Determining the attractiveness of a revenue-generating company vs. a development-stage opportunity varies tremendously in healthcare, but there are a few quantitative metrics that can be used in a simple screen for equities that have come unhinged from their fundamentals. Below, we present some metrics to use in a downtrodden environment, where screening can be a simple sourcing tool. Of course, quantitative screens are a stepping off point, and should be accompanied by a deep qualitative assessment.
For those without access to robust (and expensive) tools like a Bloomberg Terminal or FactSet, FinViz.com offers a great free screening tool, while Morningstar, Whale Wisdom, Guru Focus and SEC Form 4’s can fill in relevant details for other suggested screening criteria, with many offering Excel exportable content.
High Relative Cash (A Low P/C Ratio)
Price-to-Cash is a representation of a company’s market capitalization (or price per share) divided by its cash & equivalents (or cash & equivalents per share). An equity with a P/C of 5 trades at 5x its existing cash & equivalents; a P/C of 1 indicates that the equity trades in line with its cash position.
In the capital-intensive realm of drug development, having a solid balance sheet is important for two reasons: 1) Enough capital for more than a year of operations mitigates (not eliminates) the risk of a near-term financing. We’re hesitant to put money to work ahead of a possible financing, preferring an investment thesis where inflection points pre-empt a capital raise; and 2) Cash provides a backstop for the stock (not often do equities trade below their cash position, explained below).
In a market where selling comes unhinged from valuations, we like using this metric to find equities that trade at or near their cash position (a low P/C ratio), a facet of the company that may not be getting enough attention in investors’ haste to depart high-risk securities. But screening for companies with a low P/C is a stepping-off point in the diligence process, not the finish line.
Of importance, when you think you’ve found the next big arbitrage play – a stock trading below its cash position – there’s a reason. When an equity trades below the aggregate value of the company’s cash & equivalents, the market has essentially given the company, or management, no credit for its ability to create value with whatever cash it may have. Investors are indicating that this is a failing business, and that the company is more likely to burn through its cash than create value, or return the capital to shareholders. While the astute investor may notice something that the rest of the market overlooks, it’s best to approach anything trading below cash with a healthy dose of skepticism.
A current example of an equity trading very close to its cash balance: KaloBios Pharmaceuticals (KBIO). KaloBios develops antibodies for respiratory diseases like asthma and cystic fibrosis, as well as some cancers, but the stock took a major hit in January when a phase 2 study of KB003, an anti-GM-CSF antibody, failed to meaningfully improve pulmonary function in asthma patients when compared to placebo. KBIO closed the Wednesday session at $2.33 and should have ended the first quarter with just under $2.00 per share on a fully diluted basis. The equity is in the doghouse due to the phase 2 miss and the overall sentiment towards the biotechnology sector, but the company also lacks any significant, value-driving events until late this year. We’re certainly not suggesting a long position, but having equities like this on the radar makes sense given the current enterprise value (market cap + debt – cash & equivalents) of around $15 million, and a far more interesting second half of the year.
Transversely, screening for equities with a high P/C ratio can be a good first move in the search for overvalued and short-able companies.
In addition, we like to see Little to No Debt (a low D/E).
While leverage is a less preferred choice of financing for clinical stage biotech companies, debt is used occasionally to fund development operations. Screening for no- or very low-debt load, as measured by a company’s Debt-to-Equity Ratio (D/E), is a good step in weeding out outliers.
Recent Insider Buying and Institutional Ownership/Buying
As equities dip, it’s encouraging to see insiders (management and directors) buying their own stock – that is, if they hadn’t been selling at the top – and can mean one of two things: 1) Management thinks their stock is cheap; or 2) That they’re simply trying to put a bottom in on their own. Understanding the difference takes a closer look at management’s track record, but net-net, seeing insiders buying on the open-market is encouraging and a good place to find diligence-worthy companies.
