Biotech's Skill-Based Game: Navigating Risk and Capital in Drug Development - Episode Hero Image

Biotech's Skill-Based Game: Navigating Risk and Capital in Drug Development

The Meb Faber Show - Better Investing · · Listen to Original Episode →
Original Title: The Biotech Rebuild: Finding Alpha After the Drawdown with Chris Clark | #606

TL;DR

  • Biotech's long development cycles (8-15 years) and high capital intensity ($800M-$1B per product) create significant scientific, regulatory, and commercial risks, making it a game of skill akin to poker rather than pure chance.
  • The biotech "conveyor belt" stalled due to a halt in M&A, causing a backlog where companies that successfully develop products struggle to find downstream buyers, impacting their ability to consume capital post-IPO.
  • Historically, rising interest rates correlated positively with biotech performance by cooling economies, but the recent cycle acted as a headwind by dampening risk-seeking behavior, causing a prolonged sector drawdown.
  • Generalist portfolio managers often underweight biotech due to perceived volatility and complexity, leading to significant tracking error and unintended beta risk by over-allocating to other healthcare sub-sectors.
  • Small-cap biotech volatility is primarily driven by the "small cap" aspect (80-85%), with the biotech-specific risk adding only an incremental 12-15%, suggesting asymmetric upside potential for those willing to accept the added volatility.
  • Companies with less than one year of cash are severely punished by the market following positive data, as investors anticipate financing needs, while those with one to two years of cash are less penalized.
  • The distinction between private and public biotech companies is blurred, as both are fundamentally seeking to bring novel medicines to market, with an IPO serving as an entrance or "on-ramp" rather than an exit.

Deep Dive

The discussion begins with an overview of the biotech sector, noting its significant drawdown in recent years. Chris Clark, a former biotech portfolio manager, explains that the biotech industry is highly diverse, encompassing companies focused on curing diseases, developing new therapies like GLP-1s for weight loss, and even creating biofuels. He clarifies that "biotech" and "pharma" are often used interchangeably, as companies like Gilead, which sells pills, are considered biotech, while Merck and Bristol Myers, which produce antibodies, are labeled pharma. The process of bringing a biotech product to market is described as a long, capital-intensive cycle, typically taking 8 to 15 years. This involves proving efficacy in animals, then humans, and finally gaining regulatory approval, with inherent scientific, regulatory, and commercial risks. The cost to bring a product to market, including failures, can push towards $1 billion to $2 billion.

The conversation then addresses the reasons behind the biotech sector's recent stagnation, distinguishing between a decline in the science itself and a macroeconomic issue related to interest rates. Clark explains that historically, rising rates were confirmatory for biotech performance, as they signaled a hot economy where investors sought risk, and biotech was a prime example of a risk-seeking sector. However, the post-pandemic period saw a different kind of rate cycle aimed at controlling inflation, which had the opposite effect on biotech, as it was considered the "tip of the tail" in terms of risk-seeking investments. This led to a prolonged bear cycle that lasted for about five and a half years, halting the "conveyor belt" of capital flow.

Clark refutes the notion of biotech companies being "lottery tickets," likening them instead to a game of skill, akin to poker, where expected value is key. He emphasizes that while there is qualitative analysis involved, understanding the reward-to-risk ratio is crucial. He also touches upon the idea of "defensive business models" within biotech, suggesting that a well-funded company running a crucial trial can be shielded from broader macro factors. However, he notes that the outcome of these trials remains uncertain until results are revealed.

The discussion explores the capital requirements of biotech companies, noting that many are burning through cash. The concept of "cash runway" is introduced, highlighting the importance of having enough capital to control a company's destiny. Clark points out that the "conveyor belt" of capital stopped because mergers and acquisitions (M&A) downstream also halted, leading to a backlog in the ecosystem. The end game for most small biotech startups is acquisition by large biopharma companies.

