83
14,056,177.91
14,667,316.08
15,305,025.48
156,747,120.85 Y10 Terminal Value
284,067,732.36 $ 729,248,956.42
14.20
Table 5-9. Estimate of Intrinsic Value of Five Major Profitable Biotech Company.
Initial Earning ($)
(Trailing 12 months)
5-Year Growth
Assumption by Analyst
Consensus/Discount
Rate
Stable Growth Rate
After 10 Years/Discount
Rate
Intrinsic
Value ($)
Current
Price ($)
(2/18/02)
AMGN
1.17 billion
19.81%/15%
6%/12%
43.59
54.33
MEDI
141 million
27.13%/15%
6%/12%
43.44
42.98.
DNA
155.8 million
25.01 %/15%
6%/12%
16.84
47.69
IMNX
178 million
38.56%/15%
6%/12%
47.57
26.94
BGEN
286 million
16.95%/15%
6%/12%
61.27
53.41
* Considerations: Estimating the future growth rate and risk outlook of a biotech company is more art than science. New products, management, or
strategic directions can fuel growth far above historic norms. Likewise, unforeseen setbacks can cut a company's future value in half. How great are
the risks it faces? Be sure to check a company's financials and recent news stories on the company. Also, compare it to other companies in its
industry.
How to Value and Invest in a Biotech Company
119
Table 5-10. Sum of Parts Valuation of Drug Candidate Pipelines.
Product
Indication
Development Stage
Peak Sales ($MM)/
Peak EPS
Probability of
Success
Risk-adjusted
EPS($)
PE Multiple
Peak Price ($)
Years to Peak Sales
Discount Rate
Estimated NPV Per
Share
Total Value
($ Per Share) of
Drug Pipelines
1
2
3
4
Cancer
Neuro-disorder
Allergy
Auto-immune Disorder
Preclinical
200/4
Phase I
Phase H
Phase m
300/6
500/10
600/12
1%
5%
10%
80%
0.04
0.3
1
9.6
30
1.2
6
15%
0.52
30
9
5
15%
4.47
30
30
3
15%
19.73
30
288
2
15%
217.77
$242.49
Method 4: Dividend Discount Model (DDM)
The DDM model is similar to the other NPV models already presented,
except that it discounts dividends (instead of cash flows) to arrive at
intrinsic value. Likewise, the investor can then compare calculated NPV
with the actual market price of a firm's stock. The DDM is a poor model for
biotech, technology, and other rapidly growing firms given that they do not
usually provide dividends. Therefore, it can be used to value pharmaceutical
companies only provided they are profitable and pay dividends.
Method 5: Subscriber-Based Valuations
Sometimes a company can be valued based on its subscribers or its customer
accounts. Such valuations are most common in media and communications
companies that generate regular monthly income. Often, in a subscriberbased valuation, analysts estimate the average revenues per subscriber over
120
The Essential Biotech Investment Guide
their lifetime and then figure the value for the entire company based on this
approach.
Method 6: Economic Value Added (EVA)
EVA is another sophisticated modification of cash flow. It evaluates the
cost of capital and the incremental return above that cost in order to separate
businesses that truly generate cash from ones that just burn it up. This
method is used to quantify the quality of a company's business.
Method 7: Yield-Based Valuations-Valuing Market
as an Example
A dividend yield is the percentage of a company's stock price paid out as
dividend over the course of a year. Statistical evidence indicates that a
portfolio made up of large-capitalization, above-average-yielding stocks
outperforms the market over time. A good website about market valuation
using this method is www.yadeni.com
Qualitative Component of the Valuation
The qualitative component is made of key elements that value
biopharmaceutical companies. Theses include: is the management team
competent, honesty and has integrity? Does the business model make
sense? Can management deliver its promises? Do they hide bad news? Does
it have a deep pipeline? Does the information flow from clinical, scientific,
or financial press releases?
Risks of Biotech Companies
Investing public biotech stocks has two major risks:
Market risk: Systemic risk from the overall stock market and economy
How to Value and Invest in a Biotech Company
121
Company specific risk: (1) technical risk (see chart) and (2) commercial risk
(marketing and partnering).
Other risks include, but are not limited to, currency risks, credit risk, country
risk, and inflation risk.
Summary-Types of Risk.
Industry and Company Risk
Inflation Risk
Market Risk
Liquidity Risk
Credit Risk
Currency Risk
Interest Rate Risk
Political and Economic Risk
Reinvestment Risk (Call)
Market Timing Risk
Table 5-11. Business Model and Valuation Differences between Pharma
and Biotech.
Biotech/Life Sciences
Pharma
Specialty Pharma
Yes
Yes
Yes/No
Development
Mostly Yes
Yes
Yes
Marketing
Mostly No
Yes
Yes/No
Business Model
Diverse
Similar
Similar
Valuation
Diverse
Similar
Yes/No
Research/Discovery
Summary: Which Model Is Best for Valuing
Biotech Companies?
Valuation is part art and part science. There are always judgments involved
regarding the perspective of the company and the industry and the
management. Table 5-11 shows the typical business model and valuation
differences between pharma and biotech companies. The common pros and
The Essential Biotech Investment Guide
122
cons of valuation techniques are listed in Table 5-12. The author believes
that different kinds of biotech companies require different valuation
techniques. But if there is a conflict among different valuation results, the
best and most logical methods are the NPV or discount cash flow (DCF)
methods. For mature profitable biotech companies such as AMGN and
BGEN, one can use DCF to estimate if the company valuation is cheap or
not for investment. For companies with products in advanced stage, one can
use the probability-adjusted discounted model. For early-stage
biotechnology companies, one can use revenue, or book value-based
comparable valuation methods to estimate the market price at that point.
Hybrid methods can be also used for companies with products in late stage
as well as early-stage platform technologies and pipelines.
Table 5-12 Pros and Cons of Valuation Techniques.
Methodology
Pros
Cons
Comparable
• A rough way to estimate
the market price
• Most logical way
• Hard to find true
comparable
• Cannot use if earnings are
negative
• Risk may change over
time
• Assume the risk is same
• May underestimate mature
technology
Discounted
Cash Flow
Sum of Parts
• Can be used to value
different business units
within firm
• Can be used to value
early technology
portfolios
How to Value and Invest in a Biotech Company
123
Part II: Investing in Undervalued Healthcare Biotech—
Proactive Value Investing in Healthcare™
In their book Value Investing, Dr. Bruce Greenwald (Columbia Business
School) and Judd Kahn described a method for buying a good company
below its replacement value. The specific premises of value investing are:
1. Mr. Market is a strange guy; prices diverge regularly from fundamental
values.
2. You can buy undervalued stocks; fundamental values are often
measurable.
3. Fundamental value determines future price-buying under-priced stocks
plus patience implies superior returns.
How does value investing work in practice? One should look at long-term
fundamentals of underlying businesses:
1. Look intelligently for value opportunities (low P/E, low market/book
value).
2. Know what you know: circle of competence. Not all value is
measurable and measurable by you.
3. You do not have to swing. Learn how to manage risk through margin of
safety. Value implies concentration, not over-diversification. At worst,
you buy the market index.
A four-step approach to value investing is: search, value, review, and
manage risk. Search criteria for value investing are listed below (from Dr.
Greenwald's lecture notes):
124
The Essential Biotech Investment Guide
Obscure
• Small capitalization
• Spin-offs
• Boring
• Low analysts' coverage
Undesirable
• Financial distress, bankruptcy
(be careful)
• Low growth, low P/E, low P/B
• Industry problems (bad loans,
regulatory threat, overcapacity)
• Company problem (lawsuit, poor
subsidiary performance, poor year)
• Disappointing (long-term
underperformance)
Supply, Demand Imbalance
• RTC
• Privatization
Other bias and psychological bias
• Window dressing (January effect)
• Blockbusters
• Loss aversion
• Hindsight bias
• Lotteries
One buys a stock when (1) its market value is less than both its replacement
asset value and earning power value; (2) its market value is larger than its
asset value, but less than its earning power value. In this case, it requires a
sustainable competitive advantage (barrier of entry). Value growth is
difficult and investors tend to overpay for growth. The best growth is
hidden (the stock has a zero-cost growth) such as unused pricing power,
temporary problems and an under-performing division. Of course, here we
are talking about franchise growth with barrier of entry.
How to Value and Invest in a Biotech Company
125
Biotech companies, owing to bad news and industry or subsector
depression, can, from time to time, trade near their book value or low
market value/book value. A company with solid long term fundamentals
and technology could be an attractive opportunity for a risk-tolerant
investor. An intelligent investor can identify and purchase undervalued
good biotech companies in the following situations:
•
Industry recession
•
Company-specific problems: bad news, lawsuit, regulatory concerns
(FDA or political ones).
Here I will cite a few cases to illustrate how I have purchased undervalued
biotech companies using this method during the 10 years from 1993 to 2002.
Since 1994, I have picked such biotech companies as Genetic Therapy,
CEPH, Genzyme, and Human Genome Sciences, using this method (as
published in the Bio/Medical Technology Stock newsletter in 1994 and
1995). The three-, five- and ten-years returns from such selections were
superior to the BTK Index. Eight stocks are used to illustrate the concept of
buying undervalued biotech companies.
Example 1. Buy near a stock's book value and enjoy its franchise growth
free. I recommended buying Genetic Therapy (GTII) at $7 per share (near
its cash and book value) in mid-1994. Three months later, the company was
acquired by Sandoz for $21 cash per share. That is a 300% return in four
months.
Example 2. Buy Amgen during an industry recession and regulatory threat
in late 1993 or early 1994. If you hold the stock until 2001, your return is
about 600% versus the biotech index of 200% (Figure 5-2).
Example 3. Buy Genzyme on bad news. I recommended GENZ in 1994.
But if you missed that, you could have bought it during late 2000 when
product development news from a biotech company in the UK drove the
stock down (Figure 5-3). You would own a profitable biotech company and
have beaten the index.
Example 4. Trading Chiron on temporary bad news (Figure 5-4). When
Chiron announced closing a plant and writing off the loss in 1994 (a loss of
126
The Essential Biotech Investment Guide
1 cent per share), the news drove the stock down from the $80s to the $50s.
The stock rose again to 80s in a few months.
Examaple 5. Buy Centocor with the first FDA-approved monoclonal
antibody drug from a biotech company (high-demand product and highdemand by big pharma). I recommended buying it in 1995. If you held it till
JNJ bought it in 1999, you would have realized a 400% return (Figure 5-5).
Example 6. Buy Cephalon on bad news in 1994 and 1998. By 2001, that is
500% return (Figure 5-6).
Example 7. Buy Human Genome Sciences in 1994 (high demand). After a
huge run in 2000 (a 1600% increase) after industry success of sequencing
the human genome, this company is still trading in line with the index
(Figure 5-7).
Example 8. Buy Immunex on bad news. I bought Imunex in June 2001 and
realized a 50% return in 6 months (Figure 5-8).
MSGM D a i l y —
" ""
Figure 5-2. Amgen (AMGN).
5/14/02
127
How to Value and Invest in a Biotech Company
T ^ i - - - ^ - ' : « V
BTI-
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Figure 5-3. Genzyme (GENZ).
te*y —'"
+7002
*^^<s^
ttefoge"—,
Figure 5-4. Chiron (CHIR).
i
=
The Essential Biotech Investment Guide
128
CNTO D a l l y —
10/06^99
+700R
HBI
+600?:
, .
/*
+500K
+400?:
tyfo
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+300?:
+200K
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+0?.
-loo?:
Volume —
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30
VI
93
94
95
96
97
98
99
00
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Figure 5-5. Centocor (CNTO).
CEPH D a i l y —
HBI
^vAv/
93
94
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11 LiiiLiIiiilbi,L.J MLIIII
96
97
98
fa i II ill ill Mm
99
00
Figure 5-6. Cephalon (CEPH).
20
o
10
i
How to Value and Invest in a Biotech Company
129
HGSI D a i l y
W^H„|PI ! ! % „ ! .
i • 111 > i
S3
94
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f l
l^p,|
iilLXMim*&***Mm»*J&MMimMLjLjiliiA*l
96
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Figure 5-7. Human Genome Sciences (HGSI).
IMNX S a l l y
sir
J
J R
S O
N
D 0 1 F M
H M
J J f l
SO
N
D 0 2 F M A
Figure 5-8. Immunex (IMNX).
M
This page is intentionally left blank
Chapter 6
Investing in Biotechnology Mutual
Funds
B
iotechnology mutual funds have clearly demonstrated the tremendous
growth. Investors are asking many questions regarding biotech mutual
funds. Mutual funds in particular offer the following benefits: professional
management, affordability, diversification, flexibility, potential to outpace
inflation, portfolio diversity, and an opportunity to benefit from a growing
US economy. Let's review some of the basic concepts first.
Don't Put All Your Eggs in One Basket
We used to describe the concept of diversification by using the old
expression-"Don't put all your eggs in one basket." Today, as in the past,
there is nothing more critical than proper diversification (see Figure 1-8) for
an average investor. It is the one thing that protects you the best (though not
perfectly) from the greatest fear most people have about their money: losing
it! Diversification leaves you free to concentrate on a risk that is far greater,
more dangerous, more likely to occur and much more insidious, that is, the
loss of purchasing power.
131
132
The Essential Biotech Investment Guide
Purchasing Power
Purchasing power (see Figure 6-1) simply means that the dollar you invest
today must be able to buy you a dollar's worth of stuff tomorrow, or
whenever you need to spend it. What makes accomplishing this so difficult
is inflation. As we get older, we tend to spend more and more of our
disposable income on something that goes up in cost at twice the rate of
inflation—health care and college education. If you do not design a
portfolio that keeps pace with inflation, you might find yourself literally
outliving the income on your portfolio.
Impact of Inflation and Time
Postage Stamp
• From $0.04 to $0.37
in approximately 40
years
• Over 700% increase in
cost
Figure 6-1. Stamps and Inflation.
Investing in Biotech Mutual Funds
133
The Investment Pyramid
Mi n. kv Junk Bonds
I ivasury Bonds and Notes, Municipal and Corporate
Bonds
V ^
CDs, T -bills, Money Markets
Figure 6-2. Risk-Reward Parameter/Pyramid.
Professional Management
The first thing you need to know about professional management is that it
can be a blessing or a curse, depending on the quality of the professional
doing the managing. The one reality in the subjective world of professional
portfolio management is this: Your money has a better chance in the hands
of a full-time manager than with a part-time manager. By "part-time" I
mean people with a full time job, and the many stockbrokers. With mutual
funds you have someone who does nothing all day long but watch the
markets, study companies, conduct research, and manage money. Indeed, it
does not always work. The key is finding a manager with the style and
discipline that matches your needs.
134
The Essential Biotech Investment Guide
Table 6-1. The Value of Professional Management in
Biotechnology-10-Year Performance.
Net Market Capitalization
Increase (%)
Amgen
Genetech
Genzyme
Biogen
Imclone
PDLI
600
210
310
600
70
470
Asset Allocation
Asset allocation is the process that determines what percentage of your
portfolio at any given moment in time should be in stocks, bonds or cash—
domestic or international (Figure 1-6). It is a time-tested discipline that you
can use as an overlay for your entire investment process. We use mutual
funds today as a portfolio. Mutual-fund selection should balance and
complement each other in a coherent strategy customized for your specific
investment goals and built on your risk/reward parameters (see Figure 6-2).
When you consider investing overseas, there are two broad investment
categories from which you can select-conservative growth and aggressive
growth. Conservative growth investments might include blue-chip
companies of countries like Japan, UK, Germany, France, Italy, Canada,
Sweden, and Norway. Aggressive growth (and substantial risk) might be in
emerging countries, such as South America and the former Czech Republic
countries.
Investing in Biotech Mutual Funds
135
Liquidity
Liquidity simply means that you can get your money out at any time,
meaning your money is not "locked up" and unavailable when you need it.
What liquidity absolutely does not mean that you should use mutual funds
as a "parking place" for cash. Too many people today are in and out of their
funds like a money market. Establishing a proper investment time horizon is
one of the most important decisions you can make regarding mutual funds.
Discipline
The media and our popular culture have us surrounded by emotions, so it is
no surprise that most investors are besieged by emotional demons when it
comes to their money. It is my belief that emotion is the arch-enemy of the
long-term investor. Only through a well-conceived, properly executed
investment discipline can we achieve our goals. Discipline is absolutely vital
to your long-term investment success. Investment discipline is the courage
to stay the course (e.g. keep your investment style whether value or growth)
in the face of crowd hysteria, media hype, and short-term market
psychology (see Figure 6-3, Value vs. Growth). Start with a customized
plan built around your needs and objectives. That plan is based on
knowledge, research and facts, not speculation. It also involves making
educated predictions and constantly monitoring those predictions in case a
course correction is needed.
Doliar-Cost Averaging
Discipline is continued with a detailed system of regular, periodic investing
that takes advantage of one of the great strengths of mutual funds known as
"dollar-cost averaging." Of course, you may need to make periodic course
adjustments. But this method of investment is not subject to the ups and
downs of the market, as well as the emotional impact of trivial daily
occurrences that can cause panic.
136
The Essential Biotech Investment Guide
The Case for Index Funds
Indexing is a strategy that many investors choose to mirror returns of the
major indices. There is also sobering evidence that professional money
managers, who are in a position to exploit these inefficiencies, have a very
difficult time consistently beating financial markets. Not only do money
managers' sometimes fail in consistency of returns, but they can also, in
every investment style, under-perform the market index. These results
make the case for index funds.
Why Index Funds?
Index funds are much less expensive to create. There are no information
costs, no analyst expenses, less expensive to run, less tax liabilities, and
minimal transaction costs and management fees. Comparing transactions
costs across different types of funds, we find the following: Index Funds,
0.20%-0.40%; Active Value Funds, >1.30%; Active Growth Funds,
>1.75%.
When Should You Use Index Funds?
If the cost associated with active money management exceeds the payoff
associated with active money management, an index fund is a better choice
for investors. Of course, index funds can go wrong when the overall market
or sector is in a depression. Finally, remember that they can never beat the
market index.
Why Stock or Stock Mutual Funds?
Historically, stock investing has successfully kept investors well ahead of
inflation and outperformed US government bonds and US Treasury bills.
Perhaps one of the most compelling arguments for owning stocks and stock
mutual funds is that over the long term, US stocks have historically
outperformed US government bonds and Treasury bills, and kept investors
well ahead of inflation. For many investors, stock mutual funds may make
Investing in Biotech Mutual Funds
137
good sense for the portion of their investments set aside for achieving
longer-term goals, such as retirement or college planning.
Long-term Investing in the Stock Market Has
Historically Paid Off
While past performance does not guarantee future results, history has shown
that, over the long term, stock market investing can be rewarding. Figure 6-4
demonstrates this historical point of view. You have a 73% likelihood of
earning a positive investment return over a one-year period, but a 27%
chance of losing money. However, by stretching your investment time frame
to five years, you increase your chance of earning a positive return to 94%.
History has shown that just five years can make a big difference. As
outlined in the table, the difference between the 5-year and the 15-year
rolling periods is only a 6% increased probability of generating positive
returns.
Investment Goals Need to Reach Beyond the Rate of
Inflation in Order to Maintain Long-Term Purchasing Power
Investors need to consider the impact that inflation can have on all the goods
and services they buy, as well as the effect it has on their investment goals.
As you can see, inflation can significantly erode your purchasing power
over time. Inflation, as measured by the Consumer Price Index, has
averaged 4.00% annually for the past 20 years. This means that a dollar 20
years ago is worth only $0.46 today. Outpacing inflation should be an
important consideration when planning for your financial future.
Time in the Market vs. Timing the Market
Many investors think they should wait until the "right" time to invest in
stocks. However, as we all know, trying to time the market is next to
impossible, not true investing. Very few individuals have the time, technical
expertise, desire, or the "stomach" to trade. Investing is about time in the
market, and historically, the longer you are in the market, the greater your
potential for increasing wealth (Figure 6-4).
Growth and Value Investing
1927-2001
$100.000 T
$10,000--
„
Small Value
Ending Average
Wealth Return
S22.553 14.5%
• Large Value
Large Growth
• Small Growth
$1,000-
%
1927 1937
1947
1957
1967
1977
1987
This is for i1lustf<itive purposes only and not indicative of any investment
Past poiformance is no guarantee of future results. 3/1/2002,
C 2002 Ibbotson Associates. Inc.
Figure 6-3. Value Versus Growth.
$5,095
12.2%
S857
S731
9.6%
9.3%
Investing in Biotech Mutual Funds
139
Let's look at an example where one investor bought stocks on the worst
day (the day the market was at its yearly high), while another on the best
day (the day the market was at its yearly low). As you can see, the best-day
scenario has an investment value of $352,523 with an average annual total
return of 22.98%. The worst-day scenario has an investment value of
$283,560, with an average annual total return of 20.99%. Being lucky
enough to pick the exact day to invest improved the total value of the
investment by only 1.99% per year during a 10-year period. While there is
no guarantee that the stock market's strong performance will continue, you
can see it was not necessarily as important when they invested as it was that
they invested.
The Cost of Delaying
Let's look at an example of returns, proving the point that "It's time in, not
timing", that counts. If you stayed fully invested, you have a return of 24%.
If you missed the 10 best days, your return is 15.6%. If you missed the 20
best days, 10.7%. If you missed the 30 best days, 6.5%. If you missed the
40 best days, 2.9%, and so forth (see Figure 6-5 for cost of missing best
months).
The Benefits of Investing in Biotech Mutual Funds
In my opinion, mutual funds are one of the easiest ways to invest in biotech
stocks:
1. Baby boomers, the largest generation in history, are moving into their
peak earning years, which could have a positive impact on the stock market.
One reason to be optimistic about the long-term prospects of the stock
market may be the demographics behind the US economy, specifically the
consumer spending of the baby-boom generation. The largest peak shows
the baby-boom generation, born between 1946 and 1964, are now between
the ages of 36 and 54. Historically, there has been a strong relationship
between demographics, subsequent consumer spending, and social and
140
The Essential Biotech Investment Guide
economic trends, which, in turn, impact the stock market.
