Expert Financial Analysis and Reporting

Purpose of This Report

This report is being written at a time of panic in the market in which a sharp drop in the stock market indices has set off a much steeper plunge in the stock prices of emerging biotechnology companies which are the focus of SmithOnStocks. In this volatile and depressing environment, there is little investor confidence in stocks. I can’t say when confidence might return and in the interim, stocks could remain  under pressure. However, I have been through panics before and the lesson I have learned is to keep focused on the fundamentals. In this report, I have tried to ignore the carnage in the market and update my fundamental outlook on each of the stocks that I am most focused on. Biotechnology stocks really aren’t that dependent on broad economic concerns that are driving this market down with an important exception and that is that most need periodic access to capital, usually from equity offerings. At these depressed prices, for some this may necessitate issuing more shares (and warrants) than before the stock market correction. This reduces price targets. It may also be the case that current risk aversion in the market lingers. If so, this might also reduce price targets as these stocks are some of the most speculative stocks in the market. However, remember that this remains one of the most innovative technologies on the planet and innovation is a crtical factor in successful investing.

This report primarily is an update on my current thinking on the stocks and the first part of this report focuses on 13 stocks I cover most closely. However, I also discuss later in the report macro-economic issues that have impacted the overall market and macro issues more specific to biopharma. In total, this report is about 35 pages long; you may want to read it in sections.

Companies discussed are:

• Agenus
• Alimera
• Antares
• Celldex
• Chimerix
• Cytokinetics
• Derma Sciences
• Discovery Laboratories
• ImmunoCellular
• Neuralstem
• Northwest Biotherapeutics
• pSivida
• Repligen

My Current View on Stocks I Cover

Overview

In looking at the universe of companies that I cover, there has been a uniform sharp decline (destruction) of the stock price. I have written summaries of my views on the 13 companies listed above and I would urge you to read those in which you have an interest. If you have a particular interest in any one stock, there are more extensive reports on my website that go into much more depth. Before that I have summarized some of the key issues that I see for this group of companies.

Is There A Change in My View on the Potential of Drugs in Development by These Companies?

I have not reassessed my thinking on the probabilities of success on any of the key drugs in development. As I stated before, the impact on price targets for these companies resulting from this correction comes from their (relative) need to access capital and risk aversion stemming from losses incurred. Both reduce price targets.

The Home Run Products

These are products that have the ability to change the paradigm of treatment for their disease target and can produce huge commercial and stock market returns; they have asymmetric upside in my opinion. These products are in varying stages of clinical development and are in alphabetical order of the Company developing them:

• Cytokinetics: omecamtiv mecarbil for congestive heart failure-soon to be in phase 3,
• Cytokinetics: tirasemtiv for ALS-phase 3,
• Discovery Laboratories; aerosolized surfactant for respiratory distress syndrome in neonates-phase 2b
• ImmunoCellular: ICT-107 dendritic cell vaccine for newly diagnosed glioblastoma-phase 3,
• Neuralstem: NSI-566 neural stem cells for ALS, spinal cord injury and ischemic stroke-phase 2b,
• Neuralstem: NSI-189 small molecule for major depressive disorder-phase 2b,
• Northwest Biotherapeutics: DCVax-L dendritic cell vaccine for newly diagnosed glioblastoma-phase 3,
• Northwest Biotherapeutics: DCVax Direct dendritic cell vaccine for inoperable solid tumors-phase 2

Financing Issues

Strong Balance Sheets

Some of these companies have very strong balance sheets that should allow them to avoid doing financings in 2016 and probably 2017 which is a strong investment positive. These are:

• Agenus,
• Antares (if the AB rated generic to EpiPen is approved in 2H, 2016)
• Celldex
• Chimerix
• Cytokinetics
• pSivida
• Repligen

Weak Balance Sheets

I think that these four companies will have to finance in 2016 or early 2017. At these depressed prices, this will be much more dilutive than would have been the case before the market correction. Also, price weakness before and after an offering can be expected. These are:

• Alimera
• Discovery Laboratory
• Neuralstem
• Northwest Biotherapeutics

In the case of Discovery, Neuralstem and Northwest my analysis suggests that even with the significant dilution from an equity offering taken into account that these stocks still retain asymmetric upside potential. Please refer to my summaries on these companies.

Big Events for 2016

Some of the most important potential events for the year are:

• Antares: Approval of AB rated generic to EpiPen in 2H, 2016,
• Celldex: Phase 3 results for the cancer vaccine Rintega in newly diagnosed glioblastoma, late 2016 or early 2017,
• Chimerix: Topline results from phase 3 trial of brincidofovir in adenovirus,
• Cytokinetics: Beginning phase 3 of omecamtiv, 2H, 2016,
• Derma Sciences: naming of new CEO and outlining of new strategic plan, 1H, 2016
• Discovery Laboratories: Phase 2b topline results for Aerosurf (could be early 2017),
• Neuralstem: start on NSI-566 neural stem cell trial in ALS, 1Q or 2Q, 2016
• Neuralstem: Possibly announcing that phase 2 trial of NSI-566 stem cells in ALS will be totally or largely funded by grants. This could be a surprise for shorts in the stock as it means that even in the worst case scenario in which the Company does not raise money in 2016 that this trial can be carried through to conclusion. This possibility is not well understood.
• Northwest Biotherapeutics: Resolution of screening halt on DCVax-L phase 3 trial, 1Q 2016
• pSivida: Results from second phase 3 trial of Medidur in posterior uveitis in late 2016 (or early 2017)

Recommendation Changes

I have recently upgraded two stocks.

• Chimerix: In the aftermath of the failure of brincidofovir in a phase 3 trial for preventing cytomegalovirus infections in hematopoietic stem cell transplants, the stock experienced a very sharp decline. Investors seem to be ignoring the remaining strong, late stage pipeline and an exceptionally strong cash position,
• Repligen: I love this company’s business model and the price weakness brings it back into my buying range

Greatest Uncertainty

Northwest Biotherapeutics announced in August that screening for enrollment in its phase 3 clinical trial of DCVax-L in newly diagnosed glioblastoma has been halted although patients already enrolled in the trial continue to be treated per protocol. Over 300 patients have been enrolled and treated of a scheduled 348 to complete the trial. Originally, the Company gave no indication for the reason for the halt and suggested that this issue could be addressed quickly, but it has dragged on for nearly six months. This has had a devastating effect on the stock.

As I discuss at length in my summary on NWBO, I have hypothesized various reasons for this halt in screening, some of which are quite positive and others are negative. Frankly, none of the scenarios make sense. This has left me in limbo on the stock as I await an announcement on the screening halt and the resultant effect on the phase 3 trial.

Current Recommendations

My current buy recommendations are;

• Antares (ATRS, $0.95)
• Agenus (AGEN, $3.17)
• Chimerix (CMRX, $8.92)
• Cytokinetics (CYTK, $8.08)
• Repligen (REGN, $24.06)

There are three companies which I believe may have to do financing in 2016 that could cause pressure on the stock. However, I believe in each case that there is asymmetric upside for these stocks even with these financings. I will leave it to you to make a judgment on whether you want to wait on these stocks until they have solidified their cash positions which will cause significant dilution. I own each in my portfolio. These are:

• Discovery Laboratory (DSCO, $0.18)
• Neuralstem (CUR, $0.59)
• Northwest Biotherapeutics (NWBO, $2.18, this is subject to a favorable outcome on the screening halt).

I may upgrade these stocks in 2016 or at some later date.

• Derma Sciences (DSCI,$3.42)
• pSivida (PSDV, $3.65)
• Celldex (CLDX, $11.27)
• ImmunoCellular (IMUC, $0.25)

The company summaries that follow in the next section are listed in the following order:

• Antares
• Cytokinetics
• Repligen
• Chimerix
• Agenus
• Northwest Biotherapeutics
• Neuralstem
• Discovery Laboratories
• Derma Sciences
• Alimera
• pSivida
• Celldex
• ImmunoCellular

Antares

What Went Wrong in 2015?

I expected 2015 to be a breakout year for Antares based on a strong ramp in sales of Otrexup and the approval of an AB rated generic to EpiPen, the latter of which was based on guidance coming Teva and Antares. The current guidance from Teva is that approval will come no sooner that 2H, 2016. The delay has been a major factor in the price decline and while Teva remains confident of approval, the delay has raised concerns about this. The delayl in approval of an AB rated version of EpiPen combined with a disappointing launch of Otrexup have resulted in a sharp decline in the stock.

I have been consistently over-optimistic on sales of Otrexup owing to my strong belief that it has important medical and therapeutic benefits. I underestimated the impact of Medac’s competitive product Rasuvo. Medac is a privately owned company not concerned about reporting profits to shareholders and has taken a strategy of gaining share through price competition. In addition, managed care has to my great surprise not been that supportive of the cost benefits of Otrexup and Rasuvo versus much higher priced biologics. I think that this is because the large discounts offered by biologics manufacturers (their products cost $20,000 per year versus $4,800 or so for Otrexup) paradoxically provide an economic benefit to managed care to support the biologics. This is at the expense patients and organizations who are the ultimate payors. I continue to think that Otrexup and Rasuvo will eventually find a meaningful niche, but I have been saying this for many months. The most recent prescription data for Otrexup has been sluggish.