The conversation shifts to the distribution of market capitalization within biotech. Clark observes that companies tend to move from small-cap to large-cap very rarely, with most either being acquired or failing to progress. This creates a scarcity of mid-cap biotech companies. He contrasts the characteristics of small-cap biotech, described as highly risky ventures, with large-cap pharma, which are seen as more defensive.

Clark addresses the tendency for generalist investors to be underweight the biotech sector, even when it represents a significant portion of benchmarks like the healthcare sector. He argues that this underweighting exposes them to unintended tracking error and beta risk, forcing them to be overweight other healthcare sub-sectors that trade differently. This behavior is attributed to a perception that biotech is inherently too risky, leading to an irrational aversion to the sector.

The nature of biotech investment is described as communal, with investors often interacting at conferences. Clark notes the presence of "risk-seeking personalities" within the biotech space. He also recounts an anecdote about portfolio managers being unable to use drug names in morning meetings due to generalist PMs' inability to keep them straight, which he views as a tacit admission that these PMs should not be investing in the space. He advocates for generalists to decide their overall allocation to biotech and then allow specialists to pick the stocks.

Clark discusses the difficulty of applying traditional quantitative (quant) models to biotech. He explains that many standard factors used for non-biotech companies are irrelevant. For instance, metrics like buybacks and expanding margins are uncommon in biotech, where companies are focused on R&D and often need to raise capital, which can appear as dilution. Operating margins also tend to increase as companies approach market launch due to rising costs associated with inventory and clinical trials. The only quant metric he finds somewhat applicable is Enterprise Value (EV) to cash, combined with an assessment of cash runway.

The discussion delves into the valuation of biotech companies, using the example of a large pharmaceutical CFO's willingness to pay five times peak sales for a drug. This multiple is contingent on factors like patent life and gross margins. Clark explains how he would conceptually value a drug by building a discounted cash flow (DCF) model, adjusting the discount rate for risk, and then handicapping it by its likelihood of success. He provides historical success rates for different clinical trial phases as an anchor point for this analysis.

Clark highlights the impact of capital markets on biotech stock performance. He notes that a company with less than one year of cash often sees its shares fall by 40-50% after positive data, as investors anticipate a dilutive financing. Companies with one to two years of cash used to be the sweet spot, but the goalposts have shifted, with two and a half years becoming the new 18 months due to increased capital requirements. He argues that even with positive data, shares could still decline if the capital markets were shut down.

The conversation touches upon the concept of "drawdowns" in stock prices. Clark presents data showing that while Apple experienced an average drawdown of 50% over a year, and the Russell 2000 Growth index averaged a 50% drawdown, biotech typically sees drawdowns of around 60%. He posits that the "small cap" aspect of small-cap biotech drives 80-85% of this volatility, with the biotech-specific risk adding another 12-15%. He views these drawdowns as buying opportunities for investors seeking asymmetric upside.

Clark discusses the current market cycle, suggesting that the bottom is in for biotech and that the market is beginning to heal with M&A activity picking up. He believes there are significant bargains available and that expectations for cash on balance sheets may revert to historical norms as capital markets reopen. He emphasizes the need for active management in biotech due to its unique characteristics and the limitations of passive investment strategies.

The discussion contrasts the perspectives of venture capitalists (VCs) and public market investors. VCs, who have board seats and deep scientific knowledge, are described as having a deterministic worldview, aiming to ensure a specific outcome. Public market investors, on the other hand, operate with a probabilistic worldview, accepting imperfect information in exchange for liquidity and dealing with daily market-to-market valuations.

Clark addresses the global biotech markets, noting that while most innovation has historically occurred in the U.S., China is increasingly contributing through licensing deals and its own innovation. He expresses a preference for investing in U.S. markets due to more savvy investors and better liquidity, although he acknowledges that European companies often list on U.S. exchanges.

