Biotech and Sub-Prime Lenders: The Connection
by Alan J. Brochstein, CFA
AB Analytical Services
As you may be aware, I have been writing a Cancer Stock Weekly since May, just about the time I coincidentally began positioning my own portfolio for a drop in stock prices. Each week, I have detailed how this universe of primarily speculative Biotech stocks has lagged the broad market. Part of it was classic “buy the rumor, sell the news” related to the annual meeting of the industry (ASCO) that took place in early June. Another part would clearly be the barrage of FDA disappointments. The real reason, though, is becoming more apparent, and the biotech investor should pay careful attention to it: The credit crunch.
Credit crunches don’t happen that often. When they do, though, the repercussions are severe. It is capitalism’s way of dealing with the excesses. This credit crunch emanated from loose lending practices in the mortgage market, but it is now extending into other areas. Unless you don’t read newspapers, you are probably familiar with the sub-prime lenders. To summarize: Companies were lending to unqualified borrowers putting up very little down payment for appreciated real estate using funky financing gimmicks (interest only at a discounted rate even for the first few years). Shocking as this may be, the whole game is ending in an ugly way. Defaults are rising and lenders are filing for bankruptcy. What the heck does this have to do with Biotech?
The linkages elude traditional finance theory, but they are quite clear. On the one hand, speculative biotech companies are in constant need of capital (and capital’s cost is going up). On the other hand, liquidity is shrinking and the cost of owning risky securities is rising rapidly. The first point is rather obvious: Biotech companies in development burn cash, causing them to need to sell bonds or stock to finance their future growth. When it gets more difficult to do, like now, it puts them in a precarious situation of facing funding shortages or having to pay a higher cost. For bonds, that means higher interest. For stock, it means a deeper discount. The second point is the one that is seemingly escaping most investors. The problem is that the investor in the sub-prime mortgages is the same guy invested in Biotech. Well, it’s not actually the same guy, because he would have to be pretty talented to be able to analyze such disparate securities. It is the hedge fund. Don’t get me wrong – I am no hedge fund critic (though there are too many of them, their fees are too high and they are encouraged to take excessive risk). But, let’s face the fact. We haven’t learned squat since Long-Term Capital blew up in 1998.
If you are unfamiliar with that debacle and are investing in anything at all beyond U.S. Treasury securities, quit reading this article right now and click here. For the rest of you, the lessons were two-fold: Excess leverage can kill you and risky assets are a lot more correlated than traditional finance theory would suggest (and really, really smart people can do stupid things). It is the latter point that Biotech investors need to understand. Why are they so linked? If a large investor (let’s call him Mr. Multi-Strategy Hedge Fund, or MHF for short) has placed several bets and one is going against him in a bad, bad way (that would be his sub-prime exposure), he might get nervous when he tries to sell and can’t. Worse than being nervous, he might get a margin call. What does MHF do next? He can’t sell that sub-prime security at fifty cents on the dollar (it’s worth more – heck, his model values it at .75, but he can’t even get that .50 that the dealer “quotes”, though the dealer will work an order), so he has to start throwing other things out the airplane or risk crashing. That is where Biotech comes in. MHF is selling Small-Cap stocks in general (check out the Russell 2000 chart below), which he tends to be long (especially when it is going up) and anything else that he might own. Go to your favorite Biotech and look up who owns it. Chances are you will see that it is MHF. If it’s not, still, it is someone who owns something else getting hammered who just might not have the patience to stick with a risky Biotech security in these trying times.
Game Theory was the most difficult class I took in college (and not nearly as much fun as the Wednesday night North American Geography class), but it was probably the single most valuable class I ever took. To be a good investor, you must learn to think like others (and, hopefully, act BEFORE they do). While you may not care about mortgages or LBOs, keep in mind that your fellow Biotech investors, at least the big ones, do. Take a look at some non-Biotech charts, like those of the big brokerages or FNM or FRE, hedge fund FIG or private equity BX. Then, make sure that your company is adequately financed if you still feel compelled to take the risk.