Teva has not indicated the reason for the delay in approval of the AB rated version of EpiPen and in consistent public statements has suggested confidence of approval. However, Teva has consistently pushed back the timing of approval and now says no earlier than 2H, 2016. This string of delays has led to concern that there is an FDA issue, even though Teva has not believe this to be the case.

A Strong Pipeline is Being Ignored

With these uncertainties, the market has ignored the strong product pipeline and assigned almost no value to it. Quick Shot Testosterone appears to offer clear therapeutic advantages over current injectable products. Also, the overall testosterone market has stabilized as concerns about potential side effects of testosterone replacement raised in early 2014 has eased. The NDA for QST is expected to be filed in 4Q, 2016 or 1Q, 2017. Most of the problems with the Otrexup launch should not apply to Quick Shot Testosterone and I would expect a better launch. I also think that peak sales potential is much higher. QST looks to have the potential to be the best in class in the injectable testosterone market.

Antares just received approval of an AB rated generic to Imitrex (sumatriptan) and should market the product in mid-2016. A regulatory submission for an AB rated version of exenatide has been filed which has about 15 to 20% of the commercial potential of the AB rated generic to EpiPen. The Company is also working on another undisclosed pen device and has just announced a life cycle extension development effort for Makena. In addition, it plans to develop one proprietary in the same mode as Otrexup and Quick Shot Testosterone each year after 2017. I view this as a very promising pipeline.

Financial Position is OK but Not Great

The cash position at the end of 3Q, 2015 was $47 million and the Company averaged a burn rate of about $8 million per quarter in the first three quarters of 2015. At that rate, the Company has cash to last until roughly 3Q, 2017. If the AB rated generic to EpiPen is launched in 2H, 2016 the Company will become strongly cash flow positive with no need for financing.

Price Target Thinking

In looking at 2016, I think that the all-important issue is approval of the AB rated generic to EpiPen. Following introduction, the Company becomes strongly cash flow positive and highly accretive to a potential acquirer; Teva would be the likely acquirer. Please see my recent report on the Company for a more in-depth discussion in which  I came up with a price target range of $3.25 to $10.00 for 2017.

Cytokinetics

Overview

The key investment issue in 2016 will be the highly probable announcement that Amgen and Cytokinetics are advancing omecamtiv mecarbil into phase 3 after nearly ten years of careful clinical development. I think this is likely to begin in 2H, 2016. This development suggests that in congestive heart failure patients, it can improve the amount of blood pumped by the heart without increasing the workload of the heart. If this is established in phase 3 trials, omecamtiv could become a part of standard of care. This is a multi-billion commercial opportunity. Investors should understand that these trials will involve thousands of patients and will take some time; I think it will be 2019 or 2020 before we see topline results.

The Company has tirasemtiv (which is unpartnered) in phase 3 development and topline results are probable in 2017. This product has the promise of increasing quality of life and possible extending life in ALS patients and if successful in the phase 3 trial would be used a very large percentage of ALS patients. This also has blockbuster potential. Tirasemtiv failed to reach its primary endpoint of ALSFRS-r in a phase 2b trial, but the secondary endpoint of sustained vital capacity showed strongly statistically significant improvement versus control. After consulting with key opinion leaders and the FDA, the Company has launched a new trial using the slowing of the rate of decline of sustained vital capacity as the endpoint. ALSFRS-r.

ALSFRS-r has been the accepted endpoint for all recent drug trials in ALS and all have failed. Investors correctly ask if the FDA will accept sustained vital capacity as a primary endpoint. Because the Company did not receive an SPA for this trial, it suggests to me that the FDA will need to see improvement in some of the measures of respiratory function that are part of ALSFRS-r in this trial. In this regard the Company put out a highly encouraging press release in January. http://ir.cytokinetics.com/phoenix.zhtml?c=142156&p=irol-newsArticle&ID=2127897

Cytokinetics reported the results of EMPOWER. This was an exploratory analyses of data by a third party consulting firm. EMPOWER analyzed data from the control arm of the failed phase 3 clinical trial of Biogen’s dexpramipexole in patients with ALS, This analysis demonstrated that the rate of decline of slow vital capacity (SVC) predicted the risk of meaningful clinical events, including a decline in the three respiratory questions of the ALSFRS-R, as well as the time to the first occurrence of respiratory insufficiency, tracheostomy or death. This incremental information is quite encouraging.

Cytokinetics is also developing a third drug, CK-107, for the treatment of the orphan disease spinal muscular atrophy. This drug is being developed in a partnership with Astellas and will be in phase 2 trials in 2016.

Financial Issues

The Company ended 3Q, 2015 with $98 million of cash. The cash burn from operations has been running at about $10 million per quarter and if that held in 4Q, 2015 the Company currently has about $88 million of cash, CEO Robert Blum has said that the Company anticipates that it will receive $50 million in milestone payments from Amgen (for omecamtiv) and Astellas (for CK-2127107) over the next year or two. This effectively increases the availability of cash through the end of 2017 to $138 million. At the recent quarterly burn rate of $10 million, this cash would last until mid-2018. However, the expense of the phase 3 trial of tirasemtiv should increase the burn. Management has given no guidance, but if the burn were to increase to $15 million per quarter, this $138 million of cash would last until early 2018 or well past the reporting of topline results from the phase 3 trial of tirasemtiv.

Mr. Blum also stated that Cytokinetics is slated to receive more than $600 million of milestone payments from Amgen on omecamtiv mecarbil of which half or $300 million is attributable to pre-commercialization events. It is logical to think that the final pre-commercialization event would be approval which could occur in 2020. Most of this $300 million is likely to be received at the backend of the 2016 to 2020 period but other events could trigger payments along the way. There could also be milestone payment from Astellas on CK-107 and with success in the tirasemtiv phase 3, Cytokinetics might license its foreign rights in 2018. Based on looking at other deals involving comparable products, this could bring in an upfront fee of $180 million.

Potential Stock Market Value stemming from Omecamtiv Mecarbil

One important aspect of this milestone situation is that instead of taking a portion of the milestones as a cash payment, Cytokinetics can apply them to clinical trial costs in return for a greater economic interest in omecamtiv mecarbil. If this is done, Cytokinetics could ultimately approximately 50% of economics. In addition, Amgen will fund most of the costs for Cytokinetics to build a hospital sales force in the US to sell omecamtiv. Mr. Blum seems to indicate that Cytokinetics will exercise this option instead of taking the cash.

So how do we put this in an investment perspective? Let me give the highly optimistic (best case) scenario in which omecamtiv mecarbil reaches $5 billion in sales sometime in the mid to late 2020s. Biotechnology companies with highly successful new products can often sell at 6 to 10 times revenues so that the market value of omecamtiv mecarbil could reach $30 to $50 billion in this time frame of which Cytokinetics would control half of this value or $15 to $25 billion. The current market value of the Company is about $540 million. In the optimistic scenario, omecamtiv mecarbil could increase the value of Cytokinetics by 25 to 40 times or a stock price of $300 to $500 per share; remember that this would be about ten years out in this best case scenario.

Investment Thesis

I needn’t point out to you that this stock price thinking is based on a best case, optimistic scenario and there are many other lesser possibilities including failure of the phase 3 trial. Still, it gives you some sense of the upside for Cytokinetics. I would also point out that we may not see the topline results until 2020 so we have a four year wait ahead of us probably without much news on the drug. It is difficult to determine how the stock will balance this huge upside against the backdrop of maybe four years of little news flow on the product.

It seems to me that the prospects for omecamtiv mecarbil more than justify the $340 million market value of Cytokinetics if you compare it to other peer companies. As one pretty good example, ZS Pharma’s potassium lowering agent ZS-9 could have peak sales potential in the $1 to $3 billion range (roughly the same as Cytokinetics’ economic interest in omecamtiv) with potential approval in early 2016. AstraZeneca just acquired ZS Pharma for $2.3 billion. Let’s fast forward to early 2020 and assume that the phase 3 trial results are positive and suggest multi-billion sales potential for omecamtiv. In this event, it seems possible that a big pharma company (Amgen most likely) would pay $2.3 billion for Cytokinetics. If so, the takeout value based only on omecamtiv would be $48 per CYTK share. Given that there remains the risk of failure for the drug does a 4x potential upside in four years warrant purchasing the stock now? I think so.

If I am correct on omecamtiv, other parts of the company are not being given much, if any, value at this time. The next important asset is tirasemtiv for the treatment of ALS for which Cytokinetics has retained complete ownership. I have estimated that peak sales of tirasemtiv could be in excess of $1 billion. The drug is currently in a pivotal, 445 patient phase 3 trial. ClinTrials.com estimates that analysis will be completed in 1Q, 2017 so that topline results would be available in mid-2017. The Company has hinted that it could be sooner. If Amgen proceeds into phase 3 with omecamtiv mecarbil in 1H, 2016, investor attention will quickly shift to tirasemtiv.

