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Spurred by the recent (and growing) popularity of biotech stocks, lots of people here seem to be wondering similar questions: 'Why the fast run up of many stocks for no real reason?' 'Is it to late to buy X?' 'How do we value Y?' 'How do we know the science is any good?' 'Will this or that legal or scientific issue hurt the price of Z?'

Well, welcome to DAVE'S POST OF MYSTERY, where I am going to tell you the bizaare truth that you will never hear from the financial whizzes, or even from most of the best-informed on these boards. Why not? Because this stuff is either too obvious, too unuseful, or kills discussion too quickly. These are the insights I get from being a perpetual cynic, listening carefully to newbie 'stupid' questions (which are usually the best & wisest ones), and trying hard to figure out what I've done to earn the supposed money flooding into my biotech-heavy etrade account, and where that money's coming from.

Along the way I hope to (sort of) answer some of the questions at the start of this post. [warning, this post is long.]

Before you get too wrapped up in Biotechs, you've got to carefully consider your investing strategy as a whole, and ask where and whether biotechs fit in.
You can read magazines, you can read TMF posts, you can watch TV and study books. But most of all you've got to THINK about this stuff, and make sense of it in your own way. DO NOT accept the same tired old meaningless phrases of 'explanation':

"It's risky" (What does that mean? How risky? What's the worst that could happen? What's the best?)

"The volatility is meaningless!" (Why is it meaningless? My goal is buy low sell high. Therefore, without volatility on some time scale I will never make (or lose) money. What is the ideal time scale for volatility? What sorts of volatility trigger different types of investors to buy or sell -- Will a one-hour dip escalate? Will a one-day dip escalate? What would you do on a one-month or one-year dip?)

"LTBH always wins!" (Does it? Do companies grow forever? Do stock markets go up forever? How long is 'long' anyway? One year to escape short-term taxes? What's the difference between holding for 10 non-contiguous years vs. 10 contiguous years vs. investing 10 times as much for one year?)

Ready to set off on this journey into the weirdness at the underbelly of investing? Yes? OK then...

First, let's state the 'givens' that we all agree on:

1) LTBH, daytrading, momentuming, whatever... We are all buying stocks in the hope of making money.

2) There are a lot of folks -- your broker, the IRS, etc. who are 'skimming' in different ways. In other words there is a 'fee' for playing. If you like Vegas, you think of the 'house' as taking a variable cut.

So now let's state 'Dave's givens' -- stuff that people don't necessarily agree on, or don't usually explicitly say even if they do. I can't get anyone to provide cogent arguments against any of these, and I welcome you to try. Then again, maybe this stuff is just common sense.

1) Theoretically, every company has a finite lifetime. This may be 2 years, it may be 2 centuries. Aquisitions and mergers may confuse things (Do WE really die if something eats us?), but when you own stock, it's never forever. The relevent events to the average common-stock investor: The company is born (IPO), it grows up (stock price increases), it weakens (stock price decreases), it dies (somebody is stuck with worthless stock certificates).

2) The ONLY relevent stock price points are 1) The price at which you buy and 2) The price at which you sell. Excluding situations where you might borrow against the oldings (margin, for example), what the price does after you buy and before you sell is absolutely meaningless. Except for dividend reinvestments (which are rare in the fast-growing stocks we're most interested in here), money in stocks does not 'compound'. You simply buy shares, and they increase in value (or not). You don't make money faster when the price is high or lose it slower when the price is low. You DO make (or lose) money based on a percentage of what you put in, obviously. If you invest one million dollars in a stock that triples, you make 2 million. If you invested 1 dollar, you make 2. (and in the latter case, if your trading fee was $19.95, you're about $17 in the hole).

3) Right now, the market values the future. People buy in response to growth indicators. 'Value' has become confused (and often used interchangeably) with future value. This is easy to see on a plot of growth vs. market cap. When and if a 'crash' happens, it will be due to a shift away from valuing the future, or a retraction in how far ahead one is willing to buy on current growth estimates.

4) When you buy common stock at the levels most of us 'typical small investors' do, you don't own squat. You can't ever realistically walk into a company, point out a nice desk or piece of equipment, and claim it in return for the stock. Unless you really highly value the glossy mailings and your token ability to vote for directors, etc. (and this is scary anyway -- Do you really want a bunch of Yahoo-board investors choosing the management?), then a stock's only value is the possibility that you might be able to sell it for more, to a 'bigger sucker than you'.

So what do these things mean?

1) Finite company lifetime: Over the entire course of the company lifetime, the NET stock price (again, excluding dividends) is zero, or even maybe negative. This means that for every person that made money, somebody has to lose it. This is going to strike many people as wrong and weird because many successful companies have been around a long time. And any of the companies we can look at now are still in existance. But this is (as we say in stats or science) sample bias. You don't see the companies that have gone under. But, here, for example, is an example of a very sick company: (Look fast --Another one I wanted to show actually just disappeared from the listings!) Notice the typical 'healthy' stock life curve (I say 'healthy' because some never go up). A bunch of people made money on the upswing, but a bunch also lost money on the downside. Some LTBHers didn't make or lose money. Those who were in early and held to the end lost. Of course, the hard part of this is judging where things are going based on not having all the data. (Is this the top? Is this the top?) And certainly most of those who ride to the bitter end are hoping for a comeback.

