Peter: When I got your message, I had just read the following interview with Elizabeth Silverman in Individual Investor. She likes Gene Logic. iionline.com
GLGC looks interesting to me.
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Up from the Roach Motel
Elizabeth Silverman cherishes unloved stocks that deliver happy returns.
by Andrew Feinberg
Biotechnology is a notoriously volatile market sector that perhaps wiped out as many investors as it has enriched. Its companies are flush with the potential for creating highly profitable biologically derived drugs and products, but the vast majority have no revenue, no earnings, and a small float of shares. Elizabeth Silverman, an independent analyst formerly with BancBoston Robertson Stephens, has a low-risk way to play the sector: buy "roach motel" stocks.
Silverman analyzed the performance of biotech IPOs over the past five years and found one group that delivered terrific rewards. She calls them roach motel stocks because institutional investors shun them, thinking that once they underperform and check into the roach motel, as the infamous TV ad warned, they'll never check out. But Silverman found 11 stocks that checked out and moved up, returning an average of 293% from their IPOs through the end of 1998. From best performer down, the roaches were: Incyte Pharmaceuticals, Neurex, Zonagen, SangStat Medical, Inhale Therapeutic Systems, Aviron, Vical, Human Genome Sciences, Coulter Pharmaceuticals, Genset, and Pharmacyclics.
How did you develop the roach motel concept?
Over the past few years, most biotech IPOs have exhibited the same clear, depressing pattern. A stock would go public, rise a bit, and then quickly fall as investors flipped shares. A lot of biotech offerings simply died on the vine, and there was a great deal of pessimism about the sector.
Because most biotechs have small market caps, are thinly traded, and don't have analyst coverage, institutional investors won't buy in for fear they won't be able to get out without dramatically affecting share prices. I wanted to look back to see if any biotechs that were shunned later recovered and enjoyed substantial gains, and I found the roach motel stocks.
What does it mean when a stock is languishing in a roach motel?
Roach motel stocks are those that are ignored by most investors. These stocks have an average daily trading volume of less than 40,000 shares for at least one quarter without much, if any, share-price appreciation. The 40,000-shares-a-day cutoff is admittedly arbitrary, but it shows the stocks are very illiquid. Even though there may be good values among these companies, investors aren't buying in. And because large-caps recently have outperformed small-caps in almost all sectors of the market, including biotech, you're likely to find even more biotech stocks than usual that are undervalued.
So what causes stocks to check out of roach motels?
Before I studied the sector, I assumed company-specific events would be the trigger, but that isn't true. Roach motel stocks usually begin moving up when the entire biotech sector starts performing well. That suggests you should buy these stocks as the sector begins improving, rather than look for good news about a particular company.
So investors shouldn't buy biotechs when sentiment about the sector is negative?
If you do, you'll find the fundamentals of particular companies don't affect performance that much. Biotech is a unique sector in that it's binary: Sometimes stocks are hot; sometimes they endure periodic Ice Ages. When the sector is off, it's very difficult for almost any company's shares to move. But when things are going well, it's one of the few sectors where stocks can double or triple quickly.
How does an investor select the right roach motel stocks?
Concentrate on companies covered by at least two or three analysts, because institutions are more likely to invest in those. Read research reports and look closely at companies' balance sheets. Ideally, you want to find companies that are trading at or near the value of their cash on hand, and can cover their burn rate [the amount of cash they run through] for at least two years. Since good management is important, I look for managers who have worked many years in the industry.
If investors buy a roach motel stock, how long should they expect to wait for a reward?
Investors need patience. The 11 big winners I studied stayed in their roach motels for an average of seven quarters. That can be frustrating, especially when money is pouring into already profitable biotech companies and information technology companies while these stocks aren't moving.
Some companies that check into the roach motel will never check out. What are the signs of a perennial loser?
If a company doesn't deliver on its promises--if a drug isn't entering clinical trials on time, or management doesn't sign contracts as expected--watch out. It is also a potential problem if revenues aren't ramping up and annual losses aren't decreasing.
What roach motel stocks do you like now?
My favorites are Gene Logic (Nasdaq: GLGC) and CombiChem (Nasdaq: CCHM). Both have very good management teams and strong balance sheets.
Gene Logic uses a proprietary system to discover genes that might be used to develop drugs, or that drugs can act upon. It has research contracts with Procter & Gamble, American Home Products, and SmithKline Beecham. Its burn rate is $10 million to $15 million a year, it has $35 million in cash, and it's signing up three or four customers a year. The stock ran up to $10.13 last July, but recently was trading at $7.38.
CombiChem is a drug discovery company that uses computer software to identify new drug possibilities extremely quickly--it has cut the drug discovery cycle in half, which potentially saves a fortune for pharmaceutical manufacturers. The stock traded as high as $8.44 last year and recently could be had at $4. But fundamentally, nothing has changed. The company has a very good business model, and fees from customers cover all its research costs. I expect CombiChem to break even in 1999 and actually earn money in 2000, assuming it continues to attract three to five new customers per year. Gene Logic went public in November 1997 and CombiChem in May 1998, so there may be some more waiting to do.
Is there an area of biotech you think is especially promising now?
I particularly like genomic stocks, the subsector of biotechs that focuses on genetic research and mapping. For the first time, we are able to look at and analyze the blueprint of life. That means we are able to design drugs for new molecular targets. Eventually a lot of preventive medicines will come to market. What's more, this type of company tends to have a relatively low burn rate, partly because a portion of its research costs are likely to be funded by corporate partners.
Can value investors apply your theory to other sectors of the market?
I'm sure they could, but I haven't researched the issue. Clearly, if you can find stocks that are unloved for no good fundamental reason, you have a chance of achieving a very high return.
Is this a good time to invest in roach motel stocks?
It's not a bad time--and it may soon be a very good time. Right now biotech is somewhat ignored because investors are fixated on technology stocks, Internet stocks in particular. Some biotech stocks have been doing very well--the American Stock Exchange biotech index is up 75% since the summer--and in general there has been good news in the sector. Amgen won its arbitration against Johnson & Johnson for rights to the red-blood-cell stimulant NESP, while SangStat Medical reported a successful trial of its cyclosporine drug for transplant patients, as did GelTex Pharmaceuticals for Cholestagel, a drug to reduce cholesterol. Another big piece of good news could set off a real rally in the sector.
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