Tirasemtiv also seems to justify the current valuation. Using $1 billion of sales as a peak sales estimate and applying a multiple of 6 to 10 times sales, it could lead to a potential market capitalization of $6 billion to $8 billion which is over 10 times the current market value of $540 million and translates into a price or $70+. The potential of tirasemtiv also seems to justify the current price. The key catalyst will be release of topline results from the phase 3 VITALITY-ALS trial in late 2016 or early 2017.

The final component of the Cytokinetics product portfolio is CK-2127107. It will enter phase 2 development in 2016 for the orphan disease spinal muscular atrophy (SMA). This product like tirasemtiv increase skeletal muscle contractility (omecamtiv increase cardiac muscle contractility). CK-2127107 is effectively a second generation tirasemtiv which may have a better side effect profile. However, the agreement with Astellas prevents (for the time being) its development in ALS. CK-2127107 has the potential for use in several orphan diseases and addresses a significant market opportunity in the billions of dollars. If tirasemtiv fails in VITALITY-ALS due to side effect issues, CK-2127107 might be developed for ALS.

I think you can get the idea that this is an asymmetric opportunity. If omecamtiv mecarbil and tirasemtiv are successful in their clinical trials, the upside as described earlier could be a stock price in excess of $500 in ten years. On the other hand, if both drugs fail in phase 3, it is likely that investors will view the technology base as worthless in which case the downside for the stock is likely to be zero before 2020.

Repligen

Overview

I think that Repligen’s (RGEN) bioprocessing business is one of the best business models that I have seen in my many years as an analyst. Its products are used in the manufacturing of biologic drugs. They enjoy incredibly long life cycles because changing the manufacturing process for a biological product once it is approved or after it has completed phase III trials can change the characteristics of the product. Hence, a change in the manufacturing process at virtually any level can create troublesome regulatory issues as the FDA will require assurance that the product is unchanged. The agency may request new studies, possibly including clinical trials in humans that demonstrate that there is no change in the product. Few if any biopharm companies are willing to take that risk. Please see my latest report for a more in-depth discussion.

Financial Issues

Repligen is profitable and highly cash flow positive. An important element of its business model is to use its free cash flow to make accretive acquisitions.

Investment Thesis

In 2015, the stock was trading near or above $40 per share and I was reluctant to buy the stock at that level. The decline in the stock price to the low 20$ is a much better entry price.

Chimerix

Overview

I upgraded the stock to a buy following the failure of its lead drug brincidofovir in a phase 3 trial aimed at preventing cytomegalovirus infections in hematopoietic stem cell transplant patients which resulted in a price drop from $36 to the $8 to $ 9 dollar range. Results from a trial of brincidofovir in treating adenovirus infections are expected in 2H, 2016 and could lead to approval. It also has been selected for stockpiling in the event of a smallpox outbreak resulting from terrorism of accidental release from a scientific lab. Phase 3 trials in preventing double stranded DNA viral infections in solid organ transplant patients have been temporarily halted due to the recent phase 3 failure but should resume; this is a huge commercial opportunity. Importantly, Chimerix has a very strong cash position.

Please refer to my January 5 report for my reasoning.

Agenus

Overview

Agenus has done an amazing job in positioning itself as a pre-eminent player in the checkpoint modulator space stemming from the acquisition of 4-Antibody in 1Q, 2014. There are two other significant parts of Agenus. Its QS-1 adjuvant program is largely based on use in Glaxo vaccines. It has monetized the revenue stream with a royalty deal to fund its checkpoint modulator programs. Its Prophage cancer vaccines have the data to support moving forward in glioblastoma trials and other indications. The Company hasn’t ruled out developing some Prophage products on its own, but I think that finding a licensing partner is a preferred strategy.

The Company is now going into the IND stage that should allow clinical trials to begin in 2016. The FDA is allowing development to proceed quickly to the extent that Keytruda (one of the three checkpoint modulators approved by the FDA) was approved about 3 years after it went into human clinical trials. Over the next three years, we should see a significant amount of clinical data and possibly regulatory filings seeking approval.

Strong Cash Position

The Company had a strong cash position of $198 million at the end of 3Q, 2015 and the recent quarterly burn has been about $15 million. Even at this high burn rate, its cash would last until the beginning of 2019. There is a strong possibility that partnering deals could add meaningfully to cash reserves between now and 2019. I see little probability for a need to raise cash in 2017 and 2018 and with strong partnering deals there might be no need beyond this. Because Agenus is in an early development stage, this strong cash position is a major investment strength.

Price Target Thinking

One of the great difficulties for me in valuing the stock at this stage of product development in the checkpoint modulation space is that all of its products are at the pre-human trial stage so there is no clinical data. This means that much of the discussion about the Company centers on drug design which employs extremely esoteric technologies that require PhD level knowledge in several disciplines. This is far beyond my capabilities. Along with most other investors, I can see from 30,000 feet that AGEN has a leading position in the development of checkpoint modulators that should have enormous value, but is extremely hard to quantify that value.

Agenus has a fully diluted market capitalization of about $350 million. I believe that ultimately Agenus will be acquired by a major biopharm company. Such an acquisition could immediately place the acquirer in the top ten and possibly top five checkpoint modulator drug developers. I see a parallel with the Bristol-Myers Squibb decision to acquire Medarex in 2009 for $2.1 billion which led to Bristol becoming the leading factor in the development of checkpoint modulators. My most likely scenario for Agenus is that it is acquired within the next three years and potentially at a Medarex type of valuation. Obviously it is hard to be precise. At a takeover price comparable to Medarex, the price would be $15 to $20 and ay half of that price would be $8 to $10.

Northwest Biotherapeutics

Overview of 2015

On July 23, 2012 Northwest closed at a price of $12.24, which was an all-time high and it now trades at a price of $2.00. So beyond the effects of the drastic sell-off in biotech stocks as a group what happened? There was no new clinical data in the interim from July to now so that was not a factor in the sharp decline. By the way, my view remains unchanged that there is a reasonable chance for success in the phase 3 trial of DCVax-L in newly diagnosed glioblastoma and I believe that we have seen signals of efficacy in DCVax Direct that certainly warrant moving forward into phase 2 trials. Success in clinical trials with either product warrants a $1 billion plus valuation.

Back in July, I think that the confidence in the stock was catalyzed by a series of investments made in the Company by the British investor Neil Woodruff in which he invested $110 million into the Company on very positive terms and also bought stock in the open market. Investors were looking forward to the completion of the phase 3 trial of DCVax-L which at the time had enrolled over 300 of the 348 patients planned for enrollment in the trial. This pointed to a topline result in perhaps mid-2016. The Company had also indicated in early 2015 that there was a potential for a trial of DCVax-L in combination with a checkpoint inhibitor and that phase 2 trials of DCVax Direct in perhaps two or three types of inoperable solid tumors could start in 2015.

There was also the prospect for more positive data from the information arm of the phase 3 trial of DCVax-L that looked at rapid progressors and updates on maturing data from the phase 1 trial of DCVax Direct. With the enthusiasm of investors with all of this news flow I believe that the Company was in a position to pretty quickly do a major capital raise that would have given it the cash necessary to complete all of these trials.

Screening Halt in Phase 3 DCVax-l Phase 3 Trial Has Major Negative Impact on Stock

In early August 2015, the Company was jolted by an unexpected, negative event. In a press release in early August it said that screening in the phase 3 DCVax-L trial had been temporarily halted. However, patients already enrolled in the trial were to be continued to be administered DCVax-L and all other aspects of the trial were to continue as before. The Company said that more than 300 patients had been enrolled in the trial which has a planned enrollment of 348. The actual number of enrollees is thus somewhere between 301 and 347. Northwest further stated that its contract research organization (CRO) was submitting data to the FDA for the agency’s review (Northwest remains blinded), but did not specify what the reason or purpose was for this action. So what explains the screening halt?

What Could Account for the Screening Halt?

I for one cannot come up with a scenario in which I can explain with any degree of confidence what is going on. I have thought long and hard about some scenarios which are extremely positive and some that are extremely negative. However with the available information, I can’t put any probabilities on a potential outcome. There is also the distinct possibility that none of my scenarios actually capture what is going on and that we could be dealing with is something without precedent. I wrote at length on this situation on September 8, in a report called “Northwest Biotherapeutics: Thoughts on Suspension of Screening of New Patients in the Phase 3 DCVax-L Trial” .

In that report, I said that as I go through possible scenarios (negative and positive) that could have led to this suspension of screening, none of them are sufficiently convincing so as to allow me to draw a firm conclusion. My basic feeling is that something unusual is occurring and that with the facts that we have available, I cannot offer a reasonable analysis of what that is. Northwest said that in August that “The Company is in the process of preparing the trial information for regulatory review and anticipates submission within the next couple of weeks.” The Company did not specify what the type of information being submitted to the regulators was. It is hamstrung in putting out any clarifying information as the FDA might look upon this as trying to influence the agency’s analysis.

