Biotech is an exciting, volatile and at times excessively confusing space. Unfortunately, this combination exposes investors to a large volume of companies all claiming to have innovative medicines/technologies with blockbuster potential. Yet, over time the vast majority of these companies fail to create value for shareholders. In fact, their investors often find themselves suffering incredible losses.
You’ve probably seen it before; It’s Friday afternoon and the stock everyone thought was going to the moon just got cut in half on a surprise press release revealing the company is far from its target or failed a clinical trial. While this creates immense opportunity for short sellers, bulls are left in the dust.
In today’s “topic of the week,” we explore the top 5 red flags that help us identify these train wrecks waiting to happen.
5 red flags in biotech
- Lots of news, but little to no execution
- History of reverse split
- Investor base
- Financing deals with shady firms
- Departure of an executive
Lots of news, but no execution:
Some small and micro cap companies take advantage of investors through hyperbolic press releases (PRs) and frequent appearances on shows like Mad Money with an obvious intent to inflate their market capitalizations. One example is Sorrento Therapeutics (NASDAQ: SRNE) which operated this way during the pandemic (and before as well). Using headlines with buzzwords like 100% cured..., seeking emergency use authorizations…, and issuing endless press releases designed to create interest in its stock by way of its “COVID-19 solutions”. But as we can clearly see there has been zero execution on these initiates with none of the assets making it out for the early stages of development. Meanwhile SRNE’s CEO diluted stakeholders by issuing over a 100M shares through at-the-market stock offerings (called ATMs).
Take away: Always consider the real prospects of a company’s pipeline and news as well as its ability to execute. Are the press releases generating shockwaves and bumping share prices up every week with little rationale for the valuation increase? If so, it’s probably not sustainable. In the above example, SRNE’s new clinical initiatives and press releases were catered towards investors seeking to bank on effective therapies and diagnostic solutions for the pandemic.
One key metric which helps us discern the real prospects/demand for a company’s drug/asset is enrollment in its clinical trials. If the news sounds too good to be true and the trials are moving at a snail’s pace, then the asset is likely facing barriers/resistance in development. The same goes for assets in different fields. Test kits and antivirals have entirely different supply chains and talent required to adequately scale. A sub $1 billion company like SNRE was before the pandemic is highly unlikely to possess the in house talent required to commercialize all of these prospects. Successful small cap companies pick a niche and do it very well as opposed to getting spread thin on capital and man power.
History of reverse split
History can tell us a lot about a company and the ability of its management team to bring an idea from concept to market in a fiscally responsible manner. As many of you know, to be listed on the NASDAQ or NYSE exchanges a company must maintain a minimum bid price of $1.0. If a company fails to do this for 30-consecutive business days then it gets what’s called a deficiency notice. Consequently, the company is given 180 calendar days to regain a minimum bid price of $1.0 for 10-consecutive business days. Sometimes the company may be eligible for additional time if it fails to accomplish this in 180 calendar days. Ultimately, though, if the company in question cannot succeed then it’ll be delisted from the NASDAQ exchange. Rules regarding the minimum bid price requirements are similar for NYSE.
While reverse splits (R/S) happen for many reasons, often it is the result of a company running out of options (especially in small/micro cap companies). Much of the time small/micro caps will end up executing an R/S in order to maintain compliance due to an inability to keep it over $1.0 organically. What an R/S does is consolidate the outstanding shares into fewer shares (exchanging every X number of shares for 1 share), resulting in a higher price.
One recent example is Novan, Inc. (NASDAQ: NOVN) which performed a 1-for-10 R/S on 5/25/21. Over time these sorts of companies tend to perform poorly although not ubiquitously. Novavax (NASDAQ: NVAX) for instance rallied to over $300/share last year from sub-$5 at the start of 2020 and despite a 1-for-20 R/S on 5/10/19. NVAX’s story, though, is undoubtedly the exception.
How can you tell if a company has done previous R/S? A simple google search can get you started. In particular you can use this website (splithistory.com) to uncover its split history (or lack thereof). It doesn’t hurt either to verify if the company has operated under a different name in the past.
When parking your money somewhere, it’s important to know who else has joined you. In small/micro cap biotech stocks, there are certain prominent institutional investors that are well-known for their ability to identify and unlock value from high-growth investment opportunities. In the table below we list the top funds that we’ve come across in our experience and their total assets under management.
Assets Under Management (AUM)
(data in billions)
Number of Positions
Financing deals with firms we do not like
Funding is a key lifeline to commercialization and success of pipelines. While some companies manage to strike up favorable deals with well regarded firms/investment banks, others do deals with firms that don’t bring much value to the table. Commonly investors with these firms acquire warrants in the financing deal and make their money shorting the stock for years. One example is DelMar Pharmaceuticals (Nasdaq: DMPI) before it had a change in leadership and merged with Adgero Biopharmaceuticals.
For years DMPI did equity financing deals (stock and warrants) with two of the top firms we avoid (Dawson James and The Maxim Group). During this period DMPI underperformed its peers and trended downwards over time reaching all-time-lows at $0.38 on 3/23/20 from ~$5 the year prior. This is a common theme among companies that do deals with Dawson James and The Maxim Group. Adamis Pharmaceuticals (Nasdaq: ADMP) is another prime example. Only in the case of ADMP investors did not get a change in leadership like DMPI did. Consequently, ADMP has continued to perform poorly and emulates all of the red flags discussed in this article.
In addition to Dawson James and The Maxim Group, Sabby Capital Management is a third firm we watch out for.
Departure of an executive
Executives play a key role in the success of any organization. While executives leave for numerous reasons, unexpected departures in small cap biotech companies often raise questions and concerns. Outside of retirement or transitioning from a clinical stage to commercial stage, leadership changes can signal upcoming headwinds. The number one question that comes to mind when an executive resigns is does that person lack enthusiasm for the company’s growth prospects? When an executive leaves it’s either to retire or accept/seek another position. This leaves shareholders wondering about management’s perception of the company’s trajectory and potential to succeed.