Thus,
babyboomer households are facing a huge drop in financial obligations at
the same time their incomes are rising and the economy is growing. So what
does this mean for stocks? Some economists believe this generation can
dominate the consumer marketplace, lead to an increase in innovative
products and services and, ultimately, drive the stock market up (Source- The
Roaring 2000s: Harry S. Dent, Jr.).
2. Technological advancements have been affecting our economy since the
1800s. It is important to realize that in addition to changing demographics,
technological advancements have had a strong effect on the economy (see
Table 1-11). Technological advancements have improved the way
companies do business-computer programs can complete tasks in a matter
of hours that would have taken five times as long just a few years ago.
Improved efficiencies allow companies to provide customers with more
specialized, individual attention. As companies become more efficient and
productive, they become more profitable, a situation has historically driven
up the stock market.
3. Biotech mutual funds offer the experience of a professional money
manager. Many of us struggle with all the things we need to get done in a
day, and often checking the financial markets, watching interest rates, and
getting stock quotes are some of the items that get pushed to the bottom of
the list. Mutual funds are professionally managed; these fund managers
closely monitor the securities markets and individual companies, buying and
selling securities as opportunities are identified.
4. Each investment in a biotech mutual fund is spread among the various
holdings within the fund's portfolio. Because the fund's performance is not
dependent on any single security, this may help reduce the risk of problems
or losses in any one company adversely affecting your investment as a
whole.
5. Within a mutual fund "family," you may transfer assets between
investments, usually with no additional costs. You can adjust your
investment plan as your needs change and opportunities develop. The
portfolio managers and analysts believe consistent research is a critical
component in earning solid, long-term results. They strive to become
experts on the businesses in which they invest by scrutinizing financial
Investing in Biotech Mutual Funds
141
statements and evaluating stocks, looking to see if changes in the industry,
economy or company itself warrant any changes to the portfolio.
6. Mutual funds are also affordable. With a mutual fund, you can begin
investing with a relatively small amount of money. And, you can set up an
automatic investment program to add to your investment on a regular basis,
directly from your checking or savings account.
Table 6-2 lists a selection of health-care biotech funds that investor can
work with. The key to investment is finding a reputable manager with a
good track record and the style and discipline that matches your needs and
objectives.
The Essential Biotech Investment Guide
142
Stay the Course
Positive Returns Over 72-Year Period (1926 to 1997)
9 0%
9 7%
72%
1 Year
5 Years
10 Y e a r s
Holding Period
Sou'C.
njDolion
All
Figure 6-4. Positive Investment Return and Holding Period.
Market Timing Risk
The effects of missing the best month on annual returns
Relurn il Invested
for the whole year
Relurn if ihe
best monlh Is
missed
—•
1
Relurn if invesled
. tor the whole year
Return II the best
month is missed
Annual return
Annual return minus best month
llbhotsonAssooirjifisI
Figure 6-5. Cost of Missing Best Months (1970-2001).
Table 6-2. Healthcare-Biotechnology Funds.
Fund Name
AIM Global Health Care A
Alliance Health Care A
American Century Life Sciences Inv
CS Warburg Pincus GI Hlth & Sci
Comm
Dresner RCM Biotechnology N
Eaton Vance Worldwide Health Sci A
Fidelity Advisor Health Care A
Franklin Biotechnology Discovery A
Hartford Global Health A
INVESO Advantage Glob Health Sci A
INVESCO Health Sciences Inv
Janus Global Life Sciences
J. Hancock Health Sciences A
Merrill Lynch Healthcare A
Morgan Stanley Health Sciences B
Munder Framlington Healthcare A
Orbitex Health & Biotechnology A
Prudential Health Sciences A
Putnam Health Sciences A
Rydex Biotechnology Inv
Scudder Health Care S
T. Rowe Price Health Sciences
Vanguard Specialized-Health
Ticker
Symbol
Fund
Size
($MM)
Investment Style
GGHCX
AHLAX
ALSIX
WPHSX
570
73
234
91
Medium Cap Growth
Large Cap Growth
Medium Cap Growth
Medium Cap Growth
1.73
1.92
1.50
1.61
1994
1999
2000
1996
13.83
-14.98
-5.59
14.66
5 stars
Not Rated
Not Rated
4 stars
DRBNX
ETHSX
FACDX
FBDIX
HGHAX
IAGHX
FHLSX
JAGLX
JHGRX
MAHCX
HCRBX
MFHAX
ORHAX
PHLAX
PHSTX
RYOIX
SCHLX
PRHSX
VGHCX
501
742
130
805
92
459
1701.5
2376
154.7
301
600
115
77
85
3286
314
168
856
17733.9
Medium Cap Growth
Large Cap Growth
Large Cap Growth
Medium Cap Growth
Large Cap Growth
Large Cap Growth
N/A
Large Cap Growth
N/A
Medium Cap Growth
Large Cap Growth
Small Cap Growth
Medium Cap Growth
Large Cap Growth
Large Cap Growth
Medium Cap Growth
Large Cap Growth
Medium Cap Growth
N/A
1.50
1.79
1.18
1.13
1997
1994
1996
1997
2000
1994
1984
1998
1991
1994
1994
1997
1999
1999
1994
1998
1998
1995
1984
53.57
20.82
36.2
38.90
7.24
9.54
20.42
-16.32
17.05
16.55
12.75
34.21
-21.99
0.04
12.46
38.28
23.37
16.19
22.75
5 stars
5 stars
5 stars
5 stars
Not Rated
3 stars
N/A
Not Rated
N/A
5 stars
4 stars
5 stars
Not Rated
Not Rated
3 stars
5 stars
5 stars
5 stars
N/A
Source: Morningstar.com-Data through September 30, 2001.
Expense
Ratio (%)
Year Fund
Established
Annual
Return
Mornings tar
Rank
(%)
—
—
1.40
0.94
1.50
1.26
2.20
1.61
2.00
1.10
0.94
1.23
1.83
0.98
0.41
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Chapter 7
Healthcare Biotech Index
Investing: Strategies Using
Exchange-Traded-Funds (ETFs),
Biotech iShares, and BOXES
The Case for Index Funds
Indexing is a strategy that mirrors the returns of major indices. There is
also sobering evidence that professional money managers, who are in a
position to exploit market inefficiencies, have a very difficult time
consistently beating the market indices. This inconsistent performance of
active money managers provides the best evidence yet that indexing may be
the best strategy for many investors. One finds actively managed funds
breaking even against the market, after adjusting for transaction costs, and in
those that are least favorable, they underperform the market even before
adjusting for transactions costs. Studies show that money managers in every
investment style underperform the market index and lack continuity in
performance. These results make the case for index funds.
145
The Essential Biotech Investment Guide
146
Why Index Funds?
Index funds are less expensive to create; and because there are no
information costs or analyst expenses, they are less expensive to run. In
addition, they boast minimal transactions costs and management fees.
However, they cannot beat the market index. Type of fund transactions
costs: Index fund 0.20%-0.40%; Active value fund >1.30%; Active growth
fund >1.75%. Index funds also create less tax liabilities.
When Should You Use Index Funds?
If the cost associated with active money management exceeds its payoff,
then an index fund is a better choice for investors. Instead of simply
replicating an index, many funds go beyond indexing by selecting stocks
from the S&P Industrial Index, using a four-part screening process, to
achieve a combination of quality, potential capital appreciation, and current
dividend income. The result is a 15-stock portfolio that seeks total return.
Of course, the index can go wrong when the overall market or sector is in a
depression.
I. Exchange-Traded Funds (ETFs)
Let us first discuss the exchange traded funds (ETFs), index-like exchange
traded funds and strategies using them.
ETFs: Originally conceptualized for institutional investors to trade,
hedge, or short an entire portfolio of stocks in a single transaction, their
composition changed and became more comprehensive as the demand
for these funds increased.
A) Core and Satellite Strategy
Whether used for all the investor's assets or for a portion of them, ETFs
reduce the volatility risk incurred by concentrated portfolios and help to
achieve investors' objectives (see Figure 7-1).
Healthcare Biotech Index Investing
147
B) Sector Rotation and Instant Access to Thematic Groups
Index-linked ETFs allow investors to have exposure to a specific sector,
such as pharma or biotech, without the hassle of selecting individual stocks
in these areas. However individual stock selection, as recommended by
Equity Research, may add value to the portfolio. ETFs are satisfying from a
cost, trading, and tax point of view to reflect the sector changes, (see Table
5-2: business cycle model).
C) Capitalize on Market Volatility
ETF'S allow investors to react very rapidly to any move in the markets
because of their rapid response time and their ability to sell short whole
indexes, sectors, and styles.
D) Risk Management
Index-linked ETFs are efficient hedging tools because they allow broad
exposure to different markets and sectors. Index-linked funds can be shorted
on downticks and hedged at market prices with almost no premium.
E) International Exposure
ETFs allow investors to build well-diversified, global, or international
portfolios as they give access to various international markets and sectors.
They can also be used with an existing portfolio of stocks or mutual funds to
adopt specific strategies (such as selling short, hedging).
Advantages of ETFs
1) Flexibility. Investors are able to achieve multiple operations (buy, sell,
or sell short) in the domestic markets as well as international markets in
a single transaction.
The Essential Biotech Investment Guide
148
Index
Core
Portfolio:
Multi-Asset
Class
Satellites:
Active
Managers
Layered to
Enhance
Returns
Figure 7-1. Institutional Strategy Evolves to Core / Satellite.
2) Diversification. ETFs allow for diversification in a simple and effective
way.
3) Lower expense ratios. Because ETF funds are not actively managed (less
research, less trading, and no interaction between investors and fund
managers), transactions are less costly. However, this advantage can be
counterbalanced by commission costs when buying and selling ETF's.
4) Intraday trading. Index-linked ETFs trade throughout the day, allowing
investors to capitalize on market volatility. Presently, index-linked ETFs are
traded each day on the American Stock Exchange.
5) Short selling on a downtick. Short selling on a downtick is possible for
ETFs, but not for common stocks.
Healthcare Biotech Index Investing
149
Options Strategies for Suitable Clients
Options on index-linked exchange-traded funds are an efficient way to produce
income, reduce risk, and speculate. Eligible clients could adopt such strategies*
as:
1) Buy calls or puts to speculate on the ETFs price direction.
2) Simultaneously buy ETF and sell calls to produce income (covered writes).
3) Sell calls against a prior ETF position to produce income and still get
downside protection (overwrites).
4) Buy protective puts against an ETF to get protection against a downside loss
while retaining any profit opportunity if the ETFs price goes up.
5) Spreads can be less risky than selling uncovered calls, or puts can be used to
hedge a long option position.
* Please consult yourfinancialand tax advisors for suitability.
6) Tax efficiency. Firstly, Index-linked ETFs have a low turnover. Secondly,
there is no transfer of cash at the fund level, due to their unique creation and
redemption process. Consequently, there is no tax liability due to inflows
and outflows of cash.
7) Quarterly dividends. ETFs produce quarterly cash dividends paid on the
underlying stock, less fees and fund expenses. Dividends may be reinvested.
8) No investment style drift. The investment objective is more easily
pursued since the portfolios of these funds are usually steady since changes
basically result from the rebalancing of the benchmark index.
9) Portfolio transparency. Transparency results from the fact that ETFs
reflect their underlying indexes and components of the indexes are made
public daily. All necessary information is easily accessed through the
Internet quarterly (monthly for iShares) performance data, top sector
weightings, holdings, etc.).
10) Margin eligibility. The same way it applies to common stocks, ETFs can
be used in a margin account.
150
The Essential Biotech Investment Guide
11) Limited premiums/discounts. Index-linked ETFs use a unique
creation/redemption process, which allows for ongoing arbitrage
opportunities. The result of this has been that premiums/discounts
completely disappear for domestic index-linked funds and considerably
decrease for international ones.
12) Liquidity. Index-linked ETFs provide liquidity in two different ways:
•
Through secondary trading on an exchange, and
•
Through the creation process.
The latter implies that an authorized participant buys the underlying basket
of shares and puts it into the fund in return for a block of ETF shares. As a
result, the liquidity level depends on the liquidity of the underlying basket of
stocks.
Index-Linked ETFs
The index-linked funds' quick expansion should result in growth of the ETF
industry. Index-linked funds are widely accessible both domestically and
internationally. Similar to stocks traded on a major exchange, ETFs have the
same advantages of liquidity and visibility. Each ETF is designed to follow
a designated index or basket of securities. ETFs are used for asset
allocation, sector rotation, and hedging strategies. Major brand names are
iShares, Spiders, Qubes, and Diamonds.
Close-End ETFs
Close-End ETFs (CEFs) also allow easier access to financial markets. They
are professionally managed and diversified portfolios, but unlike open-end
funds, there is a limited number of CEF shares issued and traded on the
major exchanges. Transactions can take place throughout the day so the
share price of a closed-end fund can fluctuate up and down to the net asset
value of the fund.
Healthcare Biotech Index Investing
151
Advantages of Close-End ETFs
1) Professional management. Dedicated and respected professionals monitor
closed-end funds' investments.
2) Access to illiquid or inaccessible Markets. Closed-end funds make it
possible and cost-effective for US-based investors to invest in certain
specialized or illiquid markets.
3) Potential to buy assets at a discount. One major advantage of investing in
CEFs is that they allow investors to increase their total returns since they
can buy the share price of CEFs at a discount. This benefit occurs as the
discount narrows.
4) Lower expense ratios. Costs resulting from continuous inflows and
outflows of cash do not apply to closed-end funds the way they do to openend funds.
II. Index Investing
Introducing the iShares-Nasdaq Biotechnology Index Fund
The iShares Nasdaq Biotechnology Index Fund (also called iShares Nasdaq
Biotech index stock) allow the stocks comprising the Nasdaq Biotechnology
Index to trade as a single security:
1) Tracks like an index fund, works like a stock. Investors find the iShares
Nasdaq Biotechnology Index to be both cost-effective and efficient as it
offers wide exposure within the biotech sector and the use of the same
strategies applied with stocks.
2) Can be bought or sold whenever the market is open. The iShares Nasdaq
Biotech index stock can be bought or sold through any brokerage account.
3) Settles just like a stock trade. The iShares Nasdaq Biotech index stock
trades like ordinary shares of stock. It can be sold short and bought on
margin and transactions may occur at any time during the day.
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The Essential Biotech Investment Guide
4) Shields investors from the costs of shareholder activity in funds. The
iShares Nasdaq Biotech index stock is not actively managed since its
purpose is to follow the Nasdaq Biotechnology Index. Consequently, the
cost of trading securities and portfolio turnover is significantly decreased.
Moreover other investors' activities have less impact on the investment.
5) History of the Nasdaq Biotechnology Index. In 2000, it increased 23%
and represented the largest and most actively traded Nasdaq biotechnology
stocks, including companies involved in biomedical research. It is a
capitalization-weighted index.
Advantages of iShares
1) Cost-Effectiveness. Although trading the iShares Nasdaq Biotech Index
Stock incurs brokerage commissions, management fees being significantly
less than they are for most mutual funds counterbalance such costs.
2) Tax Efficiency. Tax payments are usually lower for iShares holders than
they are for holders of actively managed funds because iShares investors
only become tax liable for their capital gains, when changes are made to the
benchmark indexes. Figure 7-2 shows the strategy of tax loss harvesting at
the year-end.
3) Diversification. Diversification is as broad as it is for index funds.
4) Transparency. All the components comprising the iShares Nasdaq
Biotech index are published every trading day, unlike mutual funds, which
have an obligation to disclose their entire holdings only twice a year.
III. Strategies Using Biotech and Pharmaceutical BOXES
New Financial Engineered Products
Pharma BOXES (symbol DGE) are known as Amex Equal Weighted
Pharma Index. Unlike Mutual Funds, ETFs, UITs or HOLDRS, BOXES
provide 100% of the price appreciation and dividend payout of the stocks
underlying the index to which they are linked without any ongoing fees,
expenses or backend "loads." In addition, they provide payment of an
Healthcare Biotech Index Investing
annual supplemental coupon (See Table 7-1).
BOXES include:
153
Some characteristics of
Exchangeable for Cash
No Ongoing Fees or Expenses
Pass-Through of Dividends
Annual Supplemental Coupon
Exchange Listed
Convenience and Cost Effectiveness: Single Trade
In summary, BOXES offer portfolio diversification with tax
convenience. Because BOXES provide diversification in a single security,
investors will not be subject to annual allocations of mutual fund capital
gains.
The Essential Biotech Investment Guide
154
Possible Responses
Take Losses
•
Biotech Stocks
•
Biotech Mutual
Funds
Equitize Cash in
iShares
Equivalent iShares to
Create "Core"
•
QQQs, BBH, DGE
•
Select Sector
Spiders
Swap to Technology
iShares
Swap to iShare Sector
Fund
Figure 7-2. Tax Strategy: Loss Harvesting.
Table 7-1. How Do Pharmaceutical and Biotech BOXES Work?
Investor
Investment Bank
Initial issuance
Cash equals to a fraction of the
aggregate closing prices of the
underlining stocks
Issue BOXES
Ongoing
Quarterly base coupons
Annual supplemental coupon
Exchange by
investor
Sell BOXES
Redemption by
issuer
Maturity
Cash settlement based
on the aggregate
closing prices of the
underlining stocks plus
accrued but unpaid base
coupon amounts
Chapter 8
Risk Management Considerations
for Biotech Investors with
Concentrated Equity Positions
T
I ^he Enron case gave investors and employees a shocking wake-up call on
how to better manage their retirement or 40IK with concentrated
positions. Some investors maintain diversified portfolios whereas others
have a concentrated equity position, that is, their overall equity portfolio
includes a large percentage of a single stock. Although there is a higher risk
in terms of volatility of returns for the latter category of investors, they are
often reluctant to diversify because the sale of shares to reinvest into other
stocks would result in taxable capital gains and because of other factors,
such as their emotional attachment to the stock.
Consequently, before making a decision about whether to diversify or
not, one must analyze the effects of either strategy. The following provides
some insight into possible strategies. Keep in mind that any strategy has to
be adapted according to the specific situation and goals of each particular
investor (see Table 8-1).
155
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The Essential Biotech Investment Guide
Alternative 1: Retention of the Position and Associated
Risks
The main risks associated with a single stock are of two kinds:
Systematic risk, or "market risk," which relates to the economic situation in
general. It cannot be eliminated.
Non-systematic risk, or "firm-specific risk," which relates to a particular
firm. It can be eliminated. One way to eliminate or reduce this risk is by
diversifying by holding 40 or more stocks (Figure 8-1).
Eliminating non-systematic risk serves to reduce volatility of the overall
portfolio compared with the average individual stock. This is important to
note from a return point of view since the higher the volatility, the lower the
preservation of the accumulated wealth.
Figure 8-1. Systematic Risk and Company-Specific Risk.
Objectives
Hedge risk
• Company specific
• Industry
Market
Liquidity needs
• Short-term
• Long-term
Diversification
Defer Taxes
Retain voting rights
Risk Tolerance
Strategic/Business
Methods of Pure
Risk Management
•
•
•
•
•
Assumption
Avoidance
Reducing
Sharing
Transfer
33
%
Retention
Liquidation
Monetizing
Hedge Decisions
I
3
Q>
CQ
CD
3
CD
3^
o
o
3
C/j
Risk Management
Vehicles for Low Cost,
Concentrated and/or
Restricted Biotech
Securities
I
Asset Diversification
Strategies
Wealth Preservation,
Enhancement and Transfer
Strategies
Figure 8-2. Risk Management Strategies for Low-cost, Concentrated and/or Restricted Biotech Stock.
03
5"
3"
o
33"
<
CD
CO
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The Essential Biotech Investment Guide
Alternative 2: Liquidation of the Position and
Reinvestment of Net Proceeds
The major impediment to diversifying is taxes. Every sale of share gives rise
to a capital gain, which is subject to taxes. To come up with the right
decision, investors must find out how much more the rate of return should
be on the diversified portfolio, as compared with the single stock, should be,
to compensate for the tax liability over a certain period of time. Graphs
show that the required rate of return on the diversified portfolio decreases as
the investment time horizon increases. Thus, investors investing for the
long term should be more prone to diversification since the time allocated to
recoup the tax liability is greater. For those investing for the short term,
only specific life events should make them decide to diversify despite the
tax liability.
From a different viewpoint, the tax cost incurred by diversification can
be considered an "insurance premium," paid to prevent the value of a single
stock from a major decline and therefore to conserve the overall
accumulated wealth.
Alternative 3: Hedging, Monetizing, and Diversification
Strategies
Because the two previous strategies have disadvantages, investors have been
looking for additional strategies that allow them to diversify and/or increase
liquidity, without incurring an immediate tax liability. The following
alternatives represent ways for investors to uphold many of the benefits of
ownership and limit the volatility of their position at the same time.
Protective Put Option
The investor buys a put option, settled in cash. This gives the right to
receive a cash payment for the amount by which the strike price of the
option exceeds the stock price at maturity, if any. The investor pays a fee
for the downside protection obtained, and benefits from all upside potential.
Risk Management Considerations for Biotech Investors
159
Zero Cost (Cashless) Collars
The investor simultaneously buys a put option and sells a call option, both
settled in cash. Such strategy allows for hedging a concentrated equity
position while retaining the upside potential. Advantages are that there is no
up-front payment for the hedge, and shares need not be sold.
Exchange Fund
The investor donates certain concentrated equity positions of low-basis or
restricted shares in exchange for shares of a professionally managed
diversified portfolio. Such transfer should not incur federal income tax
liability (according to Tax counsel). One should note that legislation has
been introduced that may eliminate this benefit.
Charitable Remainder Trust
The investor irrevocably delivers securities to a trust and designates an
income beneficiary, who receives a lifetime cash flow (often the investor)
and charitable beneficiaries. When the property is removed from the estate,
the investor will benefit from a charitable income tax deduction.