I can speculate on a very favorable hypothesis that the trial has already met its end point or the exact opposite dire hypotheses that: (1) the Data Monitoring Committee (DMC) has discovered a safety issue or (2) the results of an interim analysis suggests that the trial is unlikely to successfully meet its endpoint and the DMC believes it would be futile to complete the trial. However, I have a feeling (purely intuitive) that there is something else going on that enhances or goes beyond these possible scenarios. A safety issue would be a major surprise as cancer vaccines in general and DCVax-L in particular have shown benign side effect profiles in comparison to other cancer therapies.

If it were the case that the DMC analysis suggested futility, it is highly unlikely that the trial would be ended. This is a large well controlled trial with a potentially paradigm changing treatment of glioblastoma and it could be the case that while the trial itself might not be successful, in sub-groups of patients the trial could point to significant benefits that could lead to approval for that group of patients (potentially without but probably requiring another phase 3 trial). Also, in the case of immune-oncology products it has been the case that it takes longer for therapeutic effects to be seen. It is the decision of the Company on whether to continue the trial regardless of the DMC recommendation if there is no safety issue and I think that NWBO would certainly elect to finish the trial.

It seems to me that the request for more data by the regulators indicates that regulators believe that the resultant data could answer whatever questions have arisen and allow the screening to continue. At most, only 47 patients and as few as 1 needed to complete enrollment and the number could be much less. If there were an unresolvable issue (particularly on safety), the FDA would have halted dosing in patients enrolled in the trial. All of the information that I have reviewed suggests that DCVax-L has shown impressive signals of activity in phase 1/2 trials and in the information arm of the phase 3 trial with no safety issues. This raises the hope that in coming weeks, the suspension on screening of new patients could be lifted and the enrollment in the trial completed. I am awaiting that information and like all investors I am in limbo until then.

Resolution of Screening Halt is Absolutely Critical to Stock Outlook

If the trial for whatever reason is halted, the stock will obviously plunge sharply and the ability of the Company to remain solvent will be in question. While there would remain (considerable) potential with DCVax Direct all confidence in the Company would be shattered and would make it difficult to raise cash to finance the trials needed to gain regulatory approval for DCVax Direct. Shareholders could be wiped out.

Let’s next consider the opposite possibility that the FDA tells Northwest to restart screening for enrollment and finish the trial. The reaction to this would obviously be positive but the degree would be dependent on whether the reason for the screening halt is thoroughly explained. The reaction might be more muted if there is no explanation.

With this behind the Company there might be some (possibly a lot) of good news. I would think that the Company has held back non-material news releases until the halt in screening issue is resolved. Some possible examples of news flow in the queue are:

• Earlier in the year, the Company hinted at a collaboration of DCVax-L with a checkpoint modulator. This could be set to begin.
• NWBO has been planning phase 2 trials for DCVax Direct in inoperable tumors and an explanation of their protocol and timing might be encouraging. Because these trials would be in inoperable solid tumors enrolling patients without therapeutic options, these could be the basis for regulatory approval if results are good.
• The Company has been silent on what is going on with the early access programs for DCVax-L in the UK and Germany. I believe that some patients have been treated.
• There could be more mature data on results from the phase 1 trial of DCVax Direct and the information arm of the DCVax-L phase 3 trial. Results so far have been encouraging but not conclusive.

Financial Position is Weak; there is a Need for Much More Cash

This sharp decline in the stock price has major negative implications in that NWBO needs a significant amount of cash to execute its clinical trials and it may have to raise money at sharply depressed prices. Northwest ended 3Q, 2015 with $5.3 million of cash. During 4Q, 2015 the Company raised $30 million from Woodruff and $11.7 million in a registered direct offering. The operating cash burn in the first three quarters of 2015 was $17 million and if that rate held in 4Q, 2015, NWBO ended 2015 with $30 million of cash. At a quarterly cash burn of $17 million, the Company would run out of cash in roughly June of 2016.

The Company currently has 88 million shares outstanding and 31 million warrants and options. Many of the warrants and options are out of the money but for conservatism I will include all of them in my estimates of the fully diluted share count. (Accountants would blanch at this.) This brings the fully diluted share count to 119 million and at the current price of around $2.00 the market capitalization is $238 million.

The Company has given not guidance for quarterly burn rate in 2016 but let’s assume the phase 2 trials of DCVax Direct start and a trial of DCVax-L in combination with a checkpoint inhibitor begin. The expenses of the DCVax-L trial should be winding down. As an outright guess, let’s assume that 1Q, 2016 burn rate is $17 million and accelerates to $20 million in 2Q, 3Q, and 4Q 2016. This means that the full year burn rate would be $77 million in 2016. Let’s assume that the Company wants to end the year with $30 million. If all of these assumptions hold, NWBO will need to bring in $77 million of cash in 2016.

What does this do the share count? Let’s assume that the stock is a $2.00 when the deal is done and that the discounted deal price is $1.85. Let’s also assume as in the recent registered direct offering that one-half of a warrant is issued for each share of stock. This would result in 42 million new shares and 21 million new warrants. The all in share count at the end of 2016 would then be 129 million shares and 52 million warrants for a fully diluted share count of 181 million shares. At a stock price of $2.00 this would represent a market capitalization of $362 million.

Price Target Thinking

Success in the DCVax-L trial and anticipation of approval could lead to an expectation of a blockbuster product with likely sales of well over $1 billion. The market would likely award NWBO a huge market capitalization. I look at the CAR-T companies like Juno and Kite whose current products are about one to two years behind DCVax-L and have sales potential of perhaps $200 to $300 million. Kite has a market capitalization of $2.2 billion and Juno has $3.5 billion.

I would submit that with successful topline results for DCVax-L in the phase 3 trial in newly diagnosed glioblastoma that NWBO would be awarded a $3+ billion market capitalization in 2H, 2017. There is a great deal of uncertainty on the potential for success in this trial. If at the end of 2016, you assign a probability of success of 20% the market capitalization would be $600 million and based on 181 million fully diluted shares the price would be $3.31. At 50% probability of success the price would be $8.40.

Independent Committee

In my opinion, Northwest like many small biotechs has been the target of short sellers who have used the lack of transparency of trading in dark pools (about two thirds of NWBO’s shares trade in dark pools) and strategies based on high frequency trading and illegal naked shorting to exert enormous pressure on NWBO. There has also been a well- orchestrated campaign to destroy the credibility of management and to dismiss the potential of its dendritic cell cancer vaccine technology by raising uncertainties that are always present with drug development. Another key argument of the shorts is that there is something inappropriate or criminal about the relationship of Cognate Bioscience which manufactures NWBO’s products for clinical trials; this is a privately owned company controlled by venture capital funds led by Linda Powers who is also CEO of Northwest.

The chief accuser is Adam Feuerstein of TheStreet.com who has continually blasted the Company through writing 29 blogs since the beginning of 2014 in which he has attempted to spin every news release into a negative. Feuerstein claims that DCVax-L and DCVax Direct can’t possibly work, has accused the Company of manipulating clinical data (his argument is utterly naïve and ridiculous), conducting transactions which benefit Linda Powers and Cognate at the expense of Northwest shareholders, and committing securities fraud and criminal activity.

Feuerstein has a pretty shady past in which he has made similar allegations against numerous other companies, He has been joined in this attack by Seeking Alpha which has allowed anonymous hedge fund managers who were short the stock to publish extremely totally unbalanced bearish analyses of NWBO. It may not be surprising to you that the editors who determine what is allowed to be published on Seeking Alpha were formerly colleagues of Feuerstein at TheStreet.com.

Spurred by concerns by Neil Woodford about these unending attacks, a special committee has been commissioned by Northwest’s board of directors to look into year long, repeated allegations raised by Feuerstein and anonymous short sellers writing articles on Seeking Alpha that exactly mirror Feuerstein. A good number of the allegations center on the relationship with Cognate. In my judgement, I believe that Cognate provided mission critical manufacturing services not readily available or not available at all from other vendors. Without this, the all-important clinical trials of DCVax-L and DCVax Direct could not have been conducted. Northwest lacked the financial resources to pay Cognate cash for all services so that Cognate took stock in lieu of cash. If Cognate had demanded cash only and refused stock compensation, Northwest would have been forced to halt its clinical trials and very likely would have failed as an ongoing company. If my argument is correct and I believe strongly that it is, Northwest shareholders benefitted greatly from the Cognate relationship.

The report from the independent committee could take up to three months. It could go a long way toward resolving whether short sellers with the clearly stated intent of putting severe pressure on Northwest stock have somehow discovered misconduct or if they are spinning information and fomenting for the benefit of their short positions. Based on circumstantial evidence which is all any of us have to work with, I believe that they are spinning and fomenting. I think that this is essentially a cynical, well-organized circus aimed at confusing and panicking shareholders, something that unfortunately occurs on a regular basis with small biotechnology stocks. My best judgment is that this will prove to be a positive for Northwest when all facts are analyzed by an independent committee. One of the potentially beneficial aspects of this investigation is that all of Feuerstein’s blogs are likely to be put under close scrutiny to determine if they have factual basis. He may not fare well under such close scrutiny.

