The Rare Disease Rubicon: Crossing The Chasm From Biotech To Bio-Commercial

When biotech companies develop treatments for rare diseases, achieving positive results from a Phase 3 trial is often seen as the finish line. However, this is just the beginning. The next step is preparation of marketing authorization applications for filings to and interactions with health authorities, as well as advancing commercialization.  While extremely important, a positive Phase 3 result is merely the starting line of the most dangerous and at times the most expensive part of the journey.

Commercialization is what marks a critical inflection point — where a biotech firm’s valuation is no longer being driven by market promise or the biological data like that Phase 3 trial result or even the expectation of a Healthy Authority approval.

How the “Smart Money” Behaves Before an Anticipated Approval Date

For example, according to Biopharma Watch, several forces drive a run-up in stock prices before an anticipated FDA approval data. First, speculative traders wanting to bet on approval begin to build positions between one and two months leading up to the decision date.

Hedge funds establish and build positions quietly in the weeks leading up to that date, having done due diligence and betting on their conviction in the drug. They try to build slowly so as not to send prices soaring too quickly.

During this period, short sellers may start covering their positions to reduce their risk, and it ends up inflating the price further. Then momentum traders hop on the train as the stock rises, thanks to algorithms picking up the signals, which further accelerates the run-up in the stock price. Finally, higher call option buying in the time before the decision date can result in a gamma squeeze as market makers hedge their exposures.

After the Approval

Following approval based on Phase 3 trial results, investors then start to focus on commercialization of the drug, which may cause some to sell in order to avoid risks associated with a slow ramp or weak sales initially. Additionally, shareholders may fear dilution if the company needs to raise more capital to fund the launch of its drug.

Others may take profits, unloading up to half their position on positive news to lock in those gains. Some might dump their shares right away, expecting the stock to plummet, with plans to reinvest later at a lower price. But those investors who play their cards right in choosing the strongest biotechs with the best treatments will be the big winners if they buy any dip that occurs and then continue to hold throughout the early part of the commercialization process and beyond, displaying high conviction in the finalized drug.

Identifying the Valuation Inflection Point

What many individual biotech investors don’t understand is that when a drug receives that all-important health authority approval, it’s not yet the tipping point for a shift in the company’s multiple. That tipping point is when the valuation starts to rely on discounted cash flow models linked to the numbers of prescriptions recorded instead of blue-sky speculation.

Importantly, investors need to realize that there’s a lag between the marketing approval and a meaningful ramp in revenues from the drug. According to one study, it may take almost three years for new orphan drugs and biologics to be incorporated into the clinical guidelines doctors use when determining treatments for patients. This is why it is so important to have the clinical key opinion leaders and patient advocacy groups involved with orphan disease development as early as possible, to allow for a more rapid uptake upon commercial launch.

Thus, patience (pardon the pun) is an important requirement for biotech investors — patience and the due diligence necessary to build high conviction in a particular treatment or company.

Playing the Rubicon

Hedge funds are known for conducting deep due diligence on companies and products, and individual investors can’t afford not to skip this step either. It’s how the so-called “smart money” identifies which of the many pre-revenue biotech firms are more likely than the others to reach the commercialization finish line.

Investors who dig into the biotech sector will also find some signals pointing them in the direction of which companies to look at. For example, according to McKinsey, biotech companies launching a new drug for the first time in indications without any competitors are 1.7 times more likely to exceed expectations than those in indications with at least three competitors.

These first-time launchers in rare diseases also tend to generate robust value for shareholders. In rare diseases like cutaneous T-cell lymphoma, it’s a good idea to look for new, unique treatments that offer safer alternatives to conventional therapies.

Another trend to look for among biotech companies is those that conduct their own clinical trials. This allows companies to more quickly spot problems and immediately take action on the ground, eliminating slow, third-party management by contract research organizations.

More directly for investors, self-managed clinical trials reduce costs by eliminating the middle man. Further, biotech companies that manage their own clinical trials typically have a deep network of experienced professionals and a greater understanding of the regulatory aspects of bringing their drugs to market.

Finally, investors could see an early, big return on their investment more quickly if the company they’re investing in gets acquired by Big Pharma. Small- to mid-cap biotechs become the most attractive right before or after they begin to commercialize.

Importantly, the Rubicon isn’t a final destination. It’s where commercialization begins and investors will start to see the multiple re-rate higher and see winnings on their long-held investment — if they’ve chosen wisely and decided to buy the dip and hold through the volatility associated with crossing the Rubicon.