Borrowing on Margin
The investor obtains a loan collateralized by a concentrated equity position
to increase liquidity and achieve diversification through reinvestment of the
loan proceeds. In that case, the interest expense is generally tax deductible
against an equal amount of net investment income.
However borrowing on margin does not hedge against future declines in
the value of the stock.
Conclusion
Although investors with concentrated equity positions incur higher risk,
because of greater volatility of their portfolio, the decision to diversify is not
an easy one.
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The Essential Biotech Investment Guide
Several factors should be taken into account:
•
The percentage of net worth represented by the concentrated equity
position
•
The built-in capital gain and associated tax rate
•
The investor's investment time horizon and objectives
•
(Over a long period of time, it is possible for a single stock to
outperform the market)
•
The perceived strength of the underlying security.
In any case the right decision is unique for each investor and is very
much dependent on the investor's risk tolerance. The goal is to find the right
balance between risk and rate of return. In most cases, the best results will
be achieved through a combination of several of the above alternatives.
Whereas all of the alternatives in "alternative 3" allow for deferring
taxes, they do not provide the same advantages in terms of Diversifying,
Hedging and Monetizing (Table 8-1). Table 8-2 is a summary of their effect
on the portfolio.
Risk Management Considerations for Biotech Investors
161^
Table 8-1. Hedging and Monetizing Strategies.
STRATEGY
Protective Put
Option
Cashless
Collars
Exchange
Fund
Charitable
Remainder
Trust
Borrowing on
Margin
OBJECTIVE
HEDGE
YES
YES
YES
MONETIZE
NO
except if combined
with loan
NO
except if combined
with loan
NO
except if combined
with loan
PARTIAL
YES
NO
YES
DIVERSIFY
NO
except if combined
with loan
NO
except if combined
with loan
YES
YES
YES
Table 8-2. Risk Management—Summary of Strategic Outcomes.
Disposition
Defer Capital
Gains
(low tax basis)
Remove
future
price risk
Retain voting
rights
Certainty of
sale/price
Covered
Call
Writing
Yes
Put
Purchase
No
ZeroPremium
Collar
Yes
Yes
Participating
Pre-Paid
Forwards
Yes
Yes
Yes
Yes/No
Yes
Yes
No
Yes
Yes
Yes
Yes
Yes/No
No
No
No
No
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The Essential Biotech Investment Guide
Glossary
Affiliate: An "Affiliate" is generally defined as an officer or a director of the
issuing company or a beneficial owner of more than 10% of the issue.
American Style Option: Exercisable at any time prior to and including the
expiration date. The value before expiration of American Style options will
typically be greater than or equal to the intrinsic value.
Call Option: A call option gives the holder the right, but not the obligation, to buy
the underlying asset at an agreed strike price at any point during a fixed period of
time (American Style) or on a fixed date (European Style).
Capital Gain: The gain reflects the increase in the value of a capital asset (an
investment or real estate property) above that of the purchase price. The gain is not
realized until the asset is sold. A capital gain may be short-term or long-term, but
both must be declared as income for tax purposes.
Cash Settlement: The settlement of an option contract at expiration through the
payment of cash in the amount by which the option is in the money, i.e., the
difference between market value and strike price.
European Style Option: Exercisable only on the expiration date. Value before
expiration of European Style Put Option may be less than the intrinsic value.
Intrinsic Value: The difference between the market value and strike price. For
Calls, the intrinsic value = market price - strike price. For Puts, the intrinsic value =
strike price - market price.
Over-the-Counter Option: A customized option (strike prices, maturities, and
settlement features), which is privately negotiated between the investment bank and
a counter party.
Physical Settlement: The settlement of an option contract at expiration through the
physical delivery or receipt of the underlying asset.
Put Option: A put option gives the holder the right, but not the obligation, to sell
the underlying asset at an agreed strike price at any point during a fixed period of
time (American Style) or on a fixed date (European Style).
Restricted Equity: Rule 144 identifies two primary categories restricted securities:
(1) Stock (registered or unregistered) of issuing company owned by an Affiliate of
the issue. (2) Unregistered shares issued by the company or acquired through a
private transaction. Rule 145 restricts the sales of restricted securities received
through a merger, consolidation or reorganization by (l)an Affiliate of the
disappearing company, but not an Affiliate of the surviving company; (2)an nonAffiliate who acquired shares through a private transaction.
Chapter 9
Managing Biotech Stock Options:
Your Employee Benefits
B
iotech stock options provide biotech businesses a new way to
compensate their employees for continuing years of service. However,
their widespread use is a recent phenomenon. Originally distributed to
board members only, biotech options are more widely distributed in order to
enhance corporate culture and create a tangible interest in the success of the
company. The theory is that if an employee owns a piece of the corporation,
their work may become more focused. Forty-years ago, Intel was the first
company to make biotech options available to all employees. In order to
attract illustrious candidates and retain valuable employees, other large wellknown companies have followed suit: Pepsico, IBM, General Electric, and
Wal-Mart, to name a few. Now, most biotech start-ups use these incentives
to attract quality technical and business teams to work for them. The
question of how to handle biotech stock options well is very important to
their holders, especially if they represent most of the holder's net worth.
Glossary
Disposition The owner of a newly acquired biotech stock exchanges, sells,
gives away, or otherwise transfers ownership of the purchased biotech
stock.
163
164
The Essential Biotech Investment Guide
ESOP A type of qualified plan called a biotech stock bonus plan. It invests
primarily in the company's biotech stock. Unlike 40IK plans, ESOP's can
borrow funds to purchase biotech stock. However, participants are taxed
only when they receive distributions.
ESPP (Section 423 Purchase Plans) The employee can purchase a biotech
stock at up to a 15% discount from the market value. Similar to incentive
biotech stock options, this plan can offer some preferential tax treatment if
certain rules are met. Participation cannot be limited to senior ranking
executives.
Exercise Date The day that the employee physically conducts the
transaction resulting in the purchase of company biotech stock.
Expiration Date The day that biotech options can no longer be exercised,
or the date that the holder can no longer turn biotech options into biotech
stock.
Fair Market Value The price that the biotech stock is selling for, either in
the market (on NYSE or NASDAQ, etc.), or for non-public traded biotech
stock, the value as determined by the company.
401 (K) A plan whereby an employee can set aside pre-tax dollars to save
for retirement, lowering the employee's total taxable income. In many
instances, the employer matches these contributions.
Grant Date The day that biotech options are available to the employee.
Qualified Plans ESOPs and 401Ks can be termed as qualified defined
contribution plans. By adhering to certain rules, the plans protect the
participants' interests and include various tax benefits.
S.O. Programs Holders of biotech stock options actually hold the right to
purchase biotech stock at a specified price during a specified time frame.
Vesting Date The day that the employee is able to exercise the biotech
option, therefore turning the biotech option into a biotech stock.
Managing Biotech Stock Options
165
Four Types of Common Vesting (see Table 9-2):
Straight Vesting Equal portions of your biotech options are available for
exercising, each year, over a specified number of years.
Example: An individual might have 20% of his or her biotech options
vesting each year, for five consecutive years, at which time 100% of the
biotech options would be available for exercise.
Step Vesting Various increments of biotech options vest themselves each
year, over a certain number of years; the portions are unequal.
Cliff Vesting An all or nothing situation. When a certain number of years
have been reached, all biotech options vest at once.
Performance Vesting A vesting schedule that is tied to predetermined goals
set by the company, such as earnings levels or revenue expectations. For
example, vesting occurs when the company's fourth year earnings top $0.50
EPS, or when company has five major strategic alliances.
Non-Qualified Biotech Options
Non-qualified biotech options are the most common and the most flexible.
Exercising these biotech options will subject you to ordinary income tax on
the difference between the grant price and the exercise price. However, if
you hold the biotech stock and sell at a market increase, you will be subject
to capital gains tax on the appreciation. You will have made money, but you
must pay taxes on that amount.
For example, in 1995 you received a biotech stock option to purchase
500 shares in your ABC biotech company. The grant price was $5 per share
(Table 9-1). Once your biotech option vested in 1998, you chose to exercise
it, noting that the fair market value of the share had risen to $12. At this
time, you would have paid ordinary income tax on the difference between
the grant price and the fair market value price, a seven-dollar per share
increase.
When the biotech stock increased to $15 per share two years later, you
choose to sell. The taxes now due would be the difference between the fair
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The Essential Biotech Investment Guide
market value on the date of exercise and the sale price of the biotech stock
or three dollars per share. As you can see, if you follow this taxation
process, you can then benefit from lower capital gains rates on the shares'
appreciation.
Incentive Biotech Options
Given the same example, there would be different tax implications for the
incentive biotech option, as they do not generate ordinary income tax when
exercised. However, the difference between the grant price and the fair
market value on the exercise date may have to be taken into account for the
Alternative Minimum Tax (discussed later).
Incentive biotech options, often reserved for the top executives in a
firm, have a few inherent tax advantages, but often more restrictions. These
include:
•
Incentive biotech stock options can only be granted to and exercised by
current employees within three months of termination of employment.
•
In order to have a qualified transfer with incentive biotech stock options,
you must hold the biotech stock for at least two years after the grant
date, and at least one year after the exercise date in order to take
advantage of capital gains tax rates. If your exercise meets these
requirements, the full difference between the grant price and the sell
price will be taxed as a capital gain.
•
However, should the exercise not meet the terms mentioned above, the
difference between the grant price and the fair market value on the
exercise date will be taxed as ordinary income, and any appreciation
after the exercise date will be taxed at the capital gains rate.
•
Only $100,000 worth of biotech option may become exercisable in the
first year.
167
Managing Biotech Stock Options
Table 9-1. How Do Biotech Options Work?
Price
1995
1996
1997 (exercise)
1998
Strike
Price $5
5
8
10
15
Profits
0
3
5
15
NSO
N/A
N/A
$5 income
(10-5)
$5 capital gain
(15-10)
ISO
N/A
N/A
$5 capital gain
(10-5)
$5 capital gain
(15-10)
Your Biotech Option Plan
A few simple steps will facilitate navigating your biotech option plan.
•
After your employer grants you biotech options, you are generally
obligated to wait for your biotech options to vest. The style of vesting
may be any of those listed in the glossary.
•
Once your biotech options have vested, you have specific time
parameters in which to vest them. You are now able to purchase shares
of the company's biotech stock, at a stated price, during the timeframe
set forth in the biotech option.
•
Following your purchase of the biotech stock, you can sell it
immediately, or hold the shares in anticipation of a value increase.
Caveats
First, do not let your biotech options expire! You will often have 5-10 years
to exercise your biotech options, and it is important to keep track of dates. If
the exercise date passes, you may lose out on a substantial benefit. Also,
understand the impact that terminating your employment will have on your
biotech option plan. Usually, you have three months from your last date of
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The Essential Biotech Investment Guide
employment to exercise vested biotech options (Table 9-2). The unvested
biotech options will be lost on your resignation date.
Table 9-2. Biotech Stock Options Vesting Methods.
Vesting Methods
Yearl
Year 2
Year 3
Year 4
Straight (most
common)
500
500
500
500
Step
40%
65%
85%
100%
Cliff
0
0
0
2000
Performance
0
0
$15 share
price
or $0.50 EPS
Though various biotech option plans are extremely beneficial, a
balanced portfolio is still important. Investing too heavily in a biotech
company stock places a strong dependency on company performance. Faith
in your company and work product is necessary; however, hedging your
bets for retirement is vital to your financial future. How do we make these
biotech options work for you?
Options can be exercised in
three different ways:
1. Cashless Exercise
2. Sell to Cover
3. Cash Purchase and Hold
1. Exercise: Biotech Option Fitness
Cashless exercise is the most common kind, particularly relating to nonqualified biotech options. If you are a new employee just beginning to
Managing Biotech Stock Options
169
receive biotech options or do not have large cash reserves at your disposal,
you may elect this type of exercise. A brokerage firm will act for you and
on your company's behalf to clear the trade in which the biotech stock is
purchased and sold immediately. The biotech stock is awarded to the
company at the grant price. The difference between the exercise price and
grant price, your profit, is paid to you in cash. However, if your biotech
option is an incentive biotech option, cashless exercise does not meet the
requirements of a qualified transfer, and you will not receive favorable tax
treatment for incentive biotech options.
2. Purchase and Hold
There is, however, no requirement to sell your biotech stock after you have
exercised your biotech options. In fact, if you have the cash to exercise the
biotech options outright, holding the biotech stock is an attractive
alternative, and can be lucrative should the shares increase in value.
Ownership in a firm may be a good investment and smart addition to your
portfolio.
3. Sell to Cover
This strategy requires three simple steps. First, exercise your
biopharmaceutical biotech options. Second, purchase the shares. And third,
sell only enough shares to cover the costs of the transaction. This entire
strategy is completed without exchanging any cash. The remainder of
shares, the unsold shares, become part of your portfolio and will reflect the
any future market movement.
Alternative Minimum Tax (AMT)
Alternative minimum tax (AMT) was conceived to ensure that taxpayers in
the higher income brackets, who normally reap large savings through
deductions and loophole exemptions, pay at least a minimum amount of tax.
If your AMT is higher than your regular tax payment, you will have to pay
the AMT at the time of exercise. If you are not subject to AMT, the first
time the incentive biotech option will be taxed is at the first sale. To figure
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The Essential Biotech Investment Guide
the amount of AMT you owe, your accountant will recalculate, and reinsert
certain "preference" items. Ultimately, you will end up paying a larger
amount, although there is a designated exemption amount.
For example, the general tax rate for the first $175,000 of AMT taxable
dollars is 26%. If you pay AMT in a year that does not apply to your
standing, you will be given a credit in that year.
Alternative Biotech Stock Acquisition Programs
Biotech stock option plans are not the only way for employees to acquire
ownership in the company; other plans include ESOPs, 401Ks and ESPPs.
Certain events, such as retirement or careers changes may require and
encourage you to rethink your portfolio's allocation. Taking a distribution
from your retirement assets or moving funds into another vehicle, perhaps a
tax-deferred IRA Rollover, is a biotech option. This type of account will
maintain the tax-deferred status of your assets. Also, particularly in the case
of a job change, if you are under 59 Vi, moving your funds into the IRA
Rollover directly may help you avoid premature distribution penalties.
Managing Tax Implications: Who Wants to Be a Millionaire?
As friends or family that have worked for an Internet start-up company
know, their compensation packages include stock options galore and modest
salaries. In the era of the Internet boom, employees saw their Internet
options increase hundreds of percentage points four or five years ago. The
same situation may hold true for genomic companies in the year 2000.
Since their companies gave biotech stock to employees outside of taxdeferred retirement plans, the extraordinary price increases created fast
wealth and extreme tax situations.
If you are lucky enough to be in this situation, there is relief in the form
of an 83(b) election.
Managing Biotech Stock Options
171
83(b) Election
When your employer gives or sells you company biotech stock outside of
the qualified plan, you will be subject to a vesting period before you can sell
the biotech stock. Once the vesting period has expired, you are the certified
owner of the shares. Consequently, you must report the full value of the
biotech stock as compensatory income-even if you choose to hold the shares
indefinitely.
However, if you choose to make the 83(b) election within 30 days of the
biotech stock grant, you will pay ordinary income tax on the biotech stock
when you receive it, not when it vests. This means you will pay the fair
market value of the shares on the grant date minus the purchase amount, if
any, you paid for the shares. Any appreciation thereafter would be taxed at
lower capital gains rates.
The Case for Election
Take a hypothetical situation. You become employed at a start-up
biotechnology company. They offer you 2,000 shares of biotech stock, with
a fair market value of $2.5 per share and a two-year vesting period. You
pay nothing for the shares, and do not report any income. During the next
two years, the company goes public and the biotech stock begins to rise.
Two years later, the company has gone public, and is trading at $100.00 per
share. Your biotech stock has now vested, and you will have to report
$200,000 of compensatory income-taxed at federal rates up to 39.6%.
Paying a monstrous sum of $79,200 in taxes is not a pleasing prospect.
However, different rules apply if you make the 83(b) election. Instead of
paying taxes on the biotech stock when it vests, you can pay taxes when you
receive the biotech stock. At federal tax rates of 39.6%, you would only pay
$1,980 on the $5,000 worth of biotech stock received (2000 shares at $2.5).
Furthermore, you would not have to report anything until the biotech stock
vests. Upon completing the vesting period, your biotech stock value has
risen to $200,000.
After reporting the $195,000 share value appreciation as a long-term
capital gain, your tax rate would be assessed at the much lower capital gains
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The Essential Biotech Investment Guide
rate of 20%. Taxes due now amount to $39,000. Adding the $39,000 to the
$1,980 from your initial payment supposes a tax payment of $40,980 on
your investment. The 83(b) election has shaved $38,220 off your total tax
payment. This is money in your pocket, and the savings provided through
the 83(b) election is significant. In other word, your volunteering to pay
taxes in the year you receive your biotech stock can cut your tax bill in half.
It is important to remember that this election must be made within 30 days
of receiving the biotech stock, and you will need to file certain information
with the IRS and your employer.
Election Risks
If your biotech stock increases in value substantially, the election should be
to your benefit. As we all know, biotech stocks do not always perform well.
If the shares decrease in price, you will probably have overpaid the
government. Now that the exercise price is lower than the grant price, there
is no capital appreciation and therefore no savings for you in having chosen
the election.
You should also consider how long you intend to stay with your
biopharmaceutical company. If you've chosen the 83(b) election, and you
leave your firm before your biotech options vest, you will have paid taxes
unnecessarily on assets that you do not own, and never will.
Net Unrealized Appreciation (NUA)
There is another strategy to take if you have a large concentration of highly
appreciated biotech stock and the discretionary income to pay an immediate
tax and/or penalty. Moving your assets into a non-tax deferred account is a
good start. Net unrealized appreciation allows you to move employer
biotech stock from your ESOP or 401 (k) plan at the plan's cost basis for the
biotech stock. You must pay ordinary income tax on the cost-basis amount,
and may be assessed penalties if you are younger than 59V2.
However, once you take a distribution, you will only be subject to
capital gains taxes at the current maximum rate of 20% on the net unrealized
appreciation (instead of the ordinary income tax rate of 39.6%). This capital
gains tax will be paid when the biotech stock is sold. In order for the shares'
Managing Biotech Stock Options
173
appreciation to qualify for the "long-term" capital-gain tax categorization,
you must hold the biotech stock for 12 months after taking the distribution.
State and local taxes may have different stipulations.
Making Uncle Sam's Tax Rules Work for You
This hypothetical situation will illustrate the power of the NUA strategy.
The biotech stock in the plan has a cost basis of $100,000. The value of the
biotech stock upon a lump sum distribution is now $2 million. Given the net
unrealized appreciation strategy, only the initial cost basis of $100,000
would be taxed at the ordinary income tax rate of 39.6%. If the biotech
stock is held for at least a year, the remaining $1,900,000 appreciation can
be treated as a long-term capital gain, and therefore be taxed at the lower
capital gains rate 20%. The tax advantage becomes evident.
However, if the participant had decided to roll the entire account into an
IRA, not taking advantage of the election, the entire $2 million would have
been taxed as ordinary income when it was distributed. Using the top
federal tax rate of 39.6%, taxes due would amount to $792,000. The NUA
strategy, conversely, would have necessitated a tax payment of only
$419,000. A $372,400 saving is certainly worth it. In addition to saving, the
participant also has more control over their outgoing tax money. By
choosing to sell various amounts of biotech stock at different times, as long
as the shares have been held for more than a year, the owner will only pay
capital gains rates on the amount of shares sold.
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Chapter 10
An Introduction to Healthcare
Biotechnology Hedge Fund
Investing
TTedge fund investing has grown tremendously over the last decade and
•*• -'-is expected to continue this growth because more individual investors
are allowed access to hedge fund investing and more institutions are
providing this type of asset opportunity.
Major reasons to invest in a hedge fund are:
•
High rate of return
•
Access to specialized strategies
•
Low correlation to traditional asset classes
•
In some cases, potential downside protection during difficult markets.
Characteristics of a hedge fund are:
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1) Investments are protected against market fluctuations, because they
include both long and short term investments (market-neutral).
2) Flexibility in terms of strategy and regards to which hedging is used.
3) Hedge funds usually do not have to register with the SEC.
4) Money is raised through private, rather than public offerings to investors
who may be wealthy individuals or institutional clients.
5) Hedge fund managers typically commit their own money in the fund and
receive a related portion of profit.
Hedge Fund Investment Styles
Characteristics of Hedge Fund Managers Compared with
Traditional Money Managers:
Opportunistic Investment Style. Hedge funds are usually not registered with
or regulated by the SEC. Therefore, managers are given more freedom to
change strategies without investors becoming involved.
Performance Measurement. Hedge fund managers' performance is not
measured nor does it take into account market fluctuations. Their
investments should be profitable whatever the market conditions.
Specific Fees. Managers receive most of their compensation through
performance fees (allocation or carry of interest) that they can charge since
hedge funds are not regulated. Because managers also manage their own
money, their interests are usually the same as those of investors, but it may
lead them to take too many risks.
Introduction to Healthcare Biotech Hedge Fund Investing
177
Legal Structure. Hedge funds are usually a limited partnerships or limited
liability companies.
Advertising or Promotion Limitations. Since hedge funds are not registered,
they cannot promote their funds in general solicitations.
Flexibility to Use a Range of Investment and Risk Management Tools.
Unregulation allows managers the flexibility to achieve high returns while
minimizing risk and the ability to avoid market uncertainties.
Three Ways to Participate Healthcare-Biotech
Hedge Funds
1) Invest Directly
Investors must have a high level of net worth and liquidity and the ability to
conduct independent and intensive investigations, since the information
disclosed by hedge fund managers may be scarce.
Because of the usual high minimum investment requirements (from $1
million to $5 million), hedge funds remain inaccessible to many investors.
2) Use a Consultant
Consultants act as intermediaries between investors and hedge fund
managers to match the needs of their investors with those of the hedge
funds' strategy and performance.