The work of the independent committee, in my opinion, is not a terribly important element of the investment thesis for Northwest in the short term. Without question, the key issue is why screening for the phase 3 trial of DCVax-L was suspended. It is important to understand that the trial itself was not suspended as patients already enrolled are continuing to be treated in accordance with the trial protocol.

Neuralstem

Overview

Neuralstem’s stock has performed extremely poorly this year as it began 2015 at $2.81 and is currently trading at around $0.75. I recently wrote an update on the Company and I would suggest that you refer to that article for a more in-depth view on my thinking.

In that report, I emphasized that an upcoming presentation at Biotech Showcase on January 12 could be quite important. The key factor driving the stock is the outlook for clinical trials of its NSI-566 neural stem cells in treating ALS. Following the reporting of phase 2 results in March of 2015, there were some questions raised as to whether some patients might have experienced an acceleration of their disease. In subsequent news releases, the Company stated that this was not the case, but did not explain why.

We also have been anxiously waiting to hear about when a phase 2b trial of NSI-566 stem cells in ALS might begin. If this trial is successful, it could be one of two trials that could be the basis of a regulatory filing. With exceptional results, there is some chance that FDA might grant approval on the basis of just this one trial. ALS is a devastating, progressive disease in which patients die 3 to 5 years following diagnosis and go through a horrifying deterioration in quality of life. There are no drugs or treatments that have shown an ability to slow or stabilize the disease. In small numbers of patients, NSI-566 has shown an ability to stabilize the disease for over two years. The question that needs to be answered in the upcoming trial (s) is whether this is a fluke (I don’t think so) and whether these cells are effective in some patients who can be identified before treatment.

The Company originally seemed to think that the phase 2b trial could be started in the summer of 2015, but this time point came and went and the Company distressing to investors said nothing. Investors kept waiting for word on the trial, but there was no news through the balance of 2015. The Company also went into a radio silence mode almost certainly because it was in delicate discussions with the FDA about the design of the trial and did not want to release details of the dialogue. This was for fear that agency might interpret that Neuralstem was trying to pressure the agency in some way. Overall, we have had essentially nine months of silence on the all-important clinical trial plans for NSI-566. In this no news environment, the stock was pummeled by short sellers.

The Presentation at Biotech Showcase

I thought that the scheduling of the presentation at Biotech showcase would provide investors with the much awaited updates in regard to NSI-566. Management gave a very strange presentation that started with and was primarily focused on the Company’s second drug in development, the oral, small molecule drug NSI-189, which will be going into phase 2 development for major depressive disorder. Most of the slides dealt with NSI-189 and there was no mention of NSI-566 stem cells until late in the presentation. Even then, information was on just one part of a slide at the end of the presentation. To the first time listener, one would think that this Company is all about NSI-189. To long term observers of the Company, it gave the impression that management was sharply de-emphasizing NSI-566.

In point of fact, the presentation did give some very important updates on NSI-566. It appears that the delay in starting the phase 2b was because the FDA wanted the trial to include a control arm. Neuralstem when suggesting that the phase 2b trial would start in mid-2015 was thinking that the FDA would accept historical results from the placebo arms of recent ALS trials such as Biogen’s dexpramipexole and Cytokinetics” tirasemtiv as a basis of comparison to NSS-566. The FDA has apparently insisted on using a sham surgery as the control arm.

The use of using sham surgery as a control arm presented huge issues. The surgery used to implant NSI-566 neural stem cells is intensive, complex and carries meaningful risk. It would be unethical, in my opinion, to subject a patient to this type of risk with no prospective benefit. This means that a sham surgery could not just be the surgery without implantation of the stem cells.

Management stated that there has been a consensus building around how to conduct a sham surgery in the control arm. They believe they have reached consensus and the trial will begin in spring or summer of 2016. This is nearly a one year delay relative to expectations in early 2015. While this is extremely important news, there was no elaboration on issues such as enrollment criteria, size of the trial, details of the sham surgery and a potential timeline to get to topline results. My guess is that topline results are likely in 2018 or 2019.

Almost as an aside management said that past ALS trials have been funded by grants and that this will probably be the case with the phase 2b trial. They said that information on this grant funding could be released in 1H, 2016. This is extremely important information as the Company is in a very weak financial condition at this time. In a worst case scenario, this trial could possibly be completed with no financial support from Neuralstem. I look forward to seeing if it is the case that grants can largely fund the trial.

There have been no important innovations in the drug treatment of depression for nearly 30 years. NSI-189 has a radically different mechanism of action and has given signals of activity in phase 1b trials. The NSI-189 trial will commence in early 2016 and topline data should be available in 2H, 2017. It is a randomized trial that will enroll 250 patients and is powered to show efficacy with half of the effect size seen in the phase 1b trial. This is a truly unique molecule in an area that has had no therapeutic innovation for nearly three decades. I view NSI-189 as being potentially as paradigm changing as NSI-566 if the trials are successful. The NSI-189 trial will be funded by Neuralstem.

Financial Issues

The Company has historically burned 1.0 to 1.5 million per month and with the NSI-189 trial will go up somewhat (as a guess let’s say $2.0 million). The Company ended the year with $18 million of cash. At a burn rate of $1.5 million per month the company would run out of cash in 9 months. At a burn rate of $2.0 million, they would be out of cash in 9 months. To get to the 2H, 2017 when topline results for NSI-189 are available, they will need to cover a burn of $35 to $40 million and have perhaps $5 to 10 million on the balance sheet. This suggest that the Company will have to raise about $30 million in 2016.

One very critical thing in evaluating the financial status is the determination of whether grants indeed will fund all of the development costs for NSI-566. If so, this means that in virtually any worst case scenario, the phase 2b trial can be completed. If this is not the case, it greatly increases the degree of financial distress.

Neuralstem has 116 million shares outstanding, 45 million warrants and 20 million options. Many or most of the warrants and options are far out of the money and generally accepted accounting principles would exclude them from a fully diluted share count of 181 million shares. Let’s ignore this and include them in the share count on the basis that successful outcomes in either the NSI-566 of NSI-189 phase 2 trial could cause a dramatic climb in the stock. Hence I am looking at a fully diluted share count of 180 million shares.

In order to raise $30 million at the current price of $0.75, an equity deal would probably have to be done at a discount of around $0.68. In addition, the deal would likely require one warrant to be issued with each share of stock. This would require the issuance of 44 million shares and 44 million warrants. This would bring the fully diluted share count to 269 million shares.

Investment Thinking

In a scenario in which NSI-189 shows encouraging data in the phase 2 controlled trial, it could be easily partnered and there would likely be very significant inflow of cash which could alleviate the need for raising more money in the equity market. This would be looked at as a huge opportunity for Neuralstem but because of the historical unpredictability of depression trials there would be some restraint. My guess is that NSI-189 with a successful phase 2 trial could lead to a market capitalization of around $250 to $300 million in late 2017 or $0.93 to $1.12. Some potential for the possible success of NSI-566 stem cells could significantly increase this price target in late 2017.

The ALS market in the US is about 25,000 patients. If NSI-566 is successful it is likely to be in a subset of these patients. Probably young and healthy patients who have been recently diagnosed and do not have xxx ALS. I think that the price of NSI-566 stem cells would be at orphan drug levels of perhaps $300,000 per operation and the costs of the operation would be incremental to that. With this price, each 1000 patients would create $300 million of revenues. Obviously, this is a home run even if the cells are only effective in a small subset of patients. I think that the market would capitalize these revenues at 7 to 10 times so that $300 million of sales could lead to a $2.1 billion to $3.0 billion market capitalization. Based on fully diluted share of 269 million this would result in a stock price of $7 to $10 per share.

Discovery Laboratories

Overview

I think that of all the drugs in development that I am involved with, DSCO’s Aerosurf (surfactant supplementation) has the potential to have the most societal and therapeutic importance. Human surfactant has a critical function in breathing through the mechanism of reducing surface tension in the alveolae of the lungs. (Alveolae expand and contract like a ball0on in the breathing process.) Babies born prematurely are born with varying deficiencies in the ability to produce surfactant with the youngest being at most risk. In many of these babies they must be given a surfactant derived from the lungs of pigs or cattle.

In severe cases, babies must be intubated and given mechanical ventilation with the surfactant being delivered through the intubation tube. While this is a lifesaving procedure, it can cause great stress on and considerable damage to the lungs. In less severely ill babies they are supported by nasal continuous positive airway pressure (nCPAP) which delivers only oxygen to the lungs. The problem with nCPAP is that many of the babies do not respond and must be transferred to mechanical ventilation and surfactant replacement. However, it is difficult to predict at the beginning nCPAP whether the baby will need to move on to mechanical ventilation.