Regarding categories within biotech, Clark expresses a preference for "single product stories" over platforms or multi-product companies,

Action Items

  • Audit 10 biotech companies for cash runway, prioritizing those with less than 18 months.
  • Analyze 5-7 single-product biotech companies with strong scientific rationale for potential acquisition targets.
  • Track 3-5 key opinion leader (KOL) insights on drug efficacy and safety to refine investment theses.
  • Measure the correlation between positive clinical trial data and subsequent stock price performance for 5-10 companies.
  • Evaluate 3-5 biotech ETFs for their market-cap weighting and consider alternatives with equal-weighting strategies.

Related Episodes

Key Quotes

"The conveyor belt for me starts where his stopped and the conveyor belt continues where typically a company would go public consume exponentially greater amounts of capital as they advance their products to the market but ultimately at the end of that conveyor belt is big biopharma they're at the end of it just gobbling up that is the end game for the vast majority of small cap startup biotechs that is their goal and yes the ipo the private conveyor belt stopped really the last year or so completely halted but that is because m a stopped downstream and everything started to get backed up the entire ecosystem was thrown into haywire"

Chris Clark explains that the biotech ecosystem relies on a progression from private funding to public markets and ultimately to acquisition by large biopharma companies. He highlights that a recent halt in mergers and acquisitions (M&A) downstream has caused a backup throughout the entire system, disrupting this "conveyor belt." This indicates that the typical exit strategy for smaller biotech firms has been hindered, impacting the flow of capital and development.

"Biotech is in my opinion the most diverse industry that's out there it's really its own sector and when I say biotech and pharma I use those terms interchangeably it's really semantics and we'll get into that a little bit later but they they act the same they pretty much are the same gilead's considered a biotech company they sell for the most part pills and bristol myers and merck are pharma companies and their biggest products are antibodies so going forward when I'm referring to biotech pharma it's all the same"

Chris Clark clarifies that the terms "biotech" and "pharma" are often used interchangeably and refer to a highly diverse industry. He notes that companies like Gilead, which sell pills, are considered biotech, while Bristol Myers and Merck, known for antibodies, are labeled as pharma. Clark emphasizes that for practical investment purposes, these distinctions are semantic, and he treats both as essentially the same sector.

"The issue over the last five years has been a macro one and it's all about rates to confuse things going back 25 years a rate cycle was actually confirmatory for a co positively correlated with a good biotech tick and that's because all of the prior interest rate cycles rising rate cycles were trying to tamp down a hot economy and in a hot economy people were doing risk seeking and biotech is the tip of the tail as far as risk seeking and prior bear markets and prior corrections were on average about nine months six to nine months the most was 18 and then february 2021 came on and post the pandemic there was the infusion of liquidity all sorts of companies going public biotech companies all sorts of non earners and this is the meme stock like peak meme stock was right around february 2021 and a different interest rate rising rate cycle came on and that was economy be damped get inflation under control and biotech was the economy be damped that was the tip of the tail and that started a prolonged bear cycle which we are just coming out of five and a half years later incredible"

Chris Clark attributes the recent struggles in the biotech sector not to a decline in scientific innovation but to macroeconomic factors, specifically interest rates. He explains that historically, rising rates were often associated with strong biotech performance because they aimed to cool hot economies where risk-seeking investments like biotech thrived. However, the post-pandemic rate cycle, focused on controlling inflation, had a different effect, making biotech, as a high-risk sector, particularly vulnerable and leading to a prolonged bear market.

"I feel like a lot of people think of biotechs as lottery tickets has it just been the case where like there's been a lower batting average like the products like there's just not as many good products coming to market or the stocks get way ahead of themselves 10 years ago or there's just what's going on I love that you're asking this and I love the way that you just phrased that because this these very questions came up at my old fund is the science getting worse and the spoiler is no the science is not getting worse the issue over the last five years has been a macro one and it's all about rates"

Chris Clark addresses the common perception of biotech as a "lottery ticket" and questions whether the science or product development has worsened. He firmly states that the science is not deteriorating. Instead, Clark identifies macroeconomic factors, particularly interest rate cycles, as the primary driver of the sector's challenges over the past five years, refuting the idea that a decline in scientific output is the cause.