3) Invest Through a Third-Party Firm
This popular method allows easier access to hedge fund managers and
requires lower minimum investments (from $100,000 to $250,000).
Investors' assets are combined and turned over to managers. Firms
providing hedge fund strategies are able to build long-term relationships
with managers, perform professional investigation, and offer their expertise
in asset allocation.
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Conduct Necessary Due Diligence Prior to Investing in
Healthcare Hedge Fund
Such requirements exist whether investments are direct or involve an
intermediary. Due-diligence customarily includes:
•
Background checks on the manager. It is important to monitor the
manager's track record to determine if the fund's performance is based
on personal management decisions.
•
Fund's performance compared with competitors. Suitable indices may
be used to assess performance over the long term.
•
Amount of money under management. Too much money under
management may lead to lower performance. Also, the amount of
money managed over time should be monitored.
•
Composition of the management team. The skills and qualifications of
each team member (i.e. analysts, traders) should be such that they attract
investors.
•
Amount of money that the manager and team invested personally. The
higher this amount, the higher the connection is with investors' interests
•
The fund's tax implications. The tax strategy should be efficient: How
are the returns before and after tax? What is the timing to get the K-l
report?
•
The manager's liquidity schedule. It is important to know how often
shares can be traded and if there is minimum lock-up period.
•
The rights of investors within the fund.
Introduction to Healthcare Biotech Hedge Fund Investing
179
Conclusion
The growing accessibility of hedge fund investing has broken traditional
barriers restricting it to large investors. Favorable market conditions in the
1990s have fostered this expansion and made available information and a
significant increase in the number of funds.
The main advantage resulting from hedge funds investing is its high
potential for profitability. However, in order to balance risk, investors
should diversify and make sure they have access to accurate information.
Summary-Hedge Fund Strategies
There is a large array of strategies available to managers. Such strategies can
be altered, depending on market fluctuations.
Long/Short equity
The manager invests in undervalued or overvalued equities. This strategy
may be used in one or several industries.
Relative value/market neutral
Such strategy implies buying and selling at the same time similar securities
to take advantage of pricing differentials. The goal is to smooth the effect of
market fluctuations.
Macro
Macro-economic models are often used to decide on various global
strategies (i.e. across countries, markets, and currencies) and to invest in
different financial vehicles. This strategy is characterized by flexibility but
implies a high degree of risk.
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Distressed securities
Such strategy implies to invest in companies with financial difficulty, in the
process of restructuring, or bankruptcy, or with low credit ratings. Portfolios
usually concentrate in debt instruments.
Merger arbitrage/event-driven
Managers invest in companies, going through a process of a major change in
their financial structure and operating strategy. In order to protect the
portfolio, managers need to carefully manage risk, diversify, and use
hedging strategies.
Short selling
Managers speculate, establishing short positions in companies that are
expected to go downward.
Emerging markets
Managers invest in debt and equity securities in new financial markets with
high growth potential.
Sector
Such strategy concentrates investments in specific sectors that are expected
to grow significantly (such as technology, and health sciences).
Chapter 11
An Introduction to Healthcare
Biotechnology Private Equity
Investing
O
nce reserved only for institutional investors (such as pension plans),
private equity investments are attracting more individual investors
because they offer more opportunities. By definition, private equity
investing means making an investment in the nonpublic securities of a
company that may or may not be public. Table 11-1 lists the pros and cons
of private equity investing.
There are three general categories of private equity investing, each of
which has its own subcategories, differing by investment strategies:
•
Venture capital
•
Buyouts or leveraged buyouts (LBOs)
•
Special situations
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Table 11-1. The Pros and Cons of Private Equity Investing.
Advantages of private equity
investing
Attractive rates of return
Low correlation with the public
equity markets
Potential tax advantages (because of
long-term)
Concept of "Perfect Information"*
Drawbacks of private equity
investing
Risk because of irregular
capital calls and harvest
schedules
Illiquid nature of most private
companies
Risk of loss of capital
* "Perfect information" refers to the ability private equity managers have to
access crucial information such as the strategic and tactical plan of the firm.
Such access to information is most helpful in deciding in whether to invest
and when to invest.
I. Healthcare Venture Capital
Venture capital is a business, which consists in building businesses, that is,
investing in companies that have undeveloped or developing products or
revenue. Venture capital typically concentrates in areas such as new
technologies: communications, and the biotechnology industry. Over the last
few years, venture capital, benefiting from the tremendous rate of return in
these sectors, has gone through impressive growth.
Nevertheless, while potentially providing higher rates of return, venture
capital remains much riskier since it is dependent on fluctuations of the
equity markets, (particularly for initial public offerings or IPO's)
Introduction to Healthcare Biotech Private Equity Investing
183
Four Investment Stages of Health Care-Biotech Venture
Capital Funding
1. Early/Seed Stage
Investors commit capital to companies that are still in a conceptual phase of
development or are not yet fully operating. Funds are allocated to research,
product development, and initial marketing.
2. Second Stage
Investors commit capital to companies that are already producing and
shipping products or have growing accounts receivable and inventories but
may not yet be profitable.
3. Third Stage
Investors commit capital to companies that are breaking even, turning profit,
or are profitable in order to support a major growth expansion. Funds are
typically allocated to marketing, and product development.
4. Late Stage
Investors commit capital to provide for the growth of already-established
companies.
II. Healthcare Buyout Funds
Unlike venture capital, buyouts are affected by one or two large buyout
funds looking out for funds in the market. Although buyouts are very
speculative compared with venture capital, they are usually less risky.
Buyouts typically concentrate in areas such as communications,
finance/insurance, real estate, and consumer products industries.
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III. Special Situations in Healthcare
Special investing situations focus on distressed debt, equity-linked debt,
project financing, and one-time opportunities. A major portion of this
category includes investment in subordinated debt, also known as
"mezzanine debt financing."
The distinction between all three categories becomes blurred over time
because the distinctive criteria of early/late stage does not apply as much
any more.
Key Considerations
•
Private equity investing is particularly relevant for long-term investors.
In the long run, they are able to bear the higher risk they incur.
•
Private equity investing may be a way to diversify the investors'
portfolio. The correlation between private equity and public equity
markets is low.
•
Private equity provides a way to invest more efficiently and to foresee
future performances. Investors have access to significant data.
•
Private equity can help to mitigate risk. Investors have control of the
management team and strategic direction.
•
Private equity investments remain illiquid (unless contractually allowed
to sell). Usually private equity funds involve a 10-year commitment,
which can be extended.
•
Private equity investors should always keep liquid assets to meet their
funding obligations. Originally, investors were required to fund only a
small portion of their total capital commitment, the rest funded through
subsequent capital calls.
•
Private equity investing involves two kinds of fees: 1) Management fee:
1-2% of committed capital. 2) Incentive fee or "carried interest" 20% if
the fund achieves a certain level of profitability. Usually, fund
Introduction to Healthcare Biotech Private Equity Investing
185
managers invest their own capital in order to improve the fund's
trustworthiness.
•
Investors will not reap any benefit in the first years of their investment.
The capital invested at the beginning is relatively small, and the cost of
management and other expenses is relatively high.
How to Participate in Private Equity Investing
Restrictive factors to private equity investments are:
•
High minimum investment levels
•
Limited access to information
For these reasons, this type of investment usually applies only to
wealthy investors who can afford to get information and invest on their own.
Easier access is made possible through feeder funds or fund-of-funds where
investors can access professional due diligence and lower capital
commitments.
Considerations for selecting a private equity fund are:
•
The track record from a previous fund
•
The quality flow of capital into the fund
•
The experience of the management team
Reasons Why the Track Records Are Important?
•
The fund's objectives usually do not indicate the companies to be
invested in.
•
The track record is an indicator of future success.
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186
Five Basic Ways To Participate in Healthcare Private
Equity Investing
Each alternative presents specific features and benefits.
1. Invest Directly
Investors have a high level of net worth and liquidity. They must be able to
access information to evaluate complex situation.
Disadvantages
Advantage
High rate of return
High risk of losing the invested capital
Makes diversification difficult
2. Invest in Private Equity Funds
Investors invest through funds that are managed by investment
professionals. Such funds typically control the companies they invest in.
Advantages
Disadvantages
Allows for diversification
Risk of losing capital is low
Access remains difficult because of high
minimum investment requirements
3. Invest Through a Feeder Fund
Investors are individuals or smaller institutional investors.
Disadvantages
Advantages
Minimum investment
requirement (usually $1 million)
Fees are charged for accessing
management
4. Invest Through a Fund-of-Funds
This is a fund pool. Money is invested in a number of private equity funds.
Introduction to Healthcare Biotech Private Equity Investing
Advantages
Cost-effective diversification
Minimum investment requirement
(between $1 and 10 million)
187
Disadvantages
Risk of lower performance
Additional fees and expenses
5. Invest Through a "Gatekeeper" Consultant
Investors are public pension funds and other large institutional investors. A
knowledgeable independent consultant can help you select the fund
managers.
Advantages
Disadvantages
Helps selecting and accessing private equity fund
managers
Receives third party asset allocation expertise and
constant monitoring of funds
Fees
Measuring Performance of Healthcare Biotech Private
Equity Funds
Unlike mutual funds and hedge funds, whose performance is measured by
time-weighted rates of return, performance of private equity investing is
measured by an Internal Rate of Return (IRR), which is a standard
promulgated by the Association for Investment and Management Research
(AIMR). The IRR is computed like the yield-to-maturity on a fixed income
investment.
The reason for not using a time-weighted rate of return is that only a
portion of the committed capital is actually invested. The IRR calculation
covers only the time when the capital is actually invested and is weighted by
the amount invested at each moment.
Definition of the IRR: Discount rate used to equate the initial cash
outflows associated with an investment and each of the cash inflows that
may come from realizations, partial realizations or its mark-to-market.
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Considerations used for comparing the performance of private equity
funds:
1) Relevant comparison should be made within the same subcategory of
private equity investing because each category has a different risk level.
2) Only private equity funds with the same inception year should be
compared because each fund has evolved in a specific environment.
Conclusion
Private equity funds have grown tremendously in the last decade, primarily
due to investments committed by institutional investors. However, more and
more individual investors are attracted because of lower minimum
investment requirements and easier access to managers.
Private equity funds are a good alternative to incorporate into a
diversified portfolio in that they potentially allow for higher return in
exchange for a higher level of risk.
Chapter 12
Retirement Planning
Considerations For Biotech
Executives and Investors
Tf you had worked for Enron, and then left for a new opportunity before
-*-their Chapter 11, what options would you have for your 40IK or pension
plan? This chapter (along with the biotech option chapter) will discuss the
options you can choose and precautions needed to manage risk. Our
modern economy requires more investor discipline and several sources of
retirement income to succeed. It is important to recognize that Social
Security and employer-sponsored pensions are becoming a proportionately
smaller part of a retiree's income. Therefore, your personal savings plan
will need to be strategic and produce a comfortable return. Figure 12-1 pie
chart shown below shows various sources of income for today's retirees.
Changing Careers: Affecting Your Retirement Savings
When you change careers, there are different options for retirement savings
management, each with corresponding consequences and stipulations. If you
are on a tight budget, your first thought might be to take the cash
distribution from your current plan. Though this may provide instant
gratification, the long-term picture is not as satisfying.
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Once you take the cash distribution, the tax-deferred status of your
retirement savings is no longer in effect, therefore requiring your employer
to withhold 20% of all eligible rollover distribution pre-payment of federal
income tax. Indeed you may find this 20% doesn't even cover what you owe
the government. In addition to federal taxes, depending on your state of
residence, you may be vulnerable to state and local taxes as well.
Furthermore, if you're under age 591/2, you could owe another 10% of your
distribution to the IRS as a penalty for early withdrawal. After paying all the
necessary taxes and penalties, your nest egg will be severely diminished.
For example, an employee had amassed $100,000 in savings and opted
for a cash distribution. This employee would only get to keep $54,000 due
to the following tax consequences: 28% federal tax bracket, 8% state and
local income tax rate, and possible early withdrawal for those under age
591/2.
If you've become employed elsewhere, you may also look at your new
company's retirement plan offering. Holding your savings in your past
employer-sponsored plan limits your investment choices, as the number of
investment vehicles from which you may choose might be smaller than one
dozen and consolidation is often prohibited. However, your account can
maintain tax-deferred status, and some plans will permit loans.
Comparison shopping may prove beneficial, but often the same
obstacles may be apparent. Tax-deferred status and loans will most likely be
available, your investment choices will still be limited, and generally you
will not be eligible for equal payments under rule 72(t).
Direct And Indirect Rollovers: Spinning Your IRA
A direct rollover is one way in which the money is transferred directly from
your employer's plan to another qualified plan such as a rollover IRA; in
this case, you will not receive a physical check. Conversely, an indirect
rollover occurs when you have recently received a retirement plan
distribution check and decided to move it to a qualified plan, such as a
Rollover IRA. Unfortunately, the check you received in this instance has
had 20% withheld in taxes. In order to roll the entire [eligible] amount it into
Retirement
Planning
Considerations
for Biotech
Investors
191
an IRA, after you have received a check, you would have to make up that
20% out of your own pocket.
Sources of Income in Retirement
Earnings
20%
Social Security
40%
Other
4%
Company s
Retirement
Plan 18%
Savings &
Investments 18%
Source: U.S. Census Bureau, 1998
Figure 12-1. Retirement Sources.
Rollover and accumulate rollover IRAs offer the most flexibility when
you change jobs. Giving you the widest variety of investment options,
Rollover IRA's allow you to consolidate your retirement savings from
previous lump sum distributions and future distributions as well. They may
be tapped for income prior to age 59'/2 by taking substantially equal
payments as defined by the IRS rule 72(t).
The IRA rule, 72(t), allows you to tap into your rollover IRA account if
you need this money as an income source before you reach age 591/2. If you
need to take a distribution, it must consist of substantially equal payments amounts based upon the participant's life expectancy. These payments must
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The Essential Biotech Investment Guide
be taken for at least five years, or until age 591/2, whichever proves longer.
The undistributed portion of the account retains its tax-deferred status.
The Tax-Deferred Rollover
As tax-deferred accounts have significant advantages over taxable accounts,
the most important decision concerns the management of your lump sum
distribution. Extending the tax-advantaged status of your retirement savings
and rolling it into an IRA will allow you an increased time horizon and
prolonged tax shelter. Should you roll your assets into an IRA early in life,
the benefits can prove lucrative.
Examine the hypothetical situation of career changes at age 28, 35, 42,
and 49, and an accumulation of $10,000 at each job, assuming a current age
of 65, and an steadily 8% growth rate, compounded monthly, with no
principal fluctuation. If you chose to begin rolling your assets at age 28 and
throughout the next three job changes, the tax-shelter would be most
effective for the compounding your earnings, and at age 65 your account
would be worth about $366,000.
Another situation, assuming continuation of tax deferred status, the
value of retirement savings if a lump sum distribution was taken in cashSi 36,000; the difference if you chose the rollover option is over $304,000.
Another hypothetical illustration (see Figure 12-2): An individual
contributing $2500 per year into a qualified retirement plan (401 (k)) earning
8% annually, compounded yearly for 10 years (assume a 10% early
withdrawal penalty and 31% tax rate). Income taxes are due when you take
a distribution from a tax-deferred investment. After 40 years, you will have
$200,000 more in your tax-deferred account through tax-deferred
compounding.
Retirement: Strategy
Once you make a decision as to which type of IRA(s) to fund, you will need
to choose investment vehicles for the accounts, and build a retirement plan
strategy that matches your long-term goals and risk tolerance. Asset
Retirement Planning Considerations for Biotech Investors
193
allocation will help you to diversify your financial resources among
individual asset classes of stocks, bonds, and money market instruments.
Particularly appropriate for tax-advantaged accounts are taxable fixedincome instruments, especially zero coupon bonds, mutual funds, and unit
investment trusts. Furthermore, the mix of your investments in your IRA
accounts will depend upon your long-term goals and time horizon for such
goals.
Tax-Deferred Strategies
Taxable vs. Tax-Deferred Savings
$700,000
$600,000
$500,000
Tax-Deferred
" ivestment
ax-Deferred
Investment
After Taxes
$400,000
+ s i o i ,500
$300,000
$200,000
+ S27.000
$100,000
10 Years
20 Years
30 Years
40 Years
Assumes saving S2500 ciich year. 8% annual rate of return and 31% tax brackei. Transaction cost is not included.
Figure 12-2. Tax Deferring Advantage.
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Chapter 13
Charitable Disposition of
Appreciated Biotech Stocks
Tnvestors with concentrated biotech equity portfolios are reluctant to sell
-•-their securities, as they are liable to capital gains tax. As some of the
strategies used to defer or even eliminate tax liability (equity swaps and in
some cases short against the box) are not allowed any more, investors look
for alternative opportunities to save on tax payments. Apart from hedging
and other strategies used to defer federal and/or state tax liability (such as
cashless collars, exchange funds, and covered call writing), investors may
consider charitable giving techniques. Such techniques, not only fulfill the
philanthropic objectives of investors, but unlike direct donations they
provide tax advantages while removing appreciated biotech stock from
portfolios. Such advantages consist in:
•
Minimize or avoid undesirable tax consequences
•
Obtain an immediate tax deduction
•
Diversify holdings
•
Benefit charitable recipients
•
Promote charitable objectives
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196
Three major instruments are used to achieve these goals:
•
Private foundations
•
Charitable remainder trusts
•
National philanthropic trusts
Both these instruments should be utilized according to each investor's
specific situation and with the advice of legal and tax advisors.
I. Private Foundations
A private foundation is a not-for-profit charitable entity-a trust or a
corporation depending on state law-that offers an individual many
advantages for charitable giving as well as income, gift and estate tax
savings.
There are different types of private foundations. We will concentrate on
the non-operating private foundation, which allows the donor, as a board
member or trustee, to keep some control over the foundation distributions.
However, tax laws impose stricter conditions on private foundations than
they do on public charities in terms of operation requirements and
deductibility of contributions. The reason for this is that donations to public
charities are usually used more quickly to satisfy charitable purposes.
Before the Taxpayer Relief Act of 1997, the amount of the deduction for
contributions of appreciated stock (publicly traded stock held for at least one
year) was based on the property's cost basis. Since 1997, this amount is
now based on the full fair market value of the securities. Such provision was
extended after it expired in 1998, to contributions made after June 30' 1998.
However the total amount is limited to 20% of the donor's adjusted gross
income (30% for public charities) with any excess deduction carried forward
for a maximum of five years.
In practice most of the 35,600 U.S. private foundations are family run.
To establish and operate a private foundation requires between $500,000
and $5,000,000 to cover costs. The IRS monitors the activities of private
foundations. There is a yearly tax (1 or 2%) on net investment income. A
Charitable Disposition of Appreciated Biotech Stocks
197
minimum of 5% of the average annual market value of their assets has to be
distributed every year. If the private foundation does not comply with the
legal requirements, or takes measures that might endanger its charitable
purpose, stringent penalties may be applied.
Consequently, it is important to keep referring to tax and legal advisors
and make sure all regulations and conditions are complied with.
II. Charitable Remainder Trusts
A charitable remainder trust (CRT) is an irrevocable trust that enables an
investor to transfer highly appreciated assets to a trust in exchange for a
lifetime cash flow without generating immediate gain taxes.
Assets are turned over to one or more charities in exchange for an
annual cash flow received by the donor or a beneficiary (or beneficiaries).
CRTs have a carryover cost basis and can be tax-exempt. Consequently, if
the appreciated equity is sold while inside the trust and the proceeds are
reinvested into a diversified portfolio, the gain will not be subject to tax. The
income beneficiary is taxed on the receipt of the annual payment. Taxation
differs depending on whether the income is considered capital gain, ordinary
income, or tax-exempt income.
The amount of the charitable deduction is based on the actuarial value of
the charitable remainder interest, which is determined based on the value of
contributed assets, the age of the beneficiary (or beneficiaries), the selected
payment rate, and the rate of return published by the IRS.
The income tax deduction in a single year for contributions of capital
gain property held more than a year is limited to 30% of the donor's
adjusted income if the beneficiary is a public charity and 20% if it is a
private foundation. Any excess deduction may be carried forward for a
maximum of five years.
A CRT allows the donor to act as a trustee and control the investments.
A CRT offers the most tax advantages for appreciated assets and can include
any type of asset.
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198
There are two CRT options offering different alternatives regarding
periodic payment computations:
A) Charitable Remainder Annuity Trust (CRAT)
It is established with only one initial contribution. Payments are made once
every year at a fixed percentage of at least 5% of the fair market value of the
trust's assets.
B) Charitable Remainder Unitrust (CRUT)
It can receive future contributions. Payments are made every year and
represent a percentage of the value of the trust. The amount of the payments
may fluctuate from year to year depending on the estimated value of the
trust at the end of the year.
For example, the maximum annual payout percentage allowed by law
increases from 5.06% when trust is formed at the age of 25 to 28.90% when
trust is formed at the age of 70 (assuming the minimum charitable remainder
interest allowed by law of 10% of the trust's assets and based on a 7.2%
Applicable Federal Rate AFR).
Investors who want a fixed income every year favor CRAT. Investors
who want their income to increase thus offsetting the effect of inflation
favor CRUT. In order to ensure the charitable purpose of the trust is
satisfied, the law requires that:
•
The annual fixed pay out percentage be between 5% and 50%
•
The actuarial value of the charitable remainder interest equal at
least 10% of the value of the property at the time of
contribution.
Conclusion
CRTs allow investors to receive a cash flow now and in the future as well as
they provide significant tax advantages. CRTs are a good instrument to
Charitable Disposition of Appreciated Biotech Stocks
finance a family project, and they allow for more generous tax deductibility
than those of private foundations.
In order to decide on which vehicle to use, it is important to get advice
from tax and legal professionals who will evaluate the specific needs of
investors, based on each individual's financial objectives and personal
situation.