Aerosurf delivers surfactant via nCPAP. The uniqueness of the product is twofold. First it uses a human surfactant developed by DSCO and approved by the FDA that can be aerosolized. Attempts to deliver animal protein surfactants (these account for all usage) have been unsuccessful because of the complexity of the molecules and inconsistency of a product that is derived from animal tissues. DSCO’s human surfactant is a synthetic molecule that is relatively small and has a consistent formulation. The second innovation in Aerosurf is the aerosol generator which has been in development for over 15 years. The commercial development of the aerosol generator was developed by Battelle, one of the leading medical device developers in the world. DSCO has a unique leadership position with Aerosurf based on the proprietary surfactant that it uses and the aerosol generator.

At one point the Company thought that it would complete clinical trials of Aerosurf by 2010. An unbelievable string of missteps induced in equal measure by both the Company and the FDA has led to delay after delay. The stock has been a disaster over the last decade as it has declined from $7.70 on January 3, 2005 to a current price of $0.18. Obviously, no one who has bought and held the stock over this period of time has lost money. DSCO is as close as a company can come to having no credibility with investors who have been burned time after time. Hence. Expectations for success in Aerosurf trials is near zero. Please refer to my recent report for a more in-depth analysis. http://smithonstocks.com/discovery-laboratories-results-for-phase-2a-trial-are-quite-encouraging-why-then-did-the-stock-crash-dsco-buy-0-30/?co=discovery-laboratories

Is There an Investment Case?

So why should anyone bother with the stock? I think that you can only do this if you put on blinders, completely ignore the past and look at the clinical data so far produced. I realize that he who ignores history is doomed to repeat it. Ignoring this warning, I would point out that the Company has gained regulatory approval of its human surfactant. This means that the surfactant product used in Aerosurf has been shown to be safe and effective. The key is whether the aerosol generator effectively delivers the surfactant to the lungs. In animal models, it has been able to do this successfully. The phase 2 a trials which have largely been completed have shown safety with Aerosurf and signals of efficacy.

A randomized, double blind phase 2b trial that will enroll 250 babies is intended to show proof of concept. The first phase has just started and will enroll babies of 29 to 32 weeks gestational age. The second stage will enroll babies of 26 to 28 weeks gestational age and will probably begin later in 1Q, 2016. Topline results will be available in 4Q, 2016 or 1Q, 2017. If the trial is successful, it can probably be used as one of the two well controlled trials needed to file for regulatory approval. This will set the stage for a phase 3 trial which could provide topline results in 4Q, 2017. Assuming success in both trials, the product could be approved in late 2018 or 2019.

The results in the phase 2b trial will be a major inflection point. If they duplicate the results seen in the small phase 2a trial that was just completed, I think this will be proof of concept and that Aerosurf will be viewed as a major medical advance and there would be a high level of confidence that the product will be approved in 2018 or 2019. Management would then be faced with the decision in 2017 to seek and commercialize with a partner (which would be easy if the phase 2b results are seen as a success) or to just sell the Company outright. I think that an outright sale after a successful phase 2b could occur at a $200 to $400 million valuation based on my experience with other deals

Financial Position is Weak; May Need to Raise Cash at Currently Depressed Price

DSCO ended 3Q, 2015 with $46 million of cash and is guiding to a cash burn of $8 million in 4Q, 2015. At this quarterly burn rate, the Company would end 2016 with $6 million of cash. Management has indicated that this cash will last into 1Q, 2017. Given that topline results of the phase 2b trial are probable in 4Q, 2016 or 1Q, 2017, the Company will probably have to raise some money to get to topline results. It can’t just let cash go so close to zero.

I am expecting a $10 million raise in 2016 at terms similar to the last deal. At a price of $0.16 per share, this would result in selling 55 million units comprised of 1 share and 1 warrant and would result in the equivalent of 63 million more shares and 63 million more warrants if done at $0.16 per share. The company has 154 million fully diluted shares outstanding so that the hypothetical $10 million raise would increase the fully diluted share count to 280 million. At the current price of $0.18 this represents a fully diluted market capitalization of $45 million.

Price Target Thinking

Obviously, the market is looking for the phase 2b trial to fail, but I think that this cynicism/ skepticism is overdone because of the history of the Company; I give the phase 2b trial a reasonable chance of success and with that I think the market capitalization could reasonable increase to $200 to $400 million or $0.71 to $1.42 per share. This is the upside and the downside is $0.00 if the trial is a complete failure.

Possible Delisting

The Company has the risk of a possible delisting from NASDAQ to bulletin board status.

Derma Sciences

Overview

Derma recently issued guidance that it anticipates that the sales of the key Advanced Wound Care (AWC) business would increase 13% in 2016 and that this coupled with a $10 million reduction in operating expenses would enable the Company to be cash flow positive in 2H, 2016. The Company has been burning cash at a rate of about $9 million per quarter in 2015 as it spent heavily on the development of the biotech, wound healing product aclerastide and also invested heavily in building the sales and marketing infrastructure for AWC. The turn to positive cash flow with profitability soon to follow represents a major change in the fundamentals. Derma will no longer be looked at as a biotechnology company with a large cash burn, but as a sales and earnings driven specialty pharmaceutical company.

Guidance for 2015

Management expects that Derma Sciences can show double digit growth in sales going forward and this will be led by AWC. However it has guided (strangely, ominously) that AWC sales in 4Q, 2015 will decline by 10% versus the prior year. The Company attributes this decline to the reduction and realignment of the Company’s U.S. direct field sales force implemented during the quarter which reduced the size of the sales force from 50 to 38. The Company would not comment on this point but the reduction if 4Q sales of AWC suggests that this may be due to excess inventory in the field that is consistent with efforts to bolster sales earlier in the year. This might also explain the termination of the long time CEO Edward Quilty and the appointment of board member Stephen T. Wills as interim CEO. However, the failed bet on aclerastide may have been the primary reason.

In 2015, the Company expects sales of $84.5 million which is a 1% increase. Advanced Wound Care sales are expected to increase 9.5% to $41.7 million and traditional wound care is expected to decrease 6.4% to $42.7 million. The full year increase in AWC sales reflects strong growth from the TCC-EZ and AmnioExcel products, partially offset by flat sales or slight sales decline for Medihoney due principally to Medicare Part B reimbursement modifications. It is hoped that the reimbursement issue is now behind the Company.

Guidance for 2016

Derma Sciences expects 2016 net sales to be approximately $89.1 million, representing growth of 5% increase over 2015 Net sales of AWC products are expected to be $47.2 million in 2016, which is an increase of 13% and net sales of TWC products are expected to be $41.9 million in 2016, a decline of 2% The Company said that sales are expected to increase as the year progresses, but quarterly sales will be impacted by ordering patterns and by delivery dates, particularly in the TWC business. This suggests that the Company may be expecting the rate of year over year sales increases to be more modest in the early quarters and stronger in later ones. Investors are usually cautious on this hockey stick effect.

Assuming a cash burn of about $10 million in 4Q. 2015 Derma ended 2015 with $40 million of cash. The Company estimates that cash burn for the first half of 2016 will be approximately $7.5 million; the Company expects positive cash flow for the second half of 2016 of approximately $1.0 million. If so, the Company will end 2016 with $33 million of cash and will be cash flow positive going forward.

Stock Opinion

In my last report on Derma Sciences, I said that I was close to upgrading. The Company seems to be very cheap for a specialty pharmaceutical company as it is selling at a market capitalization of $86 million which is just under one times 2016 sales. Even if it is valued only on the basis of AWC projected sales of $47 million, it is selling at 1.8 times sales. Fast growing specialty pharmaceutical companies can sell at 3 to 4 times sales while more sluggish growth leads to valuations of 2 times sales. Derma looks cheap.

I think that the Company has shown an impressive ability to acquire new products for AWC and it has built a valuable sales and marketing infrastructure. I am very close to upgrading the stock, but for the time being I will stay on the sidelines. The company is guiding that the rate of year over year quarterly sales increases to be more modest in the early quarters and stronger in later ones. Investors are usually cautious on this hockey stick outlook. I think I will wait awhile to see if the Company can achieve this guidance and to also evaluate the new CEO and his strategy. I do anticipate upgrading later this year.

Alimera

Overview

This Company is exclusively focused on the commercial development of Iluvien. It effectively has no pipeline. The initial launch in the US early in 2015 resulted in $8.8 million of sales through the first nine months of the year and I am $16 million. European sales could reach $7 million if 2015. My worldwide sales estimate for Iluvien in 2015 is $23 and my 2016 sales estimate is $37 million. I have been impressed by the US launch in 2015 because Iluvien did not receive a J code until January 2016. This J code greatly facilitates reimbursement and should be a major boost to sales in 2016. If Alimera were well capitalized, I would be positive on the stock bit it is in a weak financial condition.

Financial Issues

In 2016, I estimate that sales will be $37 million. The gross profit margin on these sales is extremely high and translated into a gross profits estimate of $34 million. However, in 2015 cash operating costs are estimated to be $57 million and if that remains the same in 2016, Alimera could lose $23 million of cash operating income. Indeed, unless operating cost are brought down sharply which may not be possible, it will take $57 million of sales to reach breakeven. This might be achievable in 2017.

The Company ended 3Q, 2015 with $39 million of cash and I am estimating the year end cash position could be about $30 million. On my projected burn rate of about $23 million in 2016 the Company has a little over one year of cash and will need financing. Also, the balance sheet is very strained with $34 million of notes payable and $68 million of convertible preferred stock.

