Howard Simons of TheStreet.com has a column today on the drug industry that I can't quite place: is it a stroke of genius, or is it the product of a diseased Wall Street mind? I'll lay it out here, and we'll see what the readership here thinks. He's not TheStreet's regular pharma industry guy, but he gives a competent review of the problems we face:
"First, let's remember this sector's importance to us as investors. The S&P Pharmaceutical index is the largest of the 132 index groups comprising the S&P 500. It accounts for 6.879% of the market's capitalization, so given the prevalence of indexation strategies, it is highly likely that you own these firms in one form or another. . . Second, the pharmaceutical industry is as much of an intellectual property business as software and entertainment are. Just as the first copy of a new operating system costs hundreds of millions of dollars to design and test and the second copy costs about 15 cents to stamp out on a CD, pharmaceutical firms have massive initial fixed costs and minuscule variable costs of production. While their products are not stolen and counterfeited as often as software or music, they face myriad global price controls, third-party payer policies and regulations. . .A third industrial parallel for the pharmaceutical industry can be found with natural resource exploration and production. Each winner has to pay for as many as 20 losers, a daunting proposition. It is a small wonder indeed why firms in this industry spend as much time as they do in wringing out the profits from their few winners and developing me-too drugs."
(I'd add that that "20 losers" figure is just the stuff that makes it into the clinic - if you go back to the preclinical world, the ratio is far worse. Of course, from a financial point of view, each of those clinical losers adds up to more money down the chute, but the total preclinical losses are nothing to ignore, either. That's where I've been spending money since 1989.)
Simons specializes in writing about options, and he has a put-and-call man's perspective. He points out that when you buy a drug stock, you're buying the present portfolio of marketed drugs (where all the profit comes from), which is a wasting asset due to patent considerations, and you're buying the potential revenue from the stuff in the research pipeline. That pipeline, from his perspective, is a portfolio of out-of-the-money call options.
And y'know, he's got a point. Both the options and the drug candidates have a good chance of ending up worthless, but can potentially pay off at many times their existing price. And if you're going to invest in either one, you're better off with a list of them spread across different situations, because you've got enough risk on your hands as it is. (I speak as a drug industry guy and as someone who's lost money in options trades - everyone who's ever traded options has watched some of their money evaporate at some point.)
Perhaps some of you will have seen where his mind is going. Here's the pitch:
"The time has come for the pharmaceutical industry to securitize the options embedded in its product pipeline. Investors already own these options as a portfolio when they own the various stocks, so how much of a stretch is it to separate out each individual drug in the pipeline and sell it as a call warrant or option-embedded structured note to investors? The risk of each individual drug in the pipeline can then be confined to those seeking a portfolio of securities with very high risk but very high returns."
Never thought of that one, I have to say. It might fly - Simons points out that this is already how parts of the movie and petroleum exploration businesses work. A colleague of mine down the hall points out, though, that these industries are necessarily a bit more transparent than the drug industry. Would a drug company be able to provide enough information when a drug goes into Phase I, he wondered, for investors to make an informed decision?
It's a good point, but my reply was that many of the people investing in the industry already aren't all that much better informed. Actually, if you're buying small companies whose future is riding on one big approval, you're buying a single-candidate security anyway, and people make portfolios out of those. Each large drug company would transform itself, in the stock market, into a range of them with different maturity dates.
The other question is: just how much more money would we bring in by breaking out the portfolio this way? Presumably we could get more funding this way, but how much more? This plan would require more transparent bookkeeping to assign costs to the various development candidates, and investors would no doubt expect more regular updates on how things were going. You'd also have to figure out how these securities would pay off - when the drug gets approved? When the patent expires? (I sure wouldn't have wanted to be holding Vioxx warrants, that's for sure.) But there might be some real money to be made, and risk to be shared. We've got plenty of that to go around. . .