III. Alternative Charitable Gift Program Through National
Philanthropic Trust (NPT)
Major Wall Street brokerage firms usually have a charitable gift program for
individual investors. It is offered on partnership with the National
Philanthropic Trust (NPT), an independent public charity serving a national
constituency. The program enables the donor to make an irrevocable gift,
cash, stock, mutual funds shares, etc. to a donor-advised fund. The
minimum amount is usually $25,000, with no minimum for additional
deposit. The donor receives an immediate tax benefit and has the
opportunity to recommend charities for donation. Table 13-1 illustrates the
tax benefit of depositing appreciated biotech stocks through the NPT.
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Table 13-1. Tax Benefit of Depositing Appreciated Biotech Stocks
Through NPT.
Method 1
Method 2
Original cost basisbought 1000 shares of
Amgen @$20 per share
Selling 1000 shares of
Amgen @ $60, and
donate the proceeds to
a donor-advised fund
Donate the 1000 shares
@ $60 of Amgen directly
to a donor-advised fund
Current value of Amgen
$60,000
$60,000
Capital gain tax
(@20%) paid by donor
$8,000
$0
Donation received by
charity
$52,000
$60,000 (Extra $8,000
for charity)
Income tax saving to
donor (36% rate)
$18,720
$21,600
Cost basis of donation
for donor
$41,280
$38,4000 (Donor Saves
extra $2,880)
Chapter 14
Managing Your Biotech WealthEstate Planning for Biotech
Investors, Executives, and
Founders
W
ealth is comprised of all assets of a person to which liabilities have to
be deducted. For each biotech investors, it often requires a lot of
energy and time to build wealth. Now you have made lot of wealth from
smart investing in biotech and technology, what is the next step to preserve
it? To a different extent, every one of us has some wealth. Assets include
real estate, stocks, bonds, bank accounts, businesses, pensions, and life
insurance policies. Liabilities include loans, mortgages. Usually, the more
wealth accumulated by an individual, the more he is concerned with
protecting whatever he already has. One major obstacle to maintaining
wealth is the high tax rate applicable to substantial estates. Another major
concern to people is to control who will benefit from the estate after one's
death. People want to protect their loved ones and make sure they will be
provided with whatever they need for the rest of their lives.
Basically, wealth incurs a three-stage cycle of building, protecting and
transferring. Estate planning is a necessary ingredient in each of these
stages, though it is most popularly used for the latter two stages (i.e., wealth
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The Essential Biotech Investment Guide
protection, wealth transference). Individuals should plan their estates for a
variety of reasons:
•
Reduce taxes and disinherit the Internal Revenue Service
•
Save heirs headaches and money (by avoiding probate, court battles,
etc.)
•
Reap tax benefits now
•
Help preserve wealth already built and efficiently transfer it to
beneficiaries
•
Allow individuals to increase their control as to how the estate will
be managed after death
A very efficient instrument to realize the three goals/stages is the creation of
a trust. Trusts are very efficient vehicles to avoid both prohibitive tax
payments and the hassle of going through probate. In particular, the
creation of a revocable living trust will prevent the probate process. Probate
is a legal procedure, which is long, complex, expensive and public. In any
case, it is important that every individual understand the necessity to plan as
early as possible because the occurrence of death may be hurtful for the
family, both financially and personally.
Alternatives Available
There are four different alternatives individuals can take (see Table 14-1).
1) Do Nothing
Too many people do nothing and die without having given any instructions.
State law then applies to determine who are the beneficiaries of the estate,
regardless of the person's wishes. This is the worst alternative.
Managing Your Biotech Wealth-Estate Planning
203
2) Joint-Tenancy
Holding assets in joint tenancy implies that each owner owns 100% of the
shared assets. At the time of the death of a joint tenant, the other one
remains with the entirety of the assets. However, this may not solve the
problems of taxes and probate, but only delay them. Furthermore, in case of
the remarriage of the surviving tenant, it may lead to the disinheritance of
the children of the deceased joint tenant since at the death of the surviving
tenant, all the assets will be transferred to the surviving tenant's new spouse
and ultimately to his/her own children.
3) Will
To create a will is a must since it is the only way to give instructions
covering all the assets. A will is essential even if one already has a trust
because not all assets are placed in a trust. A will is a written legal
document, whereby individuals can give instructions regarding the
distribution (who will qualify as beneficiaries) and the management of the
assets after they pass away. A will accomplishes many things including:
•
Help give property, for example, to a named beneficiary after one's
death.
•
Allow the appointment of an executor who will work with attorneys to
see that items are properly handled.
•
Allow the appointment of a guardian for one's children.
•
Create a testamentary trust that will come into existence after one's
death.
Even though there are advantages to having a will, there are some
limitations. It cannot disinherit a spouse, or transfer property already
determined by law or by contract (i.e., jointly held property, life insurance).
Wills are also more contestable than trusts.
The Essential Biotech Investment Guide
204
Table 14-1. Comparison of Four Alternatives.
Do
nothing
JointTenancy
Will
Revocable
Living Trust
No
No
No
Yes
None
None
Inexpensive
Yes
Costs at Death
Yes
Yes
Yes
No
Timely
Distribution
No
To first
spouse only
No
Yes
Contestable
Yes
Yes
Yes
Yes, but difficult
to do
successfully
Flexible
Yes
Yes
Yes
Yes, until death
when trust
becomes
irrevocable
Privacy
No
First
spouse only
No
Avoids
Probate
Initial Costs
Yes
Moreover, a will can have unforeseen negative consequences:
•
Unintentionally disinherit your family
Disinheritance will occur when spouses have children from a previous
marriage and own jointly held property. In such cases, the property of one
Managing Your Biotech Wealth-Estate Planning
205
spouse will, in the first place, be transferred to the surviving spouse and in
the second place to his/her children, leaving the children of the first spouse
deceased without anything.
•
Start the probate process
Probate is a legal process by which a will is proved valid, debts are paid, an
executor or administrator is appointed by a court and the estate is distributed
to the heirs. A will does not allow avoiding the probate process.
•
Invite what is called the "Groucho Marx" problem
The Groucho Marx problem deals with the consequences involved when an
individual becomes incompetent or incapacitated to manage his/her assets
properly (as was the case for that famous actor/comedian).
4) Revocable Living Trust
This type of trust is established during the individual's lifetime through a
formal written legal agreement. A trust is like a corporation, a legal entity;
and thus, it must pay taxes (but very different in that a corporation has
limited liability and a trust does not). A trust is usually created to split
property interests whereby some beneficiaries will receive income while
others will receive principal receipts, such as stocks. Assets in a trust
generally avoid probate.
There are three types of trusts:
•
Revocable trusts: offers greatest flexibility, i.e., trust can be terminated,
changed.
•
Irrevocable trusts: advantageous for tax-planning but not flexible.
•
Testamentary trusts: created upon the individual's death. While it does
not avoid probate, it offers many tax-savings strategies.
Some important terms to know are: grantor and trustee. The person
establishing the trust is called the grantor. The individual or institution
named to hold the grantor's assets is called the trustee. Although ownership
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The Essential Biotech Investment Guide
is transferred to the trust, the grantor maintains control of these assets
(mainly in a revocable trust). There are many advantages to owning a trust
and specifically a Revocable Living Trust (RLT).
Below Are Some of the Advantages Resulting From the
Creation of a RLT
To create a RLT allows the grantor to avoid the long and costly probate
process, and maintain control of his/her assets while allowing for protection
against incapacity. The RLT reduces time, money, and frustration.
•
Avoid probate. Depending on the cases, probation costs range between
3-8% but can be as high as 10% of the assets' gross value. There may
also be additional costs such as the executor's fees, the appraiser's fees,
and filing and administrative fees. The probate process is also a very
long-winded process and can take as long as two years (sometimes even
longer) to complete. Moreover, probate allows any stranger to know
about family matters, since the probate process is public.
•
Maintain control of assets. The trust can be established with one
grantor or two (one spouse or both of them, depending on specific
situation and state laws). Grantors determine which assets to include in
the trust. Grantors decide who and how the trust will be managed.
They choose the beneficiaries and how assets should be distributed to
them. The trustee has no choice but to follow the document that
establishes the trust. As in a revocable trust, any of the terms of the trust
can be modified at any time.
•
Protect against incapacity. Protection against incapacity is another
important reason for establishing a Revocable Living Trust. A RLT
provides an efficient solution to manage assets while protecting privacy
in case of incapacity. It allows a grantor (individual) to put a plan in
place for any possible incapacity or if the grantor is unable to manage
his affairs. Otherwise, probate court is given power to step in and
appoint a guardian who will take control of the grantor's assets and
make financial decisions.
•
Reduce potential estate-tax liability. The trust can be structured in
such a way that estate tax laws are maximized (so can a will).
Managing Your Biotech Wealth-Estate Planning
207
•
Reduce income taxes in certain situation.
•
Provide different investment flows (i.e., income, principal payments)
to beneficiaries.
•
Provide professional management for trust assets (i.e., stocks). As
grantors are looking for ways to increase their wealth, a professional
investment manager may be appointed as manager to take care of
collecting the trust's income and manage and invest it in an efficient
manner.
Some Disadvantages Resulting from the Creation of a RLT
There are some disadvantages to a revocable living trust including:
Set-up costs. They include attorney's fee and trustee fee in case of a
corporate trustee. It is estimated that the estate should be at least $ 500,000
in order to offset the set-up costs (when less, if contestability is an issue or
real property is owned in more than one state, an RLT makes sense).
There is the burdensome need to re-title assets in the name of the trust.
This can be inconvenient but will need to be done anyway whether while
living or after death.
There exists the possibility of asset and portfolio mismanagement by an
inexperienced trustee. One of the biggest potential disadvantages of a RLT
is mismanagement of the trust by the trustee or successor trustees. The
trustee has a fiduciary duty to manage and invest the trust's assets exactly
according to the trust documents. If not, the beneficiaries may not receive
expected proceeds as originally envisioned by the grantor. Some trustees
are friends and family of the grantor while other trustees are corporations.
Given that the fiduciary requirement requires unbiased decisions, it is better
to have a corporate trustee than a personal friend or family trustee so as to
avoid emotional or personal relationship to interfere. Other reasons to
choose a corporate trustee to manage the trust are, experience of the
corporate trustee in financial management, financial resources, knowledge
of tax regulations, administrative capabilities, impartiality and reliability.
From a financial point of view a professional trustee will charge a fee
whereas an individual trustee may not. However, in the long run, it may
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The Essential Biotech Investment Guide
be more costly to use an individual trustee than a professional trustee, since
the individual trustees, as they may lack experience, would likely have to
pay for the services of professionals in order to fulfill their fiduciary duties
and comply with all the rules and regulations.
Other Trust Strategies to Minimize Estate Taxes
A) Credit Shelter Trust (CST) (Also Called a "Bypass Trust")
As its name implies, the bypass trust or CST allows the individual or grantor
to pass on half of an estate valued $1 million as of 2002 (1.5 million as of
2004 and 2 million as of 2006) to a beneficiary who is most likely a
surviving spouse. This transfer is made free of taxes. The spouse does not
pay estate taxes on any amount of asset because of the marital deduction,
which allows him/her to inherit any amount without any federal tax. The
remainder of the estate goes into a trust for other beneficiaries, such as
children. These beneficiaries do not receive anything from the trust until the
spouse dies. While the spouse cannot touch the money in the trust (since it
is the children's) he or she can receive income from the trust. Therefore, the
spouse becomes the income beneficiary while the children become principal
beneficiaries. The advantage of the CST is that it doubles the amount of
inheritance free of federal taxes to $2 million. This trust is most appropriate
for someone with an estate over $1 million, a higher threshold than the
revocable living trust.
B) Two-Trust Estate Plan (A-B Trust)
This trust starts out as one trust owned by both husband and wife. When
one spouse dies, the trust splits into two (some attorneys suggest that each
should have their own RLTs at first). Trust "A" is for the surviving spouse
who has full control of that trust. Trust "B" is for the deceased spouse for
the benefit of the surviving spouse and the children (see Figure 14-1).
Typically, the surviving spouse only receives the income from Trust "B"
(should be discretionary) while the children receive the principal after the
other spouse dies. This type of trust allows the children to receive up to $2
Managing Your Biotech Wealth-Estate Planning
209
million without paying estate taxes and avoiding the numerous costs related
to probate.
C) Qualified Terminable Interest Property Trust (QTIP)
This is an alternative version of the A/B Trust just discussed. A QTIP trust
is usually used by individuals who have children from a first marriage and
got married a second time. It allows the grantor to instruct how the proceeds
are to be distributed upon the death of the second spouse. That way, the
grantor gives his/her spouse lifetime income and also allows them to choose
who will receive the trust property after the second spouse's death. Without
this kind of trust, an individual's second spouse could have control over all
of the individual's estate regardless of the children's needs. A QTIP trust
also prevents the grantor's life saving from going to the estate of the
surviving spouse if he or she remarries after the second spouse's death
(many states require that a QTIP trust be combined with a "spousal waiver"
to be effective).
D) The Irrevocable Life Insurance Trust
The role of life insurance should not be underestimated as it a good option
to add to an estate plan. Life insurance allows families to continue their
lifestyle since it may prevent them from needing to sell their assets to pay
for everyday bills and estate taxes. This is typically accomplished by
creating an irrevocable life insurance trust. Such trusts provide substantial
tax advantages, provided they are structured as irrevocable. They are
commonly used to pay estate taxes but can also be used to reduce an
individual's taxable asset. This is accomplished by placing the life
insurance policy in a trust, so it is not counted as part of the individual's
estate. Already existing insurance policies can be included in the trust or
new policies can be purchased by the trust. In the first case, the donor
insured must live at least three years from the date the insurance is given in
order to keep the policy proceeds out of his or her estate.
Main benefits of Irrevocable Life Insurance Trusts are:
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777© Essential Biotech Investment Guide
1. Federal gift tax annual exclusion. Typically, the donor makes
annual gifts to the trust so that it can pay the insurance policy
premiums. The gifts can qualify for the $11,000 annual exclusion if
the trust beneficiaries are given the power to withdraw the gift
within a limited time frame.
2. Avoidance of federal estate taxes. The trustee need not pay any
federal estate taxes upon death benefits of the policy. Overall, about
40% of all estate taxes are paid by insurance (but insurance can pay
all the estate taxes).
3. Generation-skipping benefits. Like most trusts, beneficiaries are
usually spouses, children, or grandchildren.
4. Professional asset management for survivors. As an example, the
trust can purchase illiquid assets from the estate in order to provide
cash for the estate to pay taxes (though this must be accomplished
through specific non-mandatory language). Also, the trust ensures
that the proceeds of the policy are used and managed in the way the
grantor wanted (but if this is done, the UTMA assets are includible
and taxable in the custodian gift-giver's estate. The gift-giver
should not be the custodian).
E) The Charitable Remainder Trust (CRT)
One should not be misled by the name "Charitable Remainder Trust" given
to the trust. CRTs are efficient estate planning instruments and provide
significant financial benefits, i.e. they reduce taxes. As a result, it has
become a very popular method of giving money to charities. Congress
established the CRT in 1969. A CRT does not avoid taxes but provides a
tax alternative as it allows for redirecting dollars earmarked for federal and
state taxes to charitable organizations such as schools and hospitals. A CRT
is a special irrevocable trust that is established for the sole benefit of the
grantor and beneficiaries. It provides major tax incentives in return for
future gifts to charity.
Benefits of a CRT include:
Managing Your Biotech Wealth-Estate Planning
•
Avoid immediate capital gains taxes
•
Increase spendable income
•
Receive current income and future estate tax deductions
•
Provide estate tax-favored transfer to heirs and make a substantial
future gift to charity
The grantor benefits most by transferring his/her highest appreciated
assets (i.e., biggest stock market gains) into an irrevocable trust that names
one or more qualified charities as beneficiaries. The trust then sells the
appreciated assets at full market value and reinvests the proceeds in incomeproducing assets that grow tax-free. In addition, funds are often reinvested
in more conservative, income producing assets. This helps diversify the
portfolio as well. The individual or other family members can receive
lifetime income from the trust after the initial assets are sold. In addition,
the individual or grantor receives an income tax deduction equal to the
present value of the charity's remainder interest. When the grantor or the
last beneficiary dies, the remainder of the trust goes to the designated charity
(life insurance is frequently used to replace the assets going to the charity).
Gift Giving
Gift giving is another way to save on estate taxes. It is quite popular since
gifts are free from income taxes, they reduce the value of an estate and they
allow for more control of where assets are going. However, only up to
$11,000 dollars can be given to a particular individual every year and it may
be too slow a process for big estates to be reduced. Moreover, the person
who gives has no control on how the money is spent once it is given.
Gifts in Trust to Minors
The major impairment with giving to a child may be a potential tax problem.
The money put into a trust is considered to be a future interest gift and as
such does not qualify for the $11,000 annual exclusion.
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The Essential Biotech Investment Guide
However, there are a few ways of getting around this (but, a child has
access at age 21):
Create a "Minor's Trust." By setting up a Minor's Trust, an individual
may hold money for the benefit of a child and yet avoid placing a lot of
money directly in the hands of an immature person. With a Minor's Trust,
tax-free gifts can be given to children for their use in the future, i.e., college
tuition.
Create a "Crummey Trust." In a Crummey Trust, the child is given the
right to withdraw the gift from the trust for a fixed period of time. Since the
child is given this right, the gift is considered as a "present" interest and may
qualify for the $11,000 annual exclusion.
Uniform Transfers to Minors Act (UTMA) or Uniform Gifts to Minors
Act (UGMA). This allows for irrevocable gifts to be given to minors
through a transfer to a custodian. In any case, there is no trust agreement
with this type of account. Also if the giver and the custodian are the same
person, there is no reduction of the value of one's estate. Since there may be
income tax implications, it is advisable to inquire with a tax advisor.
Use of a Corporate Trustee When Creating a Trust
When creating a trust, it is recommended that the individual use a corporate
trustee such as an investment firm or professional financial planner.
Benefits of a corporate trustee are numerous including:
Investment management and trust experience
Highly regulated by state and federal government (reduces chance of fraud)
Professional asset management (the trustee should have the investment
resources and variety available in order to meet each investor's specific
needs)
Managing Your Biotech Wealth-Estate Planning
2^3
Reliability (it is easier to rely on a firm's totality of investment professionals
rather than one particular trustee who could get sick, etc.)
Objectivity (use of personal friends and family members as trustees could
significantly reduce objectivity)
Trust Administrative Services
Trust administrative services are a very important component of the trust.
Trust administration refers to all of the investment transaction activity, tax
filings and other fiduciary paperwork required of the trust. Specific services
include custody and safekeeping of all assets, distribution of trust income
and/or principle to beneficiaries. These services also include making tax
decisions concerning the trust and preparing and filing its tax return.
When to Check the Estate Plan
Though trusts and estate plans, in general, can generally be left untouched,
individuals must check their estate plans when undergoing a life event.
Such events include: births, deaths, relocating, marriages, a significant
change in personal wealth, divorces, a change of jobs or tax law. Each of
these events will impact the individual's estate, and it is advised that he or
she contact an attorney, estate planning specialist or investment professional
to decide whether the event will have any direct implication on the estate.
However, it is always advisable to periodically review your estate plan.
Conclusion
Biotech investors and entrepreneurs should have a will even those who have
trusts. It is recommended that individuals create a trust if their assets exceed
$500,000. If so, a variety of trusts can help one reduce taxes both future as
well as present. Furthermore, trusts allow the individual's family to benefit
from one's hard work and wealth building without the frustration and costs
of going to court and family feuding.
The Essential Biotech Investment Guide
214
No Trust Flan
(Assuming Bioentrepreneur
Husband D i e s First)
AJB Trust P l a n
(Assuming Bioentrepreneur
Husband D i e s First)
Husband $ 1
Million
Estate
Wife$l
Million
Estate
Wife's
App lie able
Exclusion
Amount ($1
Million)
Wife's
Applicable
Exclusion
Amount ($1
Million)
Federal Estate
Taxes (on $2
Million Minus
Credit for Tax o n 1
Million)
Figure 14-1. Tax Saving through Estate Planning.
Husband's
App lie able
Exclusion
Amount ($1
Million)
Epilogue
There you have it—a book to help you make a wise investment in
biotechnology and life science sector and preserve your biotech wealth. You
are already much richer than you were before we connected; n'cest-cepas?
I wish you a vital life of personal growth and rich fulfillment and wealth
growth through long-term investment. I trust my work would be a part of the
growth. I urge you to read this book more than once, since it contains a
great deal of useful or perhaps profitable information, and recommend this
book to a friend. I advise you, as a friend, to have an investment plan and to
stick to a style and discipline you like, to be patient, and to grow your
wealth over time. I thank you for your trust in me and in the publisher. And,
I hope you accumulate a lot of wealth over your lifetime through wise and
intelligent investments, including the biotech and life sciences sector, and
make intelligent use of your wealth for your family and society. Wish you
all the best.
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Appendix A
What Is Technical Analysis?
T^he purpose of technical analysis is to foresee the price of securities. It
A
involves trend analysis and recognizing highs and lows of stock prices.
When combined with sound fundamental analysis, technical analysis can be
helpful in stock selection, when it comes to timing the purchase and sales.
Reading chart may seem a daunting and terminology of the technicians
intimidating. You need to learn to interpret when the trend of a specific
stock or market. As someone in Wall Street once said: "Never go against the
trend" (see Figure A-l).
I. The Dow Theory
This theory, named after Charles H. Dow, is the basis for modern technical
analysis. The assumption sustaining the Dow theory is that the market
reveals all the information available to investors so that trends of stock
prices can be projected or assessed. According to this theory, the
movements of stock prices can be analyzed at three different levels:
•
Primary movements: those can be observed in the long term and
indicate whether markets are bullish or bearish.
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The Essential Biotech Investment Guide
218
•
Secondary movements: those can be observed during shorter time
periods and usually indicate opposite trends to the ones observed in the
primary movements.
•
Daily movements: those constitute the secondary movements when put
together.