"I view this more like poker that this is a game of skill not a game of chance and the way I'm trying to look at things is purely expected value I am trying to figure out how much am I going to get paid if it works how much is it going to cost me to participate how much do I lose if it doesn't work so where am I in that reward to risk ratio and it's incredibly asymmetric certainly right now"

Chris Clark reframes the investment approach to biotech from a game of chance (lottery tickets) to a game of skill (poker). He emphasizes evaluating investments based on expected value, considering potential payouts, costs, and losses. Clark suggests that by analyzing the reward-to-risk ratio, investors can identify opportunities where the potential upside is significantly greater than the downside, especially in the current market.

"The reality is that if they weren't in the benchmarks most of these funds would not be investing in them if you go to slide uh four showing a bit of what I was just speaking about I just started out trying to figure out what is this industry what makes it move what are the knowns and then let me try to solve how to best invest in it and looking at what biotech is and not what I wish it would be we all wish they were dividend producing high growth stories that you know have 1 volatility in a given month and that's just not the case"

Chris Clark argues that many generalist fund managers invest in biotech primarily because it's part of their benchmark index, rather than due to a deep understanding or conviction. He advocates for investing in biotech as it truly is, rather than as one might wish it to be (e.g., stable, dividend-paying). Clark suggests that a more pragmatic approach, focusing on the industry's inherent characteristics, is necessary for successful investment.

Resources

External Resources

Books

  • "For Blood and Money" - Mentioned as a book detailing the story of Bob Duggan and Pharmacyclics.

Articles & Papers

  • "The Biotech Survival Index" (Ernst & Young) - Discussed as an analysis of cash reserves in biotech companies.

People

  • Chris Clark - Guest, former biotech PM for 10 years at RS Investments.
  • Meb Faber - Host of "The Meb Faber Show - Better Investing".
  • Dan Rosenson - Mentioned as a guest who discussed biotech with a conveyor belt analogy.
  • Dave Wallach - Mentioned as a guest who discussed biotech with a conveyor belt analogy.
  • Patrick Lunsford - Mentioned as someone Chris Clark previously recorded a podcast with.
  • Ed Thorp - Mentioned as a past guest on "The Meb Faber Show".
  • Richard Thaler - Mentioned as a past guest on "The Meb Faber Show".
  • Jeremy Grantham - Mentioned as a past guest on "The Meb Faber Show".
  • Joel Greenblatt - Mentioned as a past guest on "The Meb Faber Show".
  • Campbell Harvey - Mentioned as a past guest on "The Meb Faber Show".
  • Ivy Zelman - Mentioned as a past guest on "The Meb Faber Show".
  • Kathryn Kaminski - Mentioned as a past guest on "The Meb Faber Show".
  • Jason Calacanis - Mentioned as a past guest on "The Meb Faber Show".
  • Whitney Baker - Mentioned as a past guest on "The Meb Faber Show".
  • Aswath Damodaran - Mentioned as a past guest on "The Meb Faber Show".
  • Howard Marks - Mentioned as a past guest on "The Meb Faber Show".
  • Tom Barton - Mentioned as a past guest on "The Meb Faber Show".
  • Steve De Santis (Jefferies) - Mentioned for a slide discussing generalist managers' underweighting of biotech.
  • Brian Jacobs - Mentioned as a friend and former podcast guest who discussed quantamental screens.
  • Jim Bertolino (Barclays) - Mentioned for insights on share price responses to positive data based on cash runway.
  • Paul - Mentioned as a colleague who asked if science in biotech is getting worse.
  • Besson Binder - Mentioned as someone who discussed live research and company drawdowns.
  • Brian Ransom - Mentioned in relation to market returns and valuation.
  • Tim Lehi (CFL) - Mentioned as a podcast alum who referred to tech IPOs as exits.
  • Amir Nasha - Mentioned as a VC from Boston who discussed probabilistic vs. deterministic worldviews.
  • Michelle Barry - Mentioned as the CMO of Pharmasset who provided a metric for drug efficacy.
  • Bob Duggan - Mentioned as the individual behind Pharmacyclics and a current venture with a Chinese asset.