Disclosure: The author doesn’t have a position in any stock mentioned in this article
AB Analytical Services is a regular contributor to BioHealth Investor
_____________________
AB Analytical Services
As you may be aware, I have been writing a Cancer Stock Weekly since May, just about the time I coincidentally began positioning my own portfolio for a drop in stock prices. Each week, I have detailed how this universe of primarily speculative Biotech stocks has lagged the broad market. Part of it was classic “buy the rumor, sell the news” related to the annual meeting of the industry (ASCO) that took place in early June. Another part would clearly be the barrage of FDA disappointments. The real reason, though, is becoming more apparent, and the biotech investor should pay careful attention to it: The credit crunch.
Credit crunches don’t happen that often. When they do, though, the repercussions are severe. It is capitalism’s way of dealing with the excesses. This credit crunch emanated from loose lending practices in the mortgage market, but it is now extending into other areas. Unless you don’t read newspapers, you are probably familiar with the sub-prime lenders. To summarize: Companies were lending to unqualified borrowers putting up very little down payment for appreciated real estate using funky financing gimmicks (interest only at a discounted rate even for the first few years). Shocking as this may be, the whole game is ending in an ugly way. Defaults are rising and lenders are filing for bankruptcy. What the heck does this have to do with Biotech?
The linkages elude traditional finance theory, but they are quite clear. On the one hand, speculative biotech companies are in constant need of capital (and capital’s cost is going up). On the other hand, liquidity is shrinking and the cost of owning risky securities is rising rapidly. The first point is rather obvious: Biotech companies in development burn cash, causing them to need to sell bonds or stock to finance their future growth. When it gets more difficult to do, like now, it puts them in a precarious situation of facing funding shortages or having to pay a higher cost. For bonds, that means higher interest. For stock, it means a deeper discount. The second point is the one that is seemingly escaping most investors. The problem is that the investor in the sub-prime mortgages is the same guy invested in Biotech. Well, it’s not actually the same guy, because he would have to be pretty talented to be able to analyze such disparate securities. It is the hedge fund. Don’t get me wrong – I am no hedge fund critic (though there are too many of them, their fees are too high and they are encouraged to take excessive risk). But, let’s face the fact. We haven’t learned squat since Long-Term Capital blew up in 1998.
If you are unfamiliar with that debacle and are investing in anything at all beyond U.S. Treasury securities, quit reading this article right now and click here. For the rest of you, the lessons were two-fold: Excess leverage can kill you and risky assets are a lot more correlated than traditional finance theory would suggest (and really, really smart people can do stupid things). It is the latter point that Biotech investors need to understand. Why are they so linked? If a large investor (let’s call him Mr. Multi-Strategy Hedge Fund, or MHF for short) has placed several bets and one is going against him in a bad, bad way (that would be his sub-prime exposure), he might get nervous when he tries to sell and can’t. Worse than being nervous, he might get a margin call. What does MHF do next? He can’t sell that sub-prime security at fifty cents on the dollar (it’s worth more – heck, his model values it at .75, but he can’t even get that .50 that the dealer “quotes”, though the dealer will work an order), so he has to start throwing other things out the airplane or risk crashing. That is where Biotech comes in. MHF is selling Small-Cap stocks in general (check out the Russell 2000 chart below), which he tends to be long (especially when it is going up) and anything else that he might own. Go to your favorite Biotech and look up who owns it. Chances are you will see that it is MHF. If it’s not, still, it is someone who owns something else getting hammered who just might not have the patience to stick with a risky Biotech security in these trying times.
Game Theory was the most difficult class I took in college (and not nearly as much fun as the Wednesday night North American Geography class), but it was probably the single most valuable class I ever took. To be a good investor, you must learn to think like others (and, hopefully, act BEFORE they do). While you may not care about mortgages or LBOs, keep in mind that your fellow Biotech investors, at least the big ones, do. Take a look at some non-Biotech charts, like those of the big brokerages or FNM or FRE, hedge fund FIG or private equity BX. Then, make sure that your company is adequately financed if you still feel compelled to take the risk.
Disclosure: The author doesn’t have a position in any stock mentioned in this article
AB Analytical Services is a regular contributor to BioHealth Investor
_____________________
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