II. Four Groups of Technical Indicators
All indicators that are used by technical analysts can be classified in one of
the following four categories. Such indicators are most significant when
used one against the other as some of them provide relevant information
when applied over the short term and others when applied over the long
term, some of them when reaching a certain range and others when reaching
extremes.
Secular Indicators
•
(20 to 30 years or two or more stock market cycles)
Asset allocation indicators-which show how portfolios are being
structured. The information is provided by the Federal Reserve's Flow
of Funds Statistics.
•
Valuation indicators-which reveal the amount of trust investors place in
stocks. Yields and payout ratios are significant measures.
Cyclical Indicators
(4 to 5 years or one stock market cycle)
In order to evaluate whether the market is bullish, cash and cash flow are
relevant indicators on a cyclical basis. The information released by the
Investment Company Institute (ICI), (i.e., Cash position of mutual funds),
helps technical analysts to detect any significant change in the actual trend.
Similarly, they can follow the U.S. buying of foreign stocks and the foreign
What is Technical Analysis?
219
buying of U.S. stocks, as it is a good supply/demand indicator. This
information is released by the Securities Industry Association.
Medium-Term
Indicators
(three to six months)
Since professionals have to publish their performance results on a quarterly
basis, the medium-term period is definitely critical for analysts. Sentiment
indicators measure how bullish or bearish investors are. As a result, they are
most relevant in the medium-term technical analysis. However, their use is
worth only as they reach extremes and if taken into account along with other
factors such as traders liquidating, investors buying and stability after a
decline. Also, it is interesting to note that sentiment indicators will foresee
highs a few months before they actually occur whereas they will precede
bottoms by only a few weeks. Often, a period of consolidation is observed
where prices stabilize before they make the next move: up, if the market was
already in an up trend, or down, if the market was already in a downtrend. It
is important for technical analysts to be dedicated and follow the markets on
a daily basis. There are different categories of sentiment indicators:
•
•
•
Polls evaluate reactions of speculative investors. Analysts recommend
using moving averages of those polls in order to smooth the results.
Transactional indicators disclose actual investments people make.
Information in that matter is pretty scarce but in order to get an idea,
analysts compare conservative and aggressive customer activity (cash
versus margin accounts) or conservative and aggressive businesses
(NYSE versus the Nasdaq markets).
The traders' attitude, regarding the short-term period, also gives analysts
relevant information. The following ratios assess participants investing
in the short-term (traders):
a) Put/call ratio, which is the put volume relative to the call
volume as reported by the Chicago Board Options Exchange CBOE. High ratios indicate market bottoms. Low ratios indicate
market tops. A 10-day moving average is used.
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The Essential Biotech Investment Guide
b) Put/call ratio for index options and equity options only. A
10-day moving average of the S&P 100 OEX is used.
c) Option premiums. Total put premium/Total call premium for
equities and indexes as reported by the Options Clearing
Corporation (OCC). A 4-week moving average is used.
d) Large block statistics (50,000 shares or more). A rising ratio
indicates that institutions are collecting money, which is good.
On the other hand a falling ratio shows that institutions are
liquidating. A 10-day moving average of the ratio of upticks to
downticks is used.
e) Corporate insider activity. This ratio assesses participants
investing in the long term. An eight-week ratio of sells to buys
as reported by Vickers is used.
a) Put/Call
ratio
Bullish
>1.0
Bearish
<0.6
b) Put/Call (index
& equity) ratio
> 1.3 for index
options
> 0.65 for equity
options
< 0.9 for index
options
< 0.35 for equity
options
c) Option
Premiums
d) Corporate
Insider
Activity
>1.5
<1.25
<0.5
>3.1
The following indicators are measures of speculative interest:
f)
Relative volume (Daily volume in the OTC/Daily volume in
the NYSE). Peaks in the market coincide with peaks in the
ratio.
What is Technical Analysis?
221
g) Relative price (S&P low-grade index/S&P high-grade index).
A raising index indicates bull markets; a declining index
indicates bear markets.
h) Average price of most active list. Usually, it is low at market
tops and high at market bottoms.
i)
•
Volume in 30 Dow stocks versus the NYSE. Usually, it reacts
the opposite way to the market.
Short-Term Indicators (less than three months). Short-term
analysis basically relies on the internal dynamics. Please note that
price and volume are used in longer term analysis such as multidecade price chart. There is one quantitative and two qualitative
momentum indicators.
a) Price. Price, as a quantitative indicator, is the most important but it
is even more meaningful if corroborated by a qualitative measure of
trend. Several indexes can be used to assess prices but the NYSE is
most meaningful because it is broad-based and capitalizationweighted. Analysts use moving averages and compare them against
one another or against the price index in order to find out about the
intensity of a trend (overbought/oversold market).
b) Volume. Generally it reflects the price momentum. As a principle,
in an uptrend market, volume needs to continue growing in order for
the market to continue the trend. Therefore, if there is a big change
in volume, it may be a sign that the market is about to start a
downtrend.
c) New Highs and new lows. If more new highs are to take place in
an uptrend, it is a sign that the trend may last longer.
d) Breadth. Breadth is the difference between rising and declining
stocks. Analysts may add a 10-day upside volume, downside
volume and net volume. If net volume is negative, it may be that the
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market is oversold. In an uptrend, the market is usually overbought,
and may stay so for several months.
In any case, it is important in order for analysts to be efficient that they
take into account several indicators. Following the DJIA would not really
give any information about what is going on in the market. Here are some
examples:
•
INDU shows the weight of the change for each stock on the Dow; this
helps to determine stocks that put pressure on the market.
•
UP shows stocks gaining the most for the day; Stocks are ranked from
the highest to the lowest gain, which enables analysts to detect industry
sectors on the move.
•
HI shows new highs for the day, indicating the leading stocks.
Added together, all the statistics help getting a broader and deeper view of
the market.
III. Top-Down Technical Analysis
The long-term drives the short term. Analysts take decisions according to
the global picture of the market. If short-term indicators say investors should
buy, this is all the more relevant when long-term trends are up. Similarly, if
the cyclical trend were up a lot, any slow down on the shorter-term trends
would be less significant.
IV. Reading Chart Patterns
Charts are very helpful tools in the short term buy/sell decision process and
as such, are widely used by analysts.
223
What is Technical Analysis?
Six Items to Look for on a Stock Price Chart
1) Moving average. It is found by summing up a stock's closing prices and
by dividing the result by the number of days used in the average. The
moving average is compared against the stock price. If it moves above the
average, it is a buy signal. If it moves below the average, it is a sell signal.
2) Momentum. It is the rate at which price or volume is increasing. If the
upward momentum is high, the stock is likely to go up. If it is slow, the
stock is likely to be reaching its peak.
3) Volume. It is more bullish to have volume expand as the stock is rising
rather that when it is falling.
Indicators of stock
Strength
Indicators of stock
Weakness
During rally
Increasing volume
Decreasing volume
During decline
Decreasing volume
Increasing volume
As a principle, big stocks (large capitalization) hit lows on high volume.
Also, a big increase in volume and a stabilized price indicate whether a
bottom or a top. Therefore, high volume is bullish when relative to a bottom
and is bearish when relative to a top. Usually, a rising stock is traded on a
high volume, but a stock may be declining with little volume.
4) Relative Strength. It is found by dividing the stock price by an index
value over time. Then, analysts plot the results to create a line of the stock's
relative strength. When that line goes up it is interpreted as bullish.
However, an upward relative strength line does not mean the stock is rising;
it may mean that the stock is falling less than its relative strength line.
Relative strength is also used to measure one industry group against another.
5) Support Level. It is the price at which the stock has bottomed in the past
(demand exceeds supply). If the stock goes below this level (breakdown), it
is interpreted as bearish (see Figure A-2).
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The Essential Biotech Investment Guide
6) Resistance Level. It is the price at which the stock has peaked in the past
(supply exceeds demand). If the stock goes above this level (breakout), it is
interpreted as bullish (Figure A-2).
Patterns Indicating a Reversal in a Stock Price Trend
Reversal chart patterns reveal a change in the direction of a stock price:
1) Head and Shoulders. It is foreseen that when a stock price falls below the
right shoulder, it will further plunge (see Figure A-3).
2) Inverted Saucer or Dome (rounded bottom, see Figure A-4). This pattern
typically figures a gradual rounding at the top (bottom).
3) Triple Top (double bottom, see Figure A-5). This scenario represents the
inability of a stock to go beyond its resistance level (or support level) after
several attempts to do so.
4) Wedge. This pattern shows a stock whose tops and bottoms are each
higher than the previous ones but with a higher rate of acceleration for
bottoms than for tops. This is a sign of momentum loss and may announce
large declines. Wedges are more often continuation patterns than reversal
patterns.
Other patterns include Ascending and Descending Triangles, V tops and
bottoms round tops and bottoms.
Patterns Indicating a Consolidation in a Stock Price Trend
Consolidation chart patterns reveal a pause in a stock price's movement,
indicating that there is a consolidation of gains or losses before the stock can
move again. The support and resistance lines (see above) are may be
varieties of consolidation patterns (more often is continuation patterns).
There are two more varieties of this pattern: Flags and Pennants. In both
cases, the stock is anticipated to continue moving in the same direction as
the slope of the previous trend. There are several other types of continuation
patterns—rectangles, symmetrical triangles, wedges, ascending, and
What is Technical Analysis?
225
descending triangles (see Chapter 5 and 6 in John Murphy's Technical
Analysis of the Financial Markets for more insight on the subject).
Figure A-1. Down Trend.
226
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Figure A-2. Support and Resistance.
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What is Technical Analysis?
227
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Source: Technical Analysis from A to Z.
Figure A-2 to A-5. Chart Patterns.
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Appendix B
Biotech and Life Science Glossary
A
Adenine (A): A nitrogenous base, one member of the base pair AT
(adeninethymine).
Amino acid: Any of a class of 20 molecules that are combined to form
proteins in living things. The sequence of amino acids in a protein, and
hence protein function, are determined by the genetic code.
Antibody: A protein produced by the immune system in humans and higher
animals, which binds to a specific antigen. When antibodies bind to
corresponding antigens they set in motion a process to eliminate the
antigens.
Antigen: A foreign substance that, when introduced into the body, can
stimulate an immune response.
Antisense: A piece of nucleic acid, typically created in the lab, which has a
sequence exactly opposite to an mRNA molecule made by the body. mRNA
molecules made by the body serve as templates for the synthesis of protein
(see transcription). Since the "antisense" mRNA molecule binds tightly to
its mirror image, it can prevent a particular protein from being made.
Autoimmune disease: A disease whereby an individual's immune system
mounts an attack on a portion of its own tissues. Tissues undergoing such an
attack can be destroyed in the process. Rheumatoid arthritis is an example of
an autoimmune disease.
229
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The Essential Biotech Investment Guide
Autosome: A chromosome not involved in sex determination. The diploid
human genome consists of 46 chromosomes, 22 pairs of autosomes, and 1
pair of sex chromosomes (the X and Y chromosomes).
B
Base pair (bp): Two nitrogenous bases (adenine and thymine or guanine
and cytosine) held together by weak bonds. Two strands of DNA are held
together in the shape of a double helix by the bonds between base pairs.
Base sequence: The order of nucleotide bases in a DNA molecule.
Bioinformatics: the science of informatics as applied to biological research.
Informatics is the management and analysis of data using advanced
computing techniques. Bioinformatics is particularly important as an adjunct
to genomics research, because of the large amount of complex data this
research generates.
Biotechnology: A set of biological techniques developed through basic
research and now applied to research and product development. In
particular, the use by industry of recombinant DNA, cell fusion, and new
bioprocessing techniques.
C
Cancer: A term describing a broad range of diseases, all characterized by
uncontrolled cell growth. Cancer is always caused by a malfunction in an
organism's genetic material. This malfunction could be caused by an
inherited genetic mutation or by a somatic cell genetic mutation (i.e., a
genetic mutation acquired during an individual's lifetime).
Candidate gene: A gene that has been implicated in causing or contributing
to the development of a particular disease.
Chromosome: The self-replicating genetic structure of cells containing the
cellular DNA that bears in its nucleotide sequence the linear array of genes.
In prokaryotes, chromosomal DNA is circular, and the entire genome is
carried on one chromosome. Eukaryotic genomes consist of a number of
chromosomes whose DNA is associated with different kinds of proteins.
Clone: An exact copy made of biological material such as a DNA segment
(a gene or other region), a whole cell, or a complete organism.
Cloning: Using specialized DNA technology (see cloning vector) to
produce multiple, exact copies of a single gene or other segment of DNA to
obtain enough material for further study. This process is used by researchers
in the Human Genome Project, and is referred to as cloning DNA. The
resulting cloned (copied) collections of DNA molecules are called clone
libraries. A second type of cloning exploits the natural process of cell
Life Science and Biotechnology Glossary
231
division to make many copies of an entire cell. The genetic makeup of these
cloned cells, called a cell line, is identical to the original cell. A third type of
cloning produces complete, genetically identical animals such as the famous
Scottish sheep, Dolly.
Code: See genetic code.
Codon: See genetic code
Combinatorial chemistry: A technique for rapidly and systematically
assembling a variety of molecular entities, or building blocks, in many
different combinations, to create tens of thousands of diverse compounds
that can be tested in drug discovery screening assays to identify potential
useful candidates.
Complementary DNA (cDNA): DNA that is synthesized from a messenger
RNA template; the single-stranded form is often used as a probe in physical
mapping.
Cross-licensing: A legal agreement in which two or more parties which
have potentially conflicting patent claims strike a deal to share rights to the
product or process in question.
Cytosine (C): A nitrogenous base, one member of the base pair GC
(guanine and cytosine).
D
Deletion: In the process of DNA replication, a deletion occurs if a
nucleotide or series of nucleotides is not copied. Such deletions may be
harmless, may result in disease, or may in rare cases be beneficial.
Diagnosis: the act of identifying the presence of a disease.
Directed mutagenesis: A specific alteration of a cloned gene in vitro before
the gene is placed back in to an organism.
DNA (deoxyribonucleic acid): The molecule that encodes genetic
information. DNA is a double stranded molecule held together by weak
bonds between base pairs of nucleotides. The four nucleotides in DNA
contain the bases: adenine (A), guanine (G), cytosine (C), and thymine (T).
In nature, base pairs form only between A and T and between G and C; thus
the base sequence of each single strand can be deduced from that of its
partner.
DNA replication: The use of existing DNA as a template for the synthesis
of new DNA strands. In humans and other eukaryotes, replication occurs in
the cell nucleus.
DNA sequence: The relative order of base pairs, whether in a fragment of
DNA, a gene, a chromosome, or an entire genome.
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The Essential Biotech Investment Guide
DNA shuffling: An in vitro process which generates genetic diversity and
then selects genes optimized for a specific biological function. DNA
shuffling can result in greatly enhanced performance by a gene and is being
used in the development of various gene therapies.
Domain: A discrete portion of a protein with its own function. The
combination of domains in a single protein determines its overall function.
Double helix: The shape that two linear strands of DNA assume when
bonded together.
E
E. coli: Common bacterium that has been studied intensively by geneticists
because of its small genome size, normal lack of pathogenicity, and ease of
growth in the laboratory.
Enzyme: A protein that acts as a catalyst, speeding the rate at which a
biochemical reaction proceeds but not altering the direction or nature of the
reaction.
Eukaryote: Cell or organism with membrane bound, structurally discrete
nucleus and other well-developed sub cellular compartments. Eukaryotes
include all organisms except viruses, bacteria, and blue green algae.
Compare prokaryote.
Exon: The protein coding DNA sequence of a gene.
Expressed sequence tag (EST): A short strand of DNA (approximately 200
base pairs long) which is part of a cDNA. Because an EST is usually unique
to a particular cDNA, and because cDNAs correspond to a particular gene in
the genome, ESTs can be used to help identify unknown genes and to map
their position in the genome.
G
Gel Electrophoresis: A DNA separation technique that is very important in
DNA sequencing. Standard sequencing procedures involve cloning DNA
fragments into special sequencing cloning vectors that carry tiny pieces of
DNA. The next step is to determine the base sequence of the tiny fragments
by a special procedure that generates a series of even tinier DNA fragments
that differ in size by only one base. These nested fragments are separated by
gel electrophoresis, in which the DNA pieces are added to a gelatinous
solution, allowing the fragments to work their way down through the gel.
Smaller pieces move faster and will reach the bottom first. Movement
through the gel is hastened by applying an electrical field to the gel.
Gene candidate: Is designated when a cDNA has homology to something
of known function but no product was produced to show it is the correct site.
Life Science and Biotechnology Glossary
233
Gene expression: The process by which a gene's coded information is
converted into the structures present and operating in the cell. Expressed
genes include those that are transcribed into mRNA and then translated into
protein and those that are transcribed into RNA but not translated into
protein (e.g., transfer and ribosomal RNAs).
Gene family: Group of closely related genes that make similar products.
Gene mapping: Determination of the relative positions of genes on a DNA
molecule (chromosome or plasmid) and of the distance, in linkage units or
physical units, between them.
Gene product: The biochemical material, either RNA or protein, resulting
from expression of a gene. The amount of gene product is used to measure
how active a gene is; abnormal amounts can be correlated with disease
causing alleles.
Gene therapy, see germ line gene therapy and somatic cell gene therapy.
Gene therapy of either kind should be clearly distinguished from the use of
genomics to discover new targets for drug discovery and new diagnostic
tools.
Gene: The fundamental physical and functional unit of heredity. A gene is
an ordered sequence of nucleotides located in a particular position on a
particular chromosome that encodes a specific functional product (i.e., a
protein or RNA molecule).
Genetic code: The sequence of nucleotides, coded in triplets (codons) along
the mRNA, that determines the sequence of amino acids in protein
synthesis. The DNA sequence of a gene can be used to predict the mRNA
sequence, and the genetic code can in turn be used to predict the amino acid
sequence.
Genetic engineering: altering the genetic material of cells or organisms in
order to make them capable of making new substances or performing new
functions.
Genetic polymorphism: a difference in DNA sequence among individuals,
groups, or populations (e.g. a genetic polymorphism might give rise to blue
eyes versus brown eyes, or straight hair versus curly hair).
Genetic testing: the analysis of an individual's genetic material. Among the
purposes of genetic testing could be to gather information on an individual's
genetic predisposition to particular health condition, or to confirm a
diagnosis of genetic disease.
Genetics: The study of the patterns of inheritance of specific traits.
Genome project: Research and technology development effort aimed at
mapping and sequencing some or all of the genome of human beings and
other organisms.
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Genome: All the genetic material in the chromosomes of a particular
organism; its size is generally given as its total number of base pairs.
Genomic library: A collection of clones made from a set of randomly
generated overlapping DNA fragments representing the entire genome of an
organism.
Genomic sequence: The order of the subunits, called bases, that make up a
particular fragment of DNA in a genome. DNA is a long molecule made up
of four different kinds of bases, which are abbreviated A, C, T, and G. A
DNA fragment that is 10 bases long might have a base sequence of, for
example, ATCGTTCCTG. The particular sequence of bases encodes
important information in an individual's genetic blueprint, and is unique for
each individual (except identical twins).
Genomics: The study of genes and their function. Recent advances in
genomics are bringing about a revolution in our understanding of the
molecular mechanisms of disease, including the complex interplay of
genetic and environmental factors. Genomics is also stimulating the
discovery of breakthrough healthcare products by revealing thousands of
new biological targets for the development of drugs, and by giving scientists
innovative ways to design new drugs, vaccines and DNA diagnostics.
Genomics-based therapeutics include "traditional" small chemical drugs,
protein drugs, and potentially gene therapy.
Guanine (G): A nitrogenous base, one member of the base pair GC
(guanine and cytosine).
H
Homology: Similarity in DNA or protein sequences between individuals of
the same species or among different species.
Human gene therapy: Insertion of normal DNA directly into cells to
correct a genetic defect.
Hybridization: The process of joining two complementary strands of DNA
or one each of DNA and RNA to form a double-stranded molecule.
I
In situ hybridization: Use of a DNA or RNA probe to detect the presence
of the complementary DNA sequence in cloned bacterial or cultured
eukaryotic cells.
In vitro: Outside a living organism.
Informatics: The study of the application of computer and statistical
techniques to the management of information. In genome projects,
informatics includes the development of methods to search databases
Life Science and Biotechnology Glossary
235
quickly, to analyze DNA sequence information, and to predict protein
sequence and structure from DNA sequence data.
Interphase: The period in the cell cycle when DNA is replicated in the
nucleus; followed by mitosis.
Intron: The DNA base sequence interrupting the protein coding sequence
of a gene; this sequence is transcribed into RNA but is cut out of the
message before it is translated into protein.
K
Kilobase (kb): Unit of length for DNA fragments equal to 1000
nucleotides.
L
Library: An unordered collection of clones (i.e., cloned DNA from a
particular organism), whose relationship to each other can be established by
physical mapping.
Linkage map: A map of the relative positions of genetic loci on a
chromosome, determined on the basis of how often the loci are inherited
together. Distance is measured in centimorgans (cM).
Linkage: The proximity of two or more markers (e.g., genes, RFLP
markers) on a chromosome; the closer together the markers are, the lower
the probability that they will be separated during DNA repair or replication
processes (binary fission in prokaryotes, mitosis or meiosis in eukaryotes),
and hence the greater the probability that they will be inherited together.
Localize: Determination of the original position (locus) of a gene or other
marker on a chromosome.
Locus (pi. loci): The position on a chromosome of a gene or other
chromosome marker; also, the DNA at that position. The use of locus is
sometimes restricted to mean regions of DNA that are expressed. See gene
expression.
M
Mapping: See gene mapping, linkage map, physical map.
Marker: An identifiable physical location on a chromosome (e.g.,
restriction enzyme cutting site, gene) whose inheritance can be monitored.
Markers can be expressed regions of DNA (genes) or some segment of
DNA with no known coding function but whose pattern of inheritance can
be determined.
Messenger RNA (mRNA): RNA that serves as a template for protein
synthesis.