So now the question: 'Is it too late to buy X?' Some will say it's never too late. They're wrong. Obviously, it can be. You just need to decide where in the company is in it's lifetime. Luckily, for pharmaceutical biotech, this question might be a little bit easier to answer, because the product development pipeline is so long. Is the number of patent applications files growing or shrinking? Is the number of drugs in clinical trials growing or decreasing? The FDA process frustrates some investors looking for quick profits, but it also provides a 10-15 year 'crystal ball' for folks willing to buy for the long term. Use it.

But also pay close attention to business plans where the FDA process is NOT applicable, or only indirectly applicable. Celera, for example, is often confused with a drug development company. It's not. It's a bioinformatics/information services company. Thus, it doesn't make stuff per se, it sells to those who do. Specifically, it aims to provide services useful to biotech companies and academia doing R&D using genetic data. Will R&D using genomic data increase or not? And what about biotech for agricultural or industrial applications like desulfonating petroleum or cleaning up toxic waste? These things can take advantage of all the recent breakthroughs in modern biology but don't have the long clinical testing process. If the new breakthroughs in biology are so useful, shouldn't these sorts of companies show profits first? Do they?

On Dave's givens 2-3 (Only 2 relevent price points, and non compounding of investments): Your profits are derived from a straight line between when you buy and when you sell. If you buy at $50 and the price goes to $500 the next day, but you sell at $52 the day after, then you make $52/share. Clearly, the theoretical ideal is to hold on only the upswings. Even better is to hold one stock on the upswings and then another that is upswinging while the first downswings. This is basically what daytraders try to do, and theoretically it's a sound approach. But practically, accurate prediction of the price movements is almost impossible (although we all know from experience that biotech prices move UP for a day or two after a big announcement, then down again after that. Which suggests a simple strategy: Be first to hear about new good news, and buy. Then sell the day after. And don't let your money sit idle until the next news release, which requires carefully following several other companies... Hey, this is beginning to sound like work!) And besides the difficulty of predicting price movements, trading fees and tax penalties add extra cost to this strategy, making it even more dodgy.

But these penalties can be slightly circumvented: 1) Move lots of money at once to cut the trading fee percentage, and 2) Only do it after holding at least a year. In a sense, this is basically what the big boys are coyly doing when they 'rebalance their portfolio' every now and then, or what the Gardners did when they sold stuff to buy CRA. Don't 'trickle' money into a stock if at all possible. Save up while doing hard research, and move big when you see a compelling opportunity. Don't fret about prices or this or that little stock you just heard about in the meantime. Be persistant and single-minded. Have a list of 5-10 stocks (I favor choosing small caps) that you work hard at researching. If something turns out to suck, drop it off the list. If you can't find a downside to one, then buy into it. And when you buy, the work doesn't stop. Keep checking into it. Ignore the short-term price dips in the absence of news. If a dip is long-term (many weeks) it signals: a trend or on-going thing you don't know about. Find out if there's anything specific to the company (Did the management all quit in the last few months? Are there new costs to doing business? Or is their product just not in demand any more (Do they make phonograph records and it's 1987?) Find out. And whether or not you believe their product is good or not, remember Dave's givens 3 and 4:

On Dave's givens 3-4 (stock buyers are getting a vague value of the future, and nothing else): A LOT of people have decided recently that they want to buy stocks. More people own stocks now, and those people are putting more money into them. And even though there are a larger number of IPOs now, they don't keep up with the money moving in to the market. This is an important trend, and the one that most of the 'wise' can't seem to incorporate into their 'old-school' thinking. It means that sellers can, in the long run, sell at higher prices, because more people want to buy and the number of stocks is limited (which means the price of stocks keeps going up). But people are not buying blindly based only on this trend (although that strategy works too, as in an index fund), they like to choose their stocks, which means evaluating the companies. And since many of the companies were already fairly priced based on current (or short-term) value, these new buyers have to buy based on what they perceive future value to be. And when folks buy the future, that's all they own. If predictions change, or the market values the future differently, then the price moves. If biotech is 'the next hot thing', then biotech prices will (and should) go up, regardless of whether the underlying companies are growing or increasing in value at all. So have most people 'discovered' biotechs yet? Do you really need to understand the science to make money here, or are the pundit's dumbed-down versions good enough? In other words, even if a company is doing the most groundbreaking exciting science in the world but no one realizes it, and will maybe only do so gradually after a long time, is it a good investment?

On a less hypothetical note: Does it matter whether or not genomics will change the world, or only that people think it will? No, not to the stock price short term (a year or less, or maybe even a decade or less). If genomics doesn't pan out, then the companies will more quickly enter the 'downside' of their life. If genomics does save mankind, or the companies realize genomics is a waste of time and move to another strategy, they can prolong their life. But the theoretical result is the same, just the time scale is changed. But I think people will be forgiving of the short-term in biotech because traditionally the products take a long time to market (not necessarily the case for non-pharmaceuticals such as ag and industrial applications, which is the biggest part of biotech.), so the growth will be stretched out more than for things like internet or electronic technologies. (Assuming no change in how the market values things, since the first things sold will be those invested based farthest in future value. In short, I think the market will 'reverse' the last decade's trends first if a 'crash' happens).

Knowing the science helps, but following a company closely at the beginning is best of all (and this from a biologist!) -- the goal is to predict the buyers, not necessarily the company. And if you're investing long term, you've got to predict the buyers long term (MUCH harder than predicting how the companies will do long term).

Well, that sort of covers things, in a long, rambling loosely/non-supported fashion. Please argue.

Oh, yeah. And remember: Buy low sell high.
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