Investment Thesis

I am on the sideline until the point in time when the financial position becomes more stable. There is the potential for severe stress. As I previously stated, I am impressed with the sales ramp of Iluvien.

PSivida

Overview

The first major investment issue for pSivida is the commercial launch of Iluvien which is being conducted by Alimera. The second is the clinical development of Medidur for the treatment of posterior uveitis which affects 175,000 people in the US and causes 30,000 cases of blindness each year making it the third leading cause of blindness. The first of two phase 3 trials of Medidur was very successful.

Iluvien

PSivida is entitled to receive about 20% net profits on a country by country basis from sales of Iluvien whose launch is being handled worldwide by Alimera. In the preceding discussion on Alimera, I said that I am impressed with the progress that Alimera has made in the US. I think that Iluvien in the US might reach profitability in late 2016 or 2017. My concern is the stretched financial condition of Alimera has the potential to interrupt the launch of Iluvien and I am waiting for this situation to become clearer before upgrading the stock. It has been rumored that Alimera is seeking a buyer. If so and they find a buyer that has strong marketing and financial resources, this could be a major positive for pSivida. I may be too cautious in not upgrading the stock now.

Medidur

The Company announced in December 2015 that the first phase 3 trial of Medidur was successful. Enrollment of the second phase 3 is expected to complete in mid-calendar 2016. With favorable results, the Company will file for approval in the US in 1H, 2017. In late December, 2015, they filed for European approval on the basis of the first phase 3 trial.

The first phase 3 trial was a 129 patient, multi-center, randomized and double-blinded trial. The primary endpoint of prevention of recurrence of disease at six months was highly statistically significant with p less than 0.00000001 on an intent to treat analysis. In patients treated with Medidur, 18.4% of patients had recurrence of posterior uveitis versus 78.6% on control. Safety results were also encouraging as the major safety concern is elevated intraocular pressure In the Medidur treated groups 27.6% of Medidur-treated eyes compared to 16.7% of control eyes had experienced an increase in intraocular pressure (IOP) above 21 mmHg for at least one observation. This was comparable to what was seen with Iluvien phase 3 trials.

Financial Issues

PSivida ended the quarter ending September of 2015 with about $23 million of cash and the recent quarterly burn rate has been about $4 million. If this burn rate holds in the just completed quarter, pSivida had about $19 million of cash at December 31, 2015. In January it raised $18 million of cash bringing the cash position to $37 million. At a $4 million burn rate this would carry the Company until the first quarter of calendar 2018.

Celldex

Overview

There are three products in development that are points of focus for Celldex in the 2016-2017 time frame

(1)        Rintega: a vaccine for glioblastoma that is targeted at about 30% of patients who express the EGFRvIII mutation, (2) glembatumumab:

(2)        glembatumumab vedotin monoclonal antibody that target the glycoprotein GPNMB which is over-expressed in triple negative breast cancer and is conjugated with the cell killing molecule auristatin, and

(3)        varilumab which stimulates T-cell activity (hits the accelerator) in contrast to the checkpoint inhibitors BMY’s Opdivo and Merck’s Keytruda (take the brakes off the immune system)

Investors had been expecting (hoping) that data from a phase 2 open label trial in recurrent glioblastoma would be sufficient for approval. However, on August 10, Celldex began a significant sell-off that has seen the stock decline from $21.35 to the current price of $11.14 when the Company announced that the FDA would not consider Rintega for approval in recurrent GBM based on this dat. There was wide expectation that it would be approved. This was the major company specific factor although there has been concern about competitive drug development against glembatumumab in triple negative breast cancer.

In looking at 2016, the major events for the stock related to the phase 3 trial of Rintega in newly diagnosed GBM. There should be an interim look in early 2016 and the final analysis in late 2016. There is some expectation of the trial being halted at the early interim look but the really critical final could be late this year. If the trial is not halted at the interim look there could be some disappointment although there shouldn’t be. There will be no news on glembatumumab other than that enrollment in the phase 3 has been completed. I have some concerns on glembatumumab because the phase 3 was launched on very limited data from phase 2 trials. Varilumab is an interesting drug and we may see some interesting phase 2 data from combination trials in 2016; I can’t say for sure.

Financial

The Company has done an excellent job in keeping the Company well financed, but it also has a ferocious burn rate. The average quarterly burn in the first three quarters of 2015 was a whopping $28 million and if that continued in 4Q, 2015 Celldex ended the year with $277 million. Projecting the $28 million quarterly burn forward, Celldex has cash to last until mid-2018. For a development stage biotechnology company this is a very strong balance sheet and a major investment positive. The Company has about 99 million shares outstanding which at current prices translates into a $1, 1 billion market capitalization.

Investment Thesis

I have had mixed feelings about the stock. Its key technology base is monoclonal antibodies with glembatumumab and varilumab being the first products arising from this base. An investment strength is that Celldex has the potential to create a very broad pipeline of products, especially in the very hot checkpoint modulator space. This would be very attractive to a potential acquirer.

The next most important event for the Company will be the interim look at the phase 3 trial of Rintega in newly diagnosed glioblastoma. There may be some modest expectations for success at this interim look but I think that is unlikely. The readout of topline data in late 2016 or early 2017 will be the key time point for determining if Rintega is effective. The phase 2 data has been encouraging on Rintega, but glioblastoma is very heterogeneous and Rintega targets just one antigen. I am concerned that tumors will have escape mechanisms that blunt the effect of Rintega. The important readout on glembatumumab will be in 2017. The net of all of this is that there is not much news in the coming year.

ImmunoCellular

Overview

The Company carefully analyzed the results of the phase 2b trial of ICT-107 and has identified a sub-group of patients in that trial that appear to respond very well to the drug. These are HLA-2 status patients. In HLA-2 patients with methylated MGMT, there was a strong signal of activity and in unmethylated MMGM patients there also appears to be benefit. I think that there was a strong signal of activity in this sub-group and that a decision to move ICT-107 in this patient population was sound.

The for the phase 3 registration trial has just started. It is a double-blind placebo-controlled study of about 400 HLA-A2 positive patients. According to Clinical Trials.gov the trial is scheduled to report topline results on the primary endpoint of overall survival in December 2019. The Company is also forecasting reaching the triggering levels of events for interims at about the 2 year (January 2018) and 2.5 year (July 2008) time points.

Financial Issues

I estimate that the phase 3 trial could cost around $40 million to conduct through reporting of topline data in late 2019. In addition, costs of running the Company and doing research on other products could cost about $6 million per year. This suggests cash usage of $58 million from now until December 2019.

I estimate that Company ended 2015 with about $20 million of cash. However, in September 2015 management announced that the governing Board of the California Institute for Regenerative Medicine (CIRM), California's stem cell agency, has awarded the Company $19.9 million to support the ICT-107 phase 3 trial. This brings the effective cash balance to $39 million of cash. Assuming that the Company wants to have a cash balance of $10 million at the end of 2019, it will need to raise about $30 million of cash in the period 2016 to 2019. However, there is no immediate need.

Stock Opinion

I think that ICT-107 has a reasonable chance of being successful in the phase 3 trial and as I noted earlier, I believe that this could be a paradigm changing drug. However, it could be nearly four years before we know if the trial is successful. I think that I will stay on the sidelines for now.

Comments on the Broad Market

Introduction

In case you are interested, I have included my views on the broad stock market outlook. In the near term, the market is panicky and emotional and I don’t know when this will end. However, this will pass (at least this has always been the case in the past). Emerging biotechnology stocks can only do well in a stable market environment so is important to think about the valuation of the market and potential returns of investing in the broad market. In this section I have focused on the current valuation of the S&P 500 and its potential long term returns. I then spend some time on issues that seem to be driving the current steep correction.

The valuation of emerging biotechnology stocks is dependent on the valuation of the broad market. They are among the most speculative stocks in the market and in order for them to do well, there must be market stability which is affected by market valuations and expected returns.

Is the S&P 500 Overvalued?

A critical question to ask is whether the stock market as measured by the S&P 500 is overvalued, undervalued or correctly valued. Put another way, is the recent correction overdone or is there more to come. I don’t know. In the near term of months or a year, investor psychology can carry markets to extremes and obviously the current tone is quite bearish, but let’s look at historical norms.

I can point out some valuation measures to provide a gauge. The mean P/E ratio of the S&P since 1880 has been about 16 times trailing 12 months EPS.  Currently, it is selling at about 20 times trailing year earnings and 16 times projected 2016 EPS. Based just on these numbers, it appears somewhat above historical norms. However, the steep drop in energy prices has had a major impact on the earnings of energy companies and this has the effect of increasing the S&P 500 P0E ratio.

The S&P 500 must also be looked at on the basis of its dividend yield in comparison to current interest rates. Historically, treasury bonds have traded at 2% to 3% premiums to dividend yields on stocks. Remember that in a stable interest rate environment the total return on a bond is the coupon while for a stock it is the stock price appreciation (or depreciation) plus dividend yield. The S&P 500 is yielding 2.3% versus a 2.5% interest rate for the 20 year treasury bond and essentially 0% for money market funds. Based on this measure the S&P 500 is undervalued relative to treasuries unless we are going into a serious recession.