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The Essential Biotech Investment Guide
Metaphase: A stage in mitosis or meiosis during which the chromosomes
are aligned along the equatorial plane
mRNA: See messenger RNA.
Multiplexing: A sequencing approach that uses several pooled samples
simultaneously, greatly increasing sequencing speed.
Mutation: Any heritable change in DNA sequence.
N
Nucleic acid: A large molecule composed of nucleotide subunits.
Nucleotide: A subunit of DNA or RNA consisting of a nitrogenous base
(adenine, guanine, thymine, or cytosine in DNA; adenine, guanine, uracil, or
cytosine in RNA), a phosphate molecule, and a sugar molecule (deoxyribose
in DNA and ribose in RNA). Thousands of nucleotides are linked to form a
DNA or RNA molecule.
Nucleus: The cellular organelle in eukaryotes that contains the genetic
material.
O
Oncogene: A gene, one or more forms of which is associated with cancer.
Many oncogenes are involved, directly or indirectly, in controlling the rate
of cell growth.
P
Physical map: A map of the locations of identifiable landmarks on DNA
(e.g., restriction enzyme cutting sites, genes), regardless of inheritance.
Distance is measured in base pairs. For the human genome, the lowestresolution physical map is the banding patterns on the 24 different
chromosomes; the highest resolution map would be the complete nucleotide
sequence of the chromosomes.
Polygenic disorder: Genetic disorder resulting from the combined action of
alleles of more than one gene (e.g., heart disease, diabetes, and some
cancers). Although such disorders are inherited, they depend on the
simultaneous presence of several alleles; thus the hereditary patterns are
usually more complex than those of single gene disorders.
Polymerase chain reaction (PCR): A method for amplifying a DNA base
sequence using a heat stable polymerase and two 20-base primers, one
complementary to the (+) strand at one end of the sequence to be amplified
and the other complementary to the (-) strand at the other end. Because the
newly synthesized DNA strands can subsequently serve as additional
templates for the same primer sequences, successive rounds of primer
Life Science and Biotechnology Glossary
237
annealing, strand elongation, and dissociation produce rapid and highly
specific amplification of the desired sequence. PCR also can be used to
detect the existence of the defined sequence in a DNA sample.
Polymorphism: Difference in DNA sequence among individuals. Genetic
variations occurring in more than 1% of a population would be considered
useful polymorphisms for genetic linkage analysis.
Positional Cloning: a technique used to identify genes, usually those that
are associated with diseases, based on their location on a chromosome. This
in in contrast to the older, "functional cloning" technique that relies on some
knowledge of a gene's protein product. For most diseases, researchers have
no such knowledge.
Primer: Short preexisting polynucleotide chain to which new
deoxyribonucleotides can be added by DNA polymerase.
Prokaryote: Cell or organism lacking a membrane-bound, structurally
discrete nucleus and other sub-cellular compartments. Bacteria are
prokaryotes. Compare eukaryote.
Promoter: A site on DNA to which RNA polymerase will bind and initiate
transcription.
Protein: A large molecule composed of one or more chains of amino acids
in a specific order; the order is determined by the base sequence of
nucleotides in the gene coding for the protein. Proteins are required for the
structure, function, and regulation of the bodys cells, tissues, and organs,
and each protein has unique functions. Examples are hormones, enzymes,
and antibodies.
Purine: A nitrogen containing, double-ring, basic compound that occurs in
nucleic acids. The purines in DNA and RNA are adenine and guanine.
Pyrimidine: A nitrogen-containing, single-ring, basic compound that occurs
in nucleic acids. The pyrimidines in DNA are cytosine and thymine; in
RNA, cytosine and uracil.
R
Recombinant DNA Technology: Procedure used to join together DNA
segments in a cell-free system (an environment outside a cell or organism).
Under appropriate conditions, a recombinant DNA molecule can enter a cell
and replicate there, either autonomously or after it has become integrated
into a cellular chromosome.
Restriction enzyme, endonuclease: A protein that recognizes specific,
short nucleotide sequences and cuts DNA at those sites. Bacteria contain
over 400 such enzymes that recognize and cut over 100 different DNA
sequences.
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The Essential Biotech Investment Guide
Restriction fragment length polymorphism (RFLP): Variation between
individuals in DNA fragment sizes cut by specific restriction enzymes;
polymorphic sequences that result in RFLPs are used as markers on both
physical maps and genetic linkage maps. RFLPs are usually caused by
mutation at a cutting site. See marker.
Ribonucleic Acid (RNA): A chemical found in the nucleus and cytoplasm
of cells; it plays an important role in protein synthesis and other chemical
activities of the cell. The structure of RNA is similar to that of DNA. There
are several classes of RNA molecules, including messenger RNA, transfer
RNA, ribosomal RNA, and other small RNAs, each serving a different
purpose.
Ribosomes: Small cellular components composed of specialized ribosomal
RNA and protein; site of protein synthesis.
S
Sequencing: Determination of the order of nucleotides (base sequences) in
a DNA or RNA molecule or the order of amino acids in a protein.
Single-gene disorder: Hereditary disorder caused by a mutant allele of a
single gene (e.g., Duchenne muscular dystrophy, retinoblastoma, sickle cell
disease).
Somatic cell: Any cell in the body except gametes and their precursors.
Southern blotting: Transfer by absorption of DNA fragments separated in
electrophoretic gels to membrane filters for detection of specific base
sequences by radio-labeled complementary probes.
T
Telomere: The end of a chromosome. This specialized structure is involved
in the replication and stability of linear DNA molecules.
Thymine (T): A nitrogenous base, one member of the base pair AT
(adeninethymine).
Transcription: The synthesis of an RNA copy from a sequence of DNA (a
gene); the first step in gene expression.
Transformation: A process by which the genetic material carried by an
individual cell is altered by incorporation of exogenous DNA into its
genome.
Translation: The process in which the genetic code carried by mRNA
directs the synthesis of proteins from amino acids. Compare transcription.
Life Science and Biotechnology Glossary
239
u
Uracil: A nitrogenous base normally found in RNA but not DNA; uracil is
capable of forming a base pair with adenine.
V
Virus: A noncellular biological entity that can reproduce only within a host
cell. Viruses consist of nucleic acid covered by protein; some animal viruses
are also surrounded by membrane. Inside the infected cell, the virus uses the
synthetic capability of the host to produce progeny virus.
Source: DOE Primer on Molecular Genetics, NHBLI/NCBI,
Genome Information System
Agricultural
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Glossary—Finance
A
Acquisition: The act of one company taking over controlling interest in
another company.
Allocation: The amount of securities assigned to an investor, broker, or
underwriter in an offering. An allocation can be equal to or less than the
amount indicated by the investor during the subscription process depending
on market demand for the securities.
American Depositary Receipt (ADR): A US security that is a repackaged
foreign security. A US bank creates an ADR based on evidence of
ownership of a specified number of shares in the foreign security, while the
underlying shares are held in a depositary in the issuing company's home
country.
American-Style Option: Exercisable at any time prior to and including the
maturity date. Value before expiration of American-style option will be
greater than or equal to its intrinsic value.
AMEX American Stock Exchange..
Annual Report (10K): Public companies are required to file an annual
report with the Securities and Exchange Commission detailing the preceding
year's financial results and plans for the upcoming year.
Annuity: A form of contract sold by life insurance companies that
guarantees a fixed or variable payment to the annuitant at some future time,
usually retirement.
Ask: the lowest acceptable price at which a bond is offered for sale. Also
called Asked Price or Offer. See also Bid, Quote and Spread.
Asset Allocation: a strategy in which a percentage of a portfolio's total
dollars is invested into each asset class (bonds, equities and cash) to balance
risk and return while achieving an investor's targeted financial goals.
B
Bear and Bull markets: A bear market is one in which prices are low or
declining; a bull market is one in which prices are high or rising.
Beta: A statistical measure of a stock's volatility compared with the overall
market. A beta of less than 1 indicates lower risk than the market; a beta of
more than 1 indicates higher risk than the market. (See volatility)
Glossary — Finance
241
Bond: A form of agreement that contains the promise of a third party,
usually a bonding company, to complete or pay for the cost of completion of
a contract if the contractor defaults. A securities instrument taking the form
of a certificate of debt on which the issuing company or governmental body
promises to pay the bondholders a specified amount of interest for a
specified length of time, and to repay the loan on the expiration date.
Burn Rate: The rate at which a company expends cash over a certain
period, usually a month.
Business Plan: A document that describes the entrepreneur's idea, the
market problem, proposed solution, business and revenue models, marketing
strategy, technology, company profile, competitive landscape, as well as
financial data for coming years. The business plan opens with a brief
executive summary, most probably the most important element of the
document due to the time constraints of venture capital funds and angels.
C
Call Option: A call option gives the holder the right, but not the obligation,
to buy the underlying asset at an agreed strike price for a fixed period of
time or on a fixed date.
Cash Settlement: The settlement of an option contract through the payment
of cash in the amount by which the option is in-the-money.
Certificate of Deposit (CD): a time deposit issued by financial institutions
which entitles the holder to receive interest plus principal at maturity. Bank
CDs cannot be withdrawn before maturity without penalty and are federally
insured up to $100,000 in principal and interest per investor and institution.
See also Brokered CD.
Chinese Wall: A term used to describe procedures enforced within a
securities firm that separate the firm's departments to restrict access to nonpublic, material information. The procedures help NASD members avoid the
illegal use "inside" information.
Closed-end Companies: An investment company that operates a mutual
fund with a limited number of shares outstanding. A closed-end fund starts
with a set number of shares. These are often listed on a stock exchange.
Common Stock: Units of ownership of a public corporation. Owners
typically are entitled to vote on the selection of directors and other important
matters as well as to receive dividends on their holdings.
Control Stock: A company's stock owned (even if purchased in the open
market) by any person who (directly or indirectly) is identified as an affiliate
is considered to be control stock and subject to the provisions of Rule 144. It
is important to be able to distinguish between control stock and unregistered
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The Essential Biotech Investment Guide
restricted securities. Although both types of stock must be sold in
accordance with the requirements of Rule 144, control stock acquired either
on the open market or pursuant to a registration statement is not subject to
the pre-sale holding period requirement. Restricted securities, however,
must be held for one year before the securities can be sold under Rule 144
provided all other Rule 144 requirements are met.
Convertible Security: A financial security (usually preferred stock or
bonds) that is exchangeable for another type of security (usually common
stock) at a prestated price.
Corporate Bond: A bond issued by a corporation to refund its outstanding
debt or finance business expansion. The corporation (the issuer) is obligated
to pay its bondholders periodic interest at a fixed rate (the coupon rate), plus
principal at maturity. Most corporate bonds have a fixed par value, pay
interest semiannually, are issued in a wide range of maturities and are rated
as to their credit quality by Moody's and Standard & Poor's.
Cost of Capital: The rate that a company must pay for its capital or the
minimum return that is required to maintain the market value of a company's
common stock.
Current Yield: The annual rate of return earned on a bond based on its
coupon rate and current market price.
D
Debt-Security: A security representing money borrowed that must be repaid
and having a fixed amount, a specific maturity or maturities, and usually a
specific rate of interest or an original purchase discount.
Derivative: A generic term often applied to a wide variety of financial
instruments that derive their cash flows, and therefore their value, by
reference to an underlying asset, reference rate, or index.
Diversification: a strategy in which assets are allocated to different
securities (e.g., bonds, stocks, cash), industries (e.g., banking,
manufacturing, transportation) and maturities (e.g., short, intermediate, long
term), to balance the potential risks and rewards of a portfolio. See also
Asset Allocation, Investment Pyramid, Ladder Portfolio and Portfolio
Management.
Dividend: the earnings of a company distributed on a prorated and
prioritized basis to its shareholders. Preferred stockholders are entitled to
receive dividends prior to common stockholders.
Due Diligence: A process undertaken by potential investors-individuals or
institutions-to analyze and assess the desirability, value, and potential of an
investment opportunity.
Glossary — Finance
243
E
Employee Stock Option Plan (ESOP): A plan established by a company
whereby a certain number of shares is reserved for purchase and issuance to
key employees. Such shares usually vest over a certain period of time to
serve as an incentive for employees to build long term value for the
company.
Equity: The ownership interest of stockholders in a company. Also, the
excess of the market value of securities over debit balances in a margin
account. (See credit and debit balance, margin)
European-Style Option: Exercisable only on the expiration date. Value
before expiration of European-style option may be less than intrinsic value.
Can be unwound prior to maturity with Morgan Stanley Dean Witter's
consent.
Exit Strategy: A fund's intended method for liquidating its holdings while
achieving the maximum possible return. These strategies depend on the exit
climates including market conditions and industry trends. Exit strategies can
include selling or distributing the portfolio company's shares after an initial
public offering (IPO), a sale of the portfolio company or a recapitalization.
F
Federal Funds Rate: The rate charged for overnight loans to member
banks. This rate, set daily by the market, is the most sensitive indicator of
the direction of interest rates. See also Federal Reserve System and
Monetary Policy.
Federal Reserve System: Established to regulate the U.S. monetary and
banking system, including reserve requirements, the money supply and
currency printing. This system consists of a seven-member Board of
Governors, 12 regional Reserve Banks and their 24 branches, and all
national and state bank members. Also called the Fed. See also Federal
Funds, Federal Funds Rate, Fed Wire, Member Bank and Monetary Policy.
Founders' Shares: Shares owned by a company's founders upon its
establishment.
G
Goodwill: The going-concern value of a company in excess of its asset
value; goodwill is considered an intangible asset. Generally, it is the value
of the business' good name, its customer relations, high employee morale,
and other factors that might translate into earning power. Nasdaq's
calculation of net tangible asset value excludes goodwill. (See goingconcern value)
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The Essential Biotech Investment Guide
H
Hedge: A tool used to offset the volatility of an existing security by an
investment
in
another security.
See
also
Asset
Allocation
and Diversification.
High Yield Bond: A bond issued to fund the growth of smaller, developing
companies or the restructuring of a larger company through a leveraged
buyout.
Holding Period: The amount of time an investment must be held to qualify
for capital gains tax benefits.
Hot Issue: Hot Issue stock is stock that is in great public demand. The price
of Hot Issue stock usually shoots up at its initial offering, since there is more
demand than there are shares available.
I
Individual investor: A person who buys or sells securities for his or her
own account. The individual investor is also called a retail investor or retail
shareholder.
Inflation Rate: Represents the changing cost of goods and services;
typically indicated by the Consumer Price Index (CPI-U).
Initial Public Offering (IPO): A company's first sale of stock to the public.
Companies making an IPO are seeking outside equity capital and a public
market for their stock.
Institutional investor: A bank, mutual fund, pension fund, or other
corporate entity that trades securities in large volumes.
Interest Rate: the cost of borrowing money, generally expressed as an
annual percentage rate.
Interest Rate Risk: The risk that interest rates will rise, reducing the
market value of existing bond investments prior to maturity. This occurs
because bonds have an inverse or opposite relationship to interest rates: as
interest rates rise, bond prices fall; as rates fall, bond prices rise. Long-term
bonds are much more sensitive to changes in interest rates than short-term
securities.
Intrinsic Value: The difference between the market value and strike price.
For calls, the intrinsic value = market price - strike price, for puts intrinsic
value = strike price - market price.
Investment Grade Bond: a bond possessing a credit rating of AAA to
BBB that is considered to have little or no risk of default by the issuer.
Investment Pyramid: a portfolio management tool used to allocate assets
into the four major investment sectors-cash equivalents, income,
growth/income, and aggressive growth-to develop a well-balanced
Glossary — Finance
245
portfolio. See also Asset Allocation, Diversification, Ladder Portfolio, and
Portfolio Management.
IPO: Initial Public Offering—the first stock offering of an enterprise that is
open to the public (a broad range of the public gets the opportunity to invest
in the firm through the sale of shares).
L
Leveraged Buyout (LBO): A takeover of a company, using a combination
of equity and borrowed funds (or loans). Generally, the target company's
assets act as the collateral for the loans taken out by the acquiring group.
LIBOR: London Interbank Offered Rate. The base short-term rate of the
Eurodollar market, charged by international banks for large loans.
Limited Partnerships: An organization comprised of a general partner who
manages a fund, and limited partners, who invest money but have limited
liability and are not involved with the day-to-day management of the fund.
In the typical venture capital fund, the general partner receives a
management fee and a percentage of the profits (or carried interest). The
limited partners receive income, capital gains, and tax benefits.
Liquidity: The ability to convert assets into cash or cash equivalents. A
portion of portfolio assets is usually allocated to cash to meet short-term
needs.
Lock-up Period: The period of time that certain stockholders have agreed
to waive their right to sell their shares of a public company.
M
Management Fee: Compensation for the management of a venture funds
activities, paid from the fund to the general partner or investment advisor.
This compensation generally includes an annual management fee.
Margin: An account in which a customer purchases securities on credit
extended by a broker/dealer. Rules of the Federal Reserve Board and NASD
govern margin accounts.
Market Capitalization: The total dollar value of all outstanding shares.
Computed as shares multiplied by current price per share. Prior to an IPO,
market capitalization is arrived at by estimating a company's future growth
and by comparing a company with similar public or private corporations.
Market Makers: Market Makers process orders for their own customers
and for other NASD broker/dealers.
Market Price: For listed securities, the price at which a bond trades in the
secondary market.
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Market Risk: The risk that changing interest rates and/or market demand
will adversely affect the value of a bond prior to maturity. See also Interest
Rate Risk and Reinvestment Risk.
Market Value: The current value of a bond in the secondary market.
Maturity: the number of years until the principal amount of a bond is due
and payable by the issuer to its bondholders. Bonds are issued in a variety of
short-, intermediate-, and long-term maturities.
Monetary Policy: How the Federal Reserve influences the availability and
cost of money and credit, including open market operations, and changes in
the Fed funds rate and/or discount rate and reserve requirements.
Money Market Fund: An open-ended mutual fund that invests highly
liquid and safe securities and pays money market rates of interest.
Money Supply: the amount of money in the economy, represented primarily
by currency in circulation and deposits in savings and checking accounts;
commonly referred to as M-l, M-2, M-3 and L.
Municipal bonds: Bonds issued by states, cities, counties, and towns to
fund public capital projects like roads, schools, sanitation facilities, bridges,
as well as operating budgets. These bonds are exempt from federal taxation
and from state and local taxes for the investors who reside in the state where
the bond is issued.
Mutual Fund: A fund operated by an investment company that raises
money from shareholders and invests it in stocks, bonds, options,
commodities, or money market securities. These funds offer investors the
advantages of diversification and professional management.
N
Nasdaq Small Cap Market: The segment of the Nasdaq market for small,
less-capitalized securities that do not qualify for inclusion in the Nasdaq
National Market.
NASDAQ The National Association of Securities Dealers Automated
Quotation system.
National Association of Securities Dealers, Inc. (NASD): The largest
self-regulatory organization for the securities industry in the United States.
NASD is responsible for the operation and regulation of Nasdaq and the
over-the-counter securities markets; it is the parent company of NASD
Regulation, Inc., and the Nasdaq Stock Market, Inc.
Net Asset Value (NAV): NAV is calculated by adding the value of all of
the investments in the fund and dividing by the number of shares of the fund
that are outstanding; generally trade at a discount to NAV.
Glossary — Finance
247
New Issue: A stock or bond offered to the public for the first time. New
issues may be initial public offerings by previously private companies or
additional stock or bond issues by companies already public. New public
offerings are registered with the Securities and Exchange Commission. (See
Securities and Exchange Commission and Registration).
Nominal Return: the stated rate of return on a bond without adjusting for
inflation. See also Nominal Rate and Real Rate of Return.
O
Odd Lot: an amount less than the normal or "round lot" trading unit. In the
case of most bonds, those purchases of less than the $1,000 denomination.
See also Round Lot.
Open-end Fund: An open-end fund, or a mutual fund, generally sells as
many shares as investor demand requires. As money flows in, the fund
grows. If money flows out of the fund the number of the fund's outstanding
shares drops.
Option: An instrument that gives the owner the right to buy or sell a
specified number of shares of a specified stock at a specified price within a
specified period of time. A call option allows the buyer to purchase the
underlying stock at any time up to the expiration date of the contract. A put
option allows the buyer to sell the underlying stock at any time up to the
expiration date of the contract.
P
Par Value: The stated or "nominal" value of a bond (typically $ 1,000) that
is paid to the bondholder at maturity. Also represents the dollar amount on
which interest is calculated, based on a specific percentage. Also called Face
Value.
Portfolio Management: Investment strategies used to select the proper
percentage of assets within a portfolio in order to maximize returns and
minimize risk, based on an investor's financial goals, stage in the investment
lifecycle, and risk tolerance profile.
Portfolio: A combined holding of more than one stock, bond, commodity,
real estate investment, cash equivalent, or other asset by an individual or
institutional investor. The purpose of the portfolio is to reduce risk by
diversification.
Preferred Stock: A senior equity security with dividends that must be paid
before dividends are paid to common stockholders. Preferred stocks rank
junior to bonds and senior to common stock in terms of payment priority
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The Essential Biotech Investment Guide
and are typically perpetual with no set maturity date. However, most have
sinking funds and/or call provisions to retire outstanding stock.
Price/Earnings Ratio: The price of a share of a stock divided by earnings
per share, usually calculated using the latest year's earnings. The p/e ratio is
also called the multiple.
Primary Market: The market where new issues of securities are initially
sold (as opposed to the Secondary Market, where existing issues trade). The
Treasury auction market is an example of a primary market.
Prime Rate: A short-term interest rate charged by commercial banks to
their most credit worthy institutional customers. The prime rate is a
benchmark rate used to determine rates on consumer loans, which are
typically tied to Prime.
Private Equity: Private equities are equity securities of companies that
have not "gone public" (in other words, companies that have not listed their
stock on a public exchange). Private equities are generally illiquid and
thought of as a long-term investment. As they are not listed on an exchange,
any investor wishing to sell securities in private companies must find a
buyer in the absence of a marketplace. In addition, there are many transfer
restrictions on private securities.