Institutional ownership is validation, though not the end-all-be-all, and it’s important to understand that there are different types of institutional owners: smart money and big money.
The former, in our case, are healthcare-focused hedge funds: Orbimed, Glenview, Baker Brothers, and Perceptive Advisors to name a few. Ownership by these – and related funds – can support an investment thesis where the motivation behind a position is based on in-depth fundamental research.
The latter consists of passive mutual funds and ETF’s that are so large and so diverse, they have to own everything and anything and aren’t necessarily paying close attention to the fundamentals, especially if they’re tracking ETFs or indices. Point to the BlackRocks and Vanguards of the investing world is a common rookie mistake in the small-cap space. Both are reputable firms, but don’t offer evidence to validate an investment thesis; because of their size and tracking of numerous indices, they’re involved anywhere and everywhere. Look where active money managers are placing their bets, but note that following blindly the smart players isn’t wise either. Understanding the real motivation behind a institutional investor’s position – arbitrage, for instance, or simply involvement in an under-market offering that came with cheap warrants – isn’t always evident.
For the Long-Term Stories, ROIC and Book Value per Share
Generating investment returns from revenue-stage companies can many times be attributed to a competitive advantage. When we think of competitive advantages, we think of Biogen Idec’s (BIIB) history of producing blockbuster MS therapies; Emergent BioSolution’s (EBS) grip on Anthrax vaccines (PropThink’s thesis here); and Alexion Pharmaceutical (ALXN) having cornered the aHUS and PNH markets with Soliris. Competitive advantages like the above, supported by an experienced management team, often evidence themselves.
Return on Invested Capital
Return on Invested Capital (ROIC) is a relevant metric to assess both the competitive advantage a firm maintains and the ability of management to increase shareholder value by prudent investing. ROIC is calculated as Net Operating Profit after Tax divided by Total Invested Capital (i.e. debt, preferred and common equity). Reviewing the formula more closely, ROIC is a function of operating margins, taxes and the return a company generates for each unit of capital on the books.
The importance of a high relative ROIC can’t be understated, and it points to many aspects of a business that we find attractive, such as a pricing advantage, leading to higher margins where investment returns surpass the cost of capital, thus increasing shareholder value.
Value-creating management teams that deploy capital in a consistently effective manner are rare, and analyzing ROIC can uncover talented executive teams. PropThink’s thesis for Albany Molecular Research can be directly attributed to management and its ability to drive value for shareholders.
Worth noting, we don’t discriminate from businesses with low ROIC, just ones that generate a low ROIC relative to competitors or have no prospects of improving returns to surpass competitors. We also tend to not focus on Return on Equity since different capital structures (i.e. use of debt) skew results and minimize comparability across companies
High relative ROIC can also be viewed as having a compounding effect of sorts that places competitors at a disadvantage. A company with higher relative margins – and by extension, ROIC – will generate more cash for the same amount of capital, allowing it to invest more heavily in pipeline R&D while the lower ROIC company will either tap equity/debt markets to achieve the same level of growth – or purposely grow at a slower pace. The latter company is inefficient, paddling upstream against a stronger current. We’d rather not jump in the boat with companies experiencing headwinds, especially in biotech, where pipeline development is capital intensive, often requiring hundreds of millions of dollars to bring a drug to market.
Book Value Per Share
Growth in Book Value per Share (BVPS, balance sheet equity divided by shares outstanding) also speaks to prudent capital allocation when comparing BVPS growth to Revenue per Share (RPS) growth over extended periods.
Value-destroying acquisitions, partnerships and joint-ventures will generally characterize a disparity between BVPS and RPS growth due to the writing down of assets that failed to perform. Many factors can explain why, yet poor timing, overpaying, and ineffective integration of operations are the primary culprits of failed strategies, and once again, attributes that can be linked to those at the helm. We prefer to see double digit growth in BVPS over a 5-10+ year period when assessing growth stories.