With interest rates likely to stay at these historically low levels for some time due to modest economic growth, low inflation and accommodative national bank policies, it does not seem to me that the S&P 500 is meaningfully overvalued or undervalued to me, but these are volatile times.

What Kind of Long Term Returns Can Be Expected from the US Stock Market?

I have never purported to be a market pundit, I am certainly not an economist and I don’t spend a lot of time trying to predict which way the stock market is going. I have been impressed by the business success of Warren Buffet and have been greatly influenced by his thinking. When asked about the market direction, he says that he has no idea which direction the market is going in the short term and I agree with him on this. Buffet points to economic growth as the major driver of stock prices if stocks are reasonably valued.

I watch business news channels off and on and when guests are asked where they think the market is headed, they invariably come up with a confident answer. They usually reach their conclusion on the basis of what they think will happen to one or two variables-, price of oil, slowing economic growth in China, Fed action, the dollar, etc. etc. The problem is that the stock market responds to a vastly greater number of inputs and the importance of these inputs varies greatly, often from day to day. Focusing on just one or two variables ignores the bewildering complexity of inputs that drive the market.

As those of you who follow my work understand, I view myself as an investor and not a trader. Over a long period of time, the stock market has been a winner’s game in which all participants who stay invested win. Trading stocks on the other hand is a zero’s sums game in which one party wins and one loses. Warren Buffer predicts the potential for stock market returns for investors as follows:  “The economy, as measured by gross domestic product, can be expected to grow at an annual rate of about 3 percent over the long term, and inflation of 2 percent would push nominal GDP growth to 5 percent, Stocks will probably rise at about that rate and dividend payments will boost total returns to 6 percent to 7 percent. Obviously stock selection can affect this, but this is a reasonable average expectation.

If you look at the period from 1928 to 2015, the nominal return on stocks (price appreciation plus dividend distribution) has been 9.5%. For the period 1966 to 2015 it was 9.6% and for 2006 to 2015 was 7.3%.This compares to Buffet’s expectation of 6% to 7% for the future. However, this does not mean that every year will show a 6% to 7% return as individual years can vary much more.

The fundamental driver of nominal stock prices has been nominal GNP growth in the US and this is still largely the case. Nominal GNP is the sum of consumption, business investment, government spending and net exports (exports minus imports). Our economy has become increasingly dependent on world trade but exports are only about 15% of our GNP. Past history suggests that if the US economy can grow in the future the stock market can also grow. We have recently been experiencing GNP growth of 2% to 3% and if you listen to 10 economists, you will get 20 different projections about what economy will do this year and next within a range of recession to growth above 3%.

My own personal prejudice is that GNP is importantly driven by human innovation (there are of course other factors) and I believe that the level of innovation in technology and biotechnology is exploding exponentially and that we are in the most vibrant period of innovation in human history. Intriguingly, this shows no sign of letting up. If this is so, it augurs well for GNP growth and profitable investing in stocks. However, like Buffet, I have no idea where the market is going in 2016. Well actually I do have an opinion. It has been my experience that the market usually goes in the opposite direction of what the consensus expectations of market participants are. Given the pervasive bearishness of the current market, this suggests to me that the stock market could be higher at the end of 2016 than the end of 2015.

In A Period of Panic, What Investors seem to be Focusing On

Obviously, day to day and month to month market fluctuations are much more volatile than what I have just described as the potential long term outlook. Investors have to weigh issues as they arise to judge whether they are just contributing volatility to the market or are a harbinger of meaningful secular change. Here are my thoughts on the price of oil and China which seem to have been the catalysts for the sharp market decline in January.

Price of Oil

The sharp decline in the price of oil is invariably cited as a reason for the decline in the stock market. This is partially based on the thought the demand for and price of oil is reflective of the strength of the US and world economy. To a much lesser extent, people worry about the negative effect on employment in the energy sector and possible negative effect on bank loans to the energy sector. The plunge in oil prices in the minds of some is a harbinger of plunging worldwide demand and recessionary conditions. However, there seems to be an alternative and more plausible reason for the plunge in prices and that is that supply exceeds demand because of overproduction.

The Saudis have made a decision to maintain their share of the world market as enhanced energy production, especially in the US, through more efficient drilling and fracking has greatly boosted world fossil fuel energy supplies. The Saudis would like to drive marginal producers out of the market and reduce supply (from small producers) by causing a sharp drop in oil prices. To the extent that this is true, the drop in oil prices is not a signal of just falling demand. The anticipated re-entry of Iranian production in the world market has also been a factor. On the demand side, however, there has been a drop in China which is the largest importer of oil.

Regardless of the cause (and I believe it is primarily oversupply) the oil price drop is of enormous benefit to our economy. Remember that one component of GNP is the net of exports minus imports. Since oil is a huge import item, the drop in oil prices decreases import spending and increases GNP all other factors being equal. Think about oil at say $100 per barrel as opposed to the current $30. This is an enormous benefit to the US economy. Instead of lining the pockets of Arab Sheiks, this incremental $70 can be used in the US for capital spending, paying down debt and increased consumption. The original market wisdom was that as the price of oil came down it would have these beneficial effects. Somehow this has morphed into the view that decline of the oil price is a harbinger of recession and dooms the stock market. I am skeptical. I think the decline in the price of oil is a positive for the market.

China in Turmoil

The slowdown in economic growth in China seems to be competing with the price of oil as the most important factor in the stock market drop. Again reiterating the caveat that I am not an economist, my research suggests that the US gross national product in 2015 was just over $18 trillion and exports were about $2.7 trillion. Our exports to China were about $0.1 billion or 0.1% of US GNP and 4 5% of exports. These numbers suggest that China is relatively insignificant as a direct contributor to US economic growth. In addition, Most economists are suggesting that China’s GNP is slowing (not going negative) from 7-9% to 5% to 7%.The Chinese just reported that 4Q, 2015 annualized GNP growth was 6.8% and the IMF is projecting 6.3% growth in 2016. However, there is wide questioning on the accuracy of Chinese economic statistics and many feel the real growth is 4% to 5%. There is also a general belief that China is shifting from an infrastructure driven economy to a consumer driven economy. If this is the case it could be a relative positive for our exports to which are driven by Chinese consumption.

Some investors will quickly reply that I am missing the point. They suggest that the sharp slowdown in commodity spending will disrupt countries driven by commodity exports- Russia, Australia, Brazil, Iran, Saudi Arabia and many developing nations. This will then lead to sharp disruption in economic activity and trigger a worldwide financial contagion. These countries are certainly going to suffer but weighing against this are the enormous benefits to the developed world.

The sharp correction of the Chinese stock market also appears to be a significant cause of investor fear. Roughly, this market has declined from around $10 trillion in value last year to about $7 trillion. The Chinese market is about 10% of the $70 trillion global market value of stocks. This is not trivial but it is also not dominant. From listening to discussions on business news channels, I gather that the Chinese market has been highly priced as compared to multiples of the US price/ earnings ratio (it is a gamblers market) and is much less tied to the Chinese economy than is the case in the US. If so, it appears that the Chinese tail has been wagging the US dog.

Please take these estimates as being representative rather than exact; this is definitely not an area in which I have much expertise.

Other issues

I think that the price of oil, the slowing economic growth of China and the sharp drop in the Chinese market have been the catalysts leading to the US market correction. From my layman’s viewpoint, these issues are likely to fade as the year progresses. There are many other issue to consider such as Federal Reserve policy, the exchange rate of the dollar, terrorism, politics, etc. From time to time, any of these may emerge as key issues but they are not as important in the near term as the price of oil and China.

Investing In Emerging Biotechnology Stocks

Introduction

SmithOnStocks focuses on small emerging biotechnology stocks and these have suffered a much more severe correction than the overall market. Why has this happened?

If you look at the broad reasons for the stock market decline, none of them directly affect small biotechnology stocks to any meaningful effect. In most cases, these companies have no marketed products and the stock prices are overwhelmingly dependent on investors’ judgments of the potential for success in clinical trials. These are obviously dependent on biological processes and not economic trends. The sharp price drop has resulted from investor fear and with that a sharply reduced propensity to take the high risks involved in these stocks, The most important direct risk induced in this sector by the stock market correction is that for some companies which have insufficient cash balances, they may have to raise cash at depressed prices which leads to shareholder dilution. In the previous section on companies, you will see that I spend a great deal of time discussing the financial status of each.

I know that some of you may ask if the market has entered into a period of risk aversion and if that is the case, will that permanently reduce the valuation levels for biotechnology stocks. I don’t know. I can say that over the 30 years I have been following biotechnology stocks that there have been numerous corrections like this one in which many investors thought the stocks would never bounce back in a meaningful way and somehow they always did. I think that this is because innovation has always been enormous. This has been largely fueled by recombinant DNA and monoclonal antibodies over the past 30