Private Placement: A large block of securities offered for sale to an
institutional investor or a financial institution through private negotiations.
Put Option: A put option gives the holder the right, but not the obligation,
to sell the underlying asset at an agreed strike price for a fixed period of
time or on a fixed date.
R
Real Estate Investment Trust (REIT): A company, usually traded
publicly, that manages a portfolio of real estate to earn profits for
shareholders. REITs make investments in a diverse array of real estate from
shopping centers to office buildings to apartment complexes and hotels.
Real Rate of Return: The return on a bond calculated after adjusting for
inflation. For example, a bond with a yield of 6% has a real rate of return of
3% when adjusted for a 3% rate of inflation. See also Inflation Rate and
Nominal Return.
Registration: The SEC's review process of all securities intended to be sold
to the public. The SEC requires that a registration statement be filed in
conjunction with any public securities offering.
Reinvestment Risk: The risk that principal and interest payments must be
reinvested at a lower interest rate, effectively reducing interest income. See
also Interest Rate Risk and Market Risk.
Glossary— Finance
249
Restricted Securities: Restricted securities (sometimes referred to as
investment letter stock) are unregistered securities received from an issuer
or affiliate in a non-public transaction. Restricted securities will typically
bear a restrictive legend on the certificate. (Another type of restricted
securities are control stocks that may not bear a restrictive legend.) Under
the "private placement" exemption of the 1933 Act, sales of unregistered
stock are permitted by a corporation or a control person to qualified
purchasers in a private transaction where the buyer of the shares agrees that
he or she will hold the shares for "investment" and signs a letter of
representation to that effect (investment letter). Many officers, directors, and
employees of corporations, own restricted securities subject to Rule 144
which they received through unregistered stock options, purchases of
founders' stock directly from the company, or compensation for services
rendered to the company.
S
Secondary Market: A market where existing bonds are traded after
issuance, generally in the over-the-counter market..
secondary Offering: A registered offering of a large block of a security
that has been previously issued to the public.
Securities Act of 1933: Generally known as the disclosure statute, this law
requires companies seeking to sell shares of stock to the public to register
their offerings unless an exemption is obtained.
Securities Act of 1934: Provides for the direct regulation of the securities
industry through statutory provisions and rules and regulations adopted
under existing statutes as well as through regulatory authority delegated to
private member-owned and operated organizations known as self-regulatory
organizations.
Securities Analyst: An individual who does investment research and
makes recommendations to buy, sell, or hold. Most analysts specialize in a
single industry or business sector. For example, a biotech analyst.
Securities and Exchange Commission (SEC): The SEC is an independent,
nonpartisan, quasi-judicial regulatory agency that is responsible for
administering the federal securities laws. These laws protect investors in
securities markets and ensure that investors have access to all material
information concerning publicly traded securities.
Settlement Date: the date that funds must be paid and securities delivered
to finalize an executed order.
Short Swing Profits: The profit made within any 6-month period by an
affiliate of a public company on sales transactions is determined by
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The Essential Biotech Investment Guide
matching the lowest purchase price to the highest sale price. These profits
must be "disgorged" to the issuer and the event must be reported on the
issuer's next proxy statement.
Short-Term Bond: A bond with a holding period of a few days to one
year. Short-term bonds are generally issued in 3-, 6- and 12-month
maturities. See also Maturity and Yield Curve.
Split: The division of outstanding shares of a corporation into a larger
number of shares.
Standard & Poor's (S&P): One of two well-recognized corporate bond
rating agencies. S&P also rates commercial paper and preferred stock,
assigning credit quality ratings to reflect an issuer's ability to make timely
interest and principal payments.
Stock: Ownership of a corporation represented by shares that are a claim on
the corporation's earnings and assets.
Suitability: A suitability violation occurs when and investment made by a
broker is inconsistent with the investor's objectives, and the broker knows or
should know the investment is inappropriate.
T
Third Market: Over-the-counter trading of exchange-listed securities
among institutional investors and broker/dealers for their own accounts (not
as agents for buyers and sellers).
Track Record: The history of success and experience of an enterprise or an
investment firm.
Treasuries: See Treasury Bill, Treasury Bond, Treasury Inflation Protection
Securities (TIPS), Treasury Note and U.S. Treasury Securities.
Treasury Bill: A short-term security issued at a discount to par which pays
no interest. Instead, the investor receives the difference between the
discounted purchase price and the par value (the accreted interest) at
maturity. T-bills are typically issued in minimum denominations of $10,000
with maturities of 3, 6 and 12 months. See also Treasury Auction and US
Treasury Securities.
Treasury Bond: A long-term bond issued in $1,000 denominations, with
maturities greater than 10 years. T-bonds pay interest at a fixed rate
semiannually and pay the principal amount (par) at maturity. The 30-year
Treasury bond, also known as the Bellwether Bond or Long Bond, is
considered a benchmark for market watchers and is the most volatile of all
Treasury securities. See also Long Bond and U.S. Treasury Securities.
Treasury Note: An intermediate-term security typically issued in
denominations of $1,000 or $5,000, with maturities ranging from 2 to 10
Glossary — Finance
251
years. The stated interest rate (coupon) is paid semiannually and the
principal amount (par) paid at maturity. See also U.S. Treasury Securities.
U
Unit Investment Trust: An investment vehicle that purchases a fixed
portfolio of income-producing securities. The units in the trust are sold to
investors by brokers. The unit holders receive an undivided interest in both
the principal and the income portion of the portfolio in proportion to the
amount of capital they invest. The portfolio of securities remains fixed until
all of the securities mature and unit holders have recovered their principal.
V
Variable Annuity: A life insurance annuity contract whose value fluctuates
with that of an underlying securities portfolio or other index of performance.
Income on a variable annuity may be taken periodically, beginning
immediately or at any future time.
Venture Capital Fund: Fund from which capital for investments is
supplied. Investors of the funds are as often institutional investors (credit
institutes, insurance companies, state, and pension funds) as they are private
individuals.
Volatility: The degree of price fluctuation for a given asset, rate, or index.
Usually expressed as a variance or standard deviation. (See beta)
Volume: Amount of trading activity, expressed in shares or dollars,
experienced by a single security or the entire market within a specified
period, usually daily, monthly, or annually.
Y
Yankee Bond: A U.S. dollar-denominated bond issued by foreign
governments and corporations in the U.S. market.
Yield: The annual percentage rate of return earned on a bond, calculated in a
number of different ways. See also Bond Equivalent Yield, Current Yield,
Effective Yield, Yield to Call, Yield to Maturity and Yield to Worst.
Yield to Call (YTC): The annual return on a bond, assuming it will be held
until it is redeemed by the issuer at the call price on the first call date.
Yield to Maturity (YTM): The annual rate of return an investor receives,
assuming a bond is held to maturity, taking into account the purchase price,
capital gain or loss, coupon rate, maturity and reinvestment rate.
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The Essential Biotech Investment Guide
Z
Zero Coupon Bond: A bond that is sold at a deep discount from its
maturity value and makes no periodic interest payments. Instead, interest
accumulates at a stated rate, compounding semiannually and growing to full
value at maturity.
Source: NASD
Appendix C
Resources and Further Readings
Books
Lowe, Janet, Warren Buffett Speaks: Wit and Wisdom from the World's
Greatest Investor. John Wiley & Sons, Inc, 1997.
Fisher, Philip A., Common Stocks and Uncommon Profits. John Wiley &
Sons, Inc., 1996.
Graham and Dodd, Security Analysis. McGraw-Hill Companies, 1934.
Greenwald, Bruce C.N., et al. Value Investing: From Graham to Buffett and
Beyond. John Wiley & Sons, Inc., 2001.
Lynch, Peter, One Up On the Wall Street Simon and Schuster, 1989.
Siegel, Jeremy J.., Stock for the Long Run, 1998.
Train, John, The Midas Touch. Harper & Row Publishers, 1987
Damodaran, Aswath, Damodaran on Valuation. John Wiley & Sons, Inc.,
1994.
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The Essential Biotech Investment Guide
254
Web Sites
www.BIO.org
www.phrma.com
www.biospace.com
www.winhoverinfo.com
www.recap.com
www .genengnews .com
www.morningstar.net
www .bloomberg.com
www.nvst.com
www.fda.gov
www.nih.gov
www.uspto.gov
www.quicken.com
www.yadeni.com
www.berkeshirehathaway.com
Newsletters
BioWorld Today www.bioworld.com
BioCentury www.biocentury.com
Newspapers and Magazines
Wall Street Journal www.wsj.com
New York Times www.nytimes.com
Financial Time www.ft.com
Business Week www.businessweek.com
Technology Review www.technologyreview.com
Nature Biotechnology www.biotech.nature.com
Science Magazine www.sciencemag.org
Appendix D
Speaking Engagement Request
If you would like information about upcoming seminars, speaking engagements, or
consulting services, please send your name, address, company name and fax and
phone numbers to:
Dr. C. Mark Tang
World Technology Ventures, LLC
One Exchange Place, Suite 1000
Jersey City, NJ 07302
Phone:(201)309-4825
e-mail: investinbiopharm@aol.com
Also, please feel free to send me your success stories to share with other biotech
investors. You may wish to check our book web site for updates on the book. The
address is www.bio-technologyinvestor.com.
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Index
biotech, 1, 2, 6, 10, 13-16, 20, 24, 33,
35,37,40,41,51,56-60,
63, 67, 79, 81-83, 85, 88,
89,91,95-98, 101, 115122, 125, 126, 131, 134,
139, 140-143, 145, 147,
151, 152, 155, 157, 163173, 175, 177, 181-183,
187, 189, 195, 199, 200,
201,213,215,229,230,
249, 255
biotech companies, 2, 6, 13, 14, 16,
5 6 , 6 0 , 8 2 , 8 3 , 9 7 , 115,
116, 121, 122, 125,257
Biotech drugs, 2, 13, 16, 24
Biotech Industry, 2, 6, 16, 67, 8 1 , 95,
401 (k)s, 20
401K, 155, 164, 170,189
8
83(b) election, 170,171,172
A-B Trust, 208
Activist Value Investor, 84
Adenine (A), 51,229, 231
Alternative Investment, 47
Alternative minimum tax (AMT), 169
AM EX Biotech Index, 1
Amgen, 4, 8, 9, 15, 24, 56, 58, 106,
125, 126, 134, 200, 257
antibiotics, 13
Antibody, 56, 60, 126, 229
asset allocation strategy, 47
Association for Investment and
Management Research
(AIMR), 187
97, 257
Biotech mutual funds, 131, 139, 140
Biotech Private Equity Funds, 187
biotech products, 2, 67, 95-97
Biotech stock option, 163-170
biotech stocks, 2, 58, 88, 96, 139,
172, 195, 199,200
Biotech Venture Capital Funding, 183
Biotechnology, 1, 2, 6, 13-15, 5 1 , 63,
89, 98, 122, 131, 134, 143,
151, 152, 175, 181, 182,
215,230
Biotechnology Industry Organization
(BIO), 2
B
Ben Graham, 82
Bioinformatics, 13, 14, 56, 60, 230
257
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The Essential Biotech Investment Guide
Bonds, 7, 11, 25, 33, 35, 44, 51, 82,
93,94, 134, 136, 193,201,
230
Bought to be sold, 42
BOXES, 145, 152-154
Business Cycle, 93, 94, 147
Business Model, 120, 121
Buy and hold, 42
Buying and Selling, 41, 140, 148, 276
c
cancer, 2, 8-10, 13, 40, 41, 60, 119
Cash, 32, 45, 47, 49, 91-93, 98-101,
113-116, 119, 120, 122,
125, 135, 149, 151,161,
169, 187, 192,210,218,
Celera Genomics, 55, 56
Centocor, 9, 24, 126, 128
Central Dogma, 52, 53
Charitable Remainder Annuity Trust
(CRAT), 198
charitable remainder trust (CRT),
197,210
Charitable Remainder Unitrust
(CRUT), 198
Chart Patterns, 222, 224, 227
Chiron, 4, 9, 58, 106, 125, 127
clinical trials, 1, 2, 13, 67, 68, 70, 71,
74,76,77,85,97, 116
Common Vesting, 165
Comparable Public Companies
Analysis, 99
concentrated equity position, 155,
159, 160
Consumer Trend, 20
Contrarian Value Investor, 85
Core and Satellite Strategy, 146
Core Holding, 48
Cost of Delaying, 139,258
Cost of Waiting, 28
covered call writing, 161, 195
cytosine(C), 51, 231
D
DCF analysis, 98,116
demographics, 15, 16, 139, 140
direct rollover, 190
discipline, 49, 133, 134, 135, 141,
189,215
discounted cash flow analysis. See
DCF analysis
disease, 1, 2, 9, 10, 13-17, 53, 55,
56,57,61,68,70,76,77,
78,97,229,230,231,233,
234, 237, 238
Disinheritance, 203, 204
Diversification, 35, 37, 38, 45, 46, 48,
123, 131, 148, 152, 153,
158, 159, 186, 187,242,
244, 247
Divestitures, 84
Dividend Discount Model, 92,119
DNA, 4, 51, 52, 54, 59, 106, 118,
230-238,
dollar-cost averaging, 29, 31, 49, 135
Dow Jones Industrial Average, 6, 39,
41
Due-diligence, 89, 178
E
EBITDA multiples, 110, 115
economic cycle, 42, 43, 93, 95
Economic Value Added (EVA), 120
Election Risks, 172
equity return, 39
ESOP, 164, 170, 243
Estate planning, 201, 210, 213, 214
Exchange Fund, 159, 161, 195
Exercise Date, 164, 166, 167
Expiration Date, 162, 164, 241, 243,
247
F
Fair Market Value, 164-166, 171
FDA, 2, 8, 9, 63, 67-78, 87, 97, 125,
126, 254
Federal Reserve (Fed), 93
Feeder Fund, 185, 186
firm-specific risk, 35, 156
free cash flow, 98, 99
Index
fundamental analysis, 39, 217
Fund-of-Funds, 185, 186
G
GARP, 48
gene, 1, 2, 8-10, 13-16, 24, 29, 35,
42-47, 51-60, 64, 97, 98,
230-238
generic drugs, 14
Genetic Therapy, 57, 125
Genzyme, 4, 10, 24, 59, 60, 106, 125,
127, 134
Gift giving, 211
growth, 1, 4, 6, 7, 9, 11, 13, 14,20,
27, 28, 32, 39, 43, 45, 48,
54,55,57,79,80,81, 87,
88,92-104, 106-110, 118,
125, 131, 134-136, 143,
145, 146, 175, 182, 183,
230, 244, 245
Growth Investing, 79, 80
guanine (G), 51, 231, 234
H
Head and Shoulders, 224
Healthcare Buyout Funds, 183
hedge fund, 47, 175-179
Hedge Fund Investment Styles, 176
Hedge Fund Strategies, 177, 179
Hedging, 147, 150, 158-161, 168,
176, 180, 195
High-Yield Bond, 45
Historic Return, 11, 32, 38, 39
Holding Period, 32-34, 42, 142, 242,
244, 250
Human Genome Sciences, 55, 60,
125, 126, 129
I
Ibbotson & Associates, 7
IBM, 14, 163
IDEC, 4, 15,24,59
Immunex, 4, 24, 59, 126, 129
Incentive Biotech Options, 166, 169
259
independent consultant, 187
Index funds, 136, 145, 146
Indexing, 136, 145, 146
Index-linked ETFs, 147-150
Industry Life Cycle, 80, 81, 95
Inflation, 7, 11, 31, 32, 33, 93, 95,
121, 131, 132, 137, 198,
244, 247, 248, 250
Initial Public Offerings (IPOs), 40
Internal Rate of Return (IRR), 116,
187
Internet, 3, 6. 23, 149, 170
Inverted Saucer, 224
Investigational New Drug (IND), 68
investment strategy, 11, 20
investment vehicles, 35, 40, 190,192
IRAs, 20, 191
Irrevocable Life Insurance Trust, 209
iShares, 145, 149, 150, 151, 152
J
James D. Watson, 51
joint tenancy, 203
L
large-cap, 38
leveraged buyouts (LBOs), 181
Liquidity, 45, 46, 100, 121, 135, 150,
177, 178, 186,245
long-term investing, 33, 39, 137
M
Managed Accounts, 47, 259
margins, 81, 87, 89, 110
market risk, 35, 121, 156, 246, 248
market share, 81, 87, 89
Maturity Date, 44, 240, 248
Mid-cap, 38, 43
Momentum, 89, 221, 223, 224
Moore law, 55
Motorola, 14
Moving average, 219, 220, 221, 223
mRNA, 54, 229, 233, 235, 236, 238
260
The Essential Biotech Investment Guide
Mutual Funds, 45, 131, 133-141, 152,
187, 193, 199, 218
N
NASDAQ Biotech Index, 1,151,152
National philanthropic trusts, 196
Net Present Value (NPV), 98, 116
Net Unrealized Appreciation (NUA),
172
New Drug Application (NDA), 70, 75,
76
Non-Qualified Biotech Options, 165
o
objectives, 46, 135, 141, 146, 160,
185, 195, 199, 250
opportunity cost, 29
Over the Counter (OTC) market, 41
P
Par Value, 44, 242, 247, 250
Patentability, 64
Patents, 16, 22, 63, 64, 66
PEG ratio, 104-107, 107
pensions, 189, 201
personalized medicine, 15, 53, 98
Philip Fisher's, 260
positive returns, 32, 137
power of compounding, 28, 30
Price/Book Value, 83, 101,113, 114
Price/Earnings Ratio, 43, 83, 101,
248
Price/Sales Ratios (P/S), 109
Private equity investing, 181, 182,
184-188
Private foundations, 196, 199
procrastination, 38
professional management, 46, 47,
131, 133, 134,151,207,
246
public companies, 2, 60, 67, 96, 99,
100, 240
purchasing power, 31, 32, 131, 132,
137
put option, 158, 159, 161, 162, 247
Q
Qualified Terminable Interest
Property Trust (QTIP), 209
R
relative valuation, 100
Resistance Level, 224
Restricted Equity, 162
retirement, 16, 20, 28, 137,155, 164,
168, 170, 189, 190, 191,
192, 240
Retirement Savings, 190-192
revocable living trust, 202, 204-208
risk, 7, 27, 29, 32, 33, 35, 45-49, 74,
77-86, 90, 99, 102-104,
118-123, 156, 161, 172,
176, 177, 179-189,240,
242, 244, 246, 247, 248
risk and return, 29, 240
RNA, 51, 52, 54, 231-235, 238, 239
Rollover IRA, 190, 191
s
Sector Rotation, 147, 150
short-term investing, 33
Single Nucleotide Polymorphisms
(SNPs), 53
Small-cap, 38
soybean, 1
Special Situations, 181,184
spin-off, 84, 124
Standard & Poor's 500 Stock Index, 7
stock market, 20, 29, 29, 38, 39, 41,
137, 139, 140,211,218
stock options, 163, 164, 166, 168,
170, 249, 260
stop-loss, 49
Subscriber-Based Valuations, 119
Success Factors, 83, 85, 86
Sum-of-the-Parts Valuations, 116
Support Level, 223, 224
261
Index
T
V
Tax Implications, 166, 170, 178, 212
Tax-Deferred Rollover, 192
technical analysis, 39, 217, 222, 225,
227
technological innovation, 14
Technology Trend, 16
The Rule of 72, 27, 28
thymine (T), 51,231,238
time horizon, 83, 135, 158, 160, 192,
193
time in the Market, 137
Timing, 39, 42, 121, 132, 139, 178
Top-down analysis, 93, 95
track record, 80, 141, 178, 185, 256
traded funds (ETFs), 146
Trading Rules, 86
transcription, 5 1 , 52, 54, 229, 237,
238
Triple Top, 224
Trusts, 193, 196, 197, 202, 203, 205,
209,210,213
Types of Risk, 33, 121
vaccines, 2, 13, 16, 56, 6 1 , 234
value, 1, 2, 15, 27, 32, 4 1 , 43-48, 64,
79-85,89-93,96,98-104,
110, 113-120, 122-125,
139, 146, 147, 150, 158,
159, 162, 165, 166, 167,
169, 171, 172, 179, 197,
198,200,206,208,211,
212, 223, 240, 242-244,
246, 247
Value Investing, 79, 82, 123, 253
Venture capital, 47, 82, 181-183, 241
u
U.S. Patent and Trademark Office, 66
U.S. Treasury bonds, 7, 11
unit investment trust, 46, 193, 251
w
wealth, 1 , 7 , 3 1 , 3 5 , 4 8 , 137, 156,
158, 170, 176, 185,201,
202,213,215
wealth protection, 201
will, 203-206
winning companies, 89
Y
Yield-Based Valuations, 120
excellent guide to the fundamentals of investing in the healthcare sector. C. Mark Tang's
ncial and scientific expertise lends his analysis and opinion a reassuring authoritativeness.
Michael Francisco
Associate Editor
Nature Biotechnology
The book is resourceful in both ureas of finance and lechnolog}', unraveling their respective role
and functions within the intricate web of biotechnology industry. It gives a well-rounded, easyto-understand description of the scientific bases constituting the business, and the various ways
to evaluate the worth and potential of different biotech companies. The book is recommended not
only for private investors and fund managers hoping to understand the dynamics of life sciences
sector and identify the winner, but also for executives as a desk reference and scientists working
in the biotech industry who may want to form their own biotech companies someday.
Shawn Leung, PhD
Managing Director
The Essential
BIOTECH
INVESTMENT GUIDE
biotechnology investment.
Jordan Schreiber, PhD, MBA
Managing Director
Merrill Lynch I lealthcare Fund
A practical, but intelligent approach to investing in the life science and biotechnology arena. Ea
to read.
Melinda Mingus, Ml), MBA
Partnei
World Technology Investment Croup Corp., USA
Very thorough and comprehensive. Best biotech investment book of the year.
Nancy Chang, PhD
Founder & ' " '
l.inox Biosystems, lin
World Scientific
www. worldscientific.com
5082 he
..