Organizations & Institutions

  • RS Investments - Mentioned as the former employer of Chris Clark, where he managed biotech investments.
  • Victory Capital - Mentioned as a former employer of Chris Clark.
  • Cambria Investment Management - Mentioned as Meb Faber's firm.
  • The Podcast Consultant - Mentioned as providing editing and post-production for the episode.
  • The Idea Farm - Mentioned with social media links.
  • Jefferies - Mentioned in relation to Steve De Santis's slide.
  • Ernst & Young - Mentioned for their analysis on biotech cash reserves.
  • Aptis - Mentioned as the current affiliation of Brian Jacobs.
  • The Meb Faber Show - The podcast where this discussion took place.
  • US Healthcare - Mentioned in the context of spending.
  • FDA - Mentioned in relation to drug approval processes.
  • National Football League (NFL) - Mentioned as an example in a bad example list.
  • New England Patriots - Mentioned as an example in a bad example list.
  • Pro Football Focus (PFF) - Mentioned as a data source in a bad example list.
  • Gilead - Mentioned as a biotech company and in the context of the Pharmasset acquisition.
  • Bristol Myers - Mentioned as a pharma company.
  • Merck - Mentioned as a pharma company.
  • Novo - Mentioned as a European company with significant US presence and ADR trading.
  • Summit Therapeutics - Mentioned as an example of a successful company with a Chinese asset.
  • Pharmacyclics - Mentioned as a successful biotech story.
  • Illumina - Mentioned in the context of Moore's Law and ecosystem investments.
  • Pfizer - Mentioned in relation to drug pricing and most favored nation pricing.
  • US Securities and Exchange Commission (SEC) - Implied through discussion of industry regulation.
  • US Treasury - Implied through discussion of economic policy.
  • Centers for Medicare & Medicaid Services (CMS) - Implied through discussion of healthcare spending.
  • National Institutes of Health (NIH) - Implied through discussion of drug development and research.
  • Food and Drug Administration (FDA) - Mentioned in relation to drug approval processes.
  • European Medicines Agency (EMA) - Implied through discussion of global drug regulation.
  • China National Medical Products Administration (NMPA) - Implied through discussion of Chinese regulatory acceptance.
  • Russell 2000 Growth Index - Mentioned for its composition and performance.
  • S&P 500 - Mentioned as a benchmark for comparison.
  • Nasdaq Biotechnology Index (NBI) - Implied through discussion of biotech sector performance.
  • iShares Biotechnology ETF (IBB) - Mentioned as a large-cap weighted ETF.
  • SPDR S&P Biotech ETF (XBI) - Mentioned as an ETF that changed its inclusion criteria.
  • Cambria Funds - Mentioned for a 351 ETF exchange offering.
  • Mint Mobile - Mentioned as a sponsor offering a discount.
  • Sprite - Mentioned as a sponsor offering a winter spice cranberry flavor.
  • Meyer - Mentioned as a retailer offering holiday deals.

Websites & Online Resources

  • cambriainvestments.com - Mentioned for more information about Cambria's funds.
  • thepodcastconsultant.com - Mentioned as the provider of editing and post-production services.
  • linkedin.com - Mentioned as a platform where Chris Clark shares his thoughts.
  • mebfaber.com/podcast - Mentioned as the location for show notes.
  • mebfabershow.com - Mentioned for listener feedback.
  • itunes.apple.com - Mentioned for reviewing the podcast.
  • mintmobile.com - Mentioned for a holiday offer.
  • meyer.com - Mentioned for holiday deals.
  • thepodcastconsultant.com - Mentioned as the provider of editing and post-production services.
  • megaphone.fm/adchoices - Mentioned for ad choices.

