Being Right in Biotech Is Only Half the Battle

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I love it when I'm right. I predicted that Astex Pharmaceuticals (NAS: ASTX) and marketing partner Eisai would receive a rejection for their blood-cancer drug, Dacogen, as a treatment for acute myeloid leukemia in patients over the age of 65. And like clockwork, last week the FDA told the duo "no."

Apparently, I'm not any smarter than the rest of you, though; Astex's shares actually went up the day after the announcement. It was pretty easy to guess the FDA's decision after the advisory panel voted 10-3 recommending that the agency not approve Dacogen for AML.

Being right isn't enough
Not every binary biotech event results in a huge stock move. It's a sad fact of investing: if you and everyone else thinks something is going to happen, there's no money to be made.

Earlier this year, Roche and Curis (NAS: CRIS) gained approval of their basal-cell carcinoma drug, Erivedge. With an approval widely expected, shares of Curis actually went down on the day despite the positive news.

And FDA decisions aren't the only binary events that can be anticipated. A few years ago, investors shrugged off the failure of Myriad Genetics' Alzheimer's drug Flurizan because it was clear the drug was a long shot anyway. Ditto for Medivation (NAS: MDVN) and Pfizer's Dimebon when it was tested for Huntington's disease. The original failure in Alzheimer's disease is a different story.

Straddle the indecision?
The big gains in biotech come when it's unclear exactly what will happen. Going into the binary event, investors have to take a middle-of-the-road valuation, because no one knows which way the stock will head until the event occurs.

You can get a hint about what investors are thinking by looking at the price of the options on the stock: In situations where investors are uncertain, the calls and puts will be expensive. In a situation where there's a 50/50 chance of it going either way, the value of the put plus the call is approximately how much investors think the stock will move up or down. Buying a straddle will make you a guaranteed winner -- either the call or the put will increase in value substantially -- but if investors were correct in guessing the post-decision valuation, the price of the winning option isn't likely to be much more than your cost basis of the two combined. There's no free lunch with options, but they can tell you a lot about investor sentiment.

Playing overexuberance
People who play the lottery don't expect to win every time, but they're willing to make the long-shot bet because the reward is so high. Same goes for long-shots at the track, roulette, and No. 16 seeds to win it all in the NCAA tournament.

Investors can do the same with binary events, sometimes with better odds.

As it turned out, buying shares of Astex the day before the FDA decision was essentially a free call option on the stock. If the FDA had shrugged off the advisory panel's recommendation, shareholders would have been sitting on a huge gain. As it was, the FDA decision went as expected and investors didn't risk anything holding over the binary event.

That shouldn't really happen; there should be some risk premium if the chance of an approval isn't zero. And if it truly is zero, there would be no reason to buy.

The problem lies in figuring out post-decision valuations, which is more art than science. Good bets like the one on Astex are a lot easier to identify after the fact than before it, but when valuations get low enough, it can be worth making a small bet on an outcome that has little chance of happening.

One to watch
In the who-knows-which-way-it'll-go category, there's Aeterna Zentaris (NAS: AEZS) and Keryx Biopharmaceuticals' (NAS: KERX) cancer drug perifosine. The companies are expecting data this month from their phase 3 trial that's testing the drug in refractory advanced colorectal cancer patients, possibly a little later. Because of the way the phase 2 and phase 3 trials were designed, it's hard to estimate the likelihood of success.

A few weeks ago, I suggested they might be good buys despite the uncertainty given the low valuations, but last week the biotech hype patrol got a hold of them and they skyrocketed. Both have returned from orbit, landing them in the zone where there doesn't look to be a compelling reason to go long or short into the event. Keep them on your watchlist -- you can use the Fool's free one here -- but they'll need to move up or down substantially to provide a margin of safety.

Fool analysts think they've found another healthcare company with upside potential. You can read about it in their new free report, "Discover the Next Rule-Breaking Multibagger." You can get your copy for free by clicking here.

At the time this article was published Fool contributorBrian Orellionce hit the trifecta at the Kentucky Derby on a $2 bet. He holds no position in any company mentioned.Click hereto see his holdings and a short bio.Motley Fool newsletter serviceshave recommended buying shares of Pfizer. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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