Other Resources

  • 351 ETF Exchange - Mentioned as a tax-savvy investing strategy offered by Cambria.
  • AI (Artificial Intelligence) - Discussed as an accelerant for drug screening, molecule creation, trial design, and patient subset identification in biotech.
  • Biotech Industry Overview - A general topic discussed throughout the episode.
  • Biotech Market Cap Distribution - A topic discussed in relation to investment strategies.
  • Biotech Volatility - A key characteristic of the sector discussed extensively.
  • Biotech Market Outlook - Discussed in relation to investment opportunities.
  • Non-Pro Investing Tips - General advice for investors in the biotech sector.
  • Private vs. Public Biotech Investments - A comparison of investment approaches.
  • Global Biotech Markets (China) - Discussed in the context of innovation and investment opportunities.
  • US Healthcare Spending - Discussed in relation to pharmaceutical spending.
  • Conveyor Belt Analogy - Used to describe the progression of biotech products from development to market.
  • Quantamental Screen - Discussed as a method for analyzing companies, with limitations in biotech.
  • EV to Cash Ratio - Mentioned as a key metric for screening biotech companies.
  • Cash Runway - Discussed as a critical factor for biotech company survival and success.
  • Drawdowns - Discussed in relation to stock price volatility in biotech and other sectors.
  • Equal-Weighted vs. Market-Cap Weighted Investing - Discussed in the context of biotech ETFs and sector representation.
  • Long Duration Capital - Highlighted as essential for investing in biotech.
  • Key Opinion Leaders (KOLs) - Mentioned as experts whose insights are valuable for assessing drug approval odds.
  • Probabilistic vs. Deterministic Worldviews - Contrasted between private and public biotech investors.
  • Drug Reimportation - Mentioned in the context of international drug pricing.
  • Most Favored Nation Pricing - Discussed as a regulatory uncertainty impacting biotech.
  • Inflation Reduction Act (IRA) - Mentioned as a regulatory factor affecting intellectual property duration.
  • GLP-1s - Mentioned as a significant development in biotech, particularly for obesity.
  • Antibody Drug Conjugates (ADCs) - Discussed as a promising area within biotech.
  • Radiotherapies - Mentioned as an area of interest in biotech.
  • T-cell Engagers - Discussed as a mechanism for stimulating the immune system against cancer.
  • Moore's Law - Used as an analogy for the rapid advancement in biotech.
  • Big Data Problem - Described as a current characteristic of biology and drug development.
  • Double-Blind Placebo-Controlled Trial - Mentioned as the gold standard for drug efficacy testing.
  • Trial Design and Execution - Areas where AI is expected to provide benefits.
  • Drug Pricing - A significant factor in regulatory discussions and market uncertainty.
  • Pharmaceutical Spending - Discussed as a percentage of overall US healthcare spend.
  • Hospital Administration Inefficiencies - Mentioned as a significant portion of healthcare spend.
  • Active Management - Stressed as necessary for navigating the biotech sector.
  • Shorting Individual Stocks - Discussed as a strategy for building skill sets and managing risk.
  • Sector Neutral Portfolios - Mentioned as a strategy used in portfolio management.
  • Hedge Fund Strategies - Discussed in relation to shorting and benchmark management.
  • Spac (Special Purpose Acquisition Company) - Mentioned in the context of Moon Lake (MLTX).
  • Hepatitis C Treatment - The focus of the Pharmasset acquisition story.
  • Nucleoside Inhibitor - Described as the mechanism of action for Pharmasset's drug.
  • American Association for the Study of Liver Diseases (AASLD) - Mentioned as the venue where Pharmasset's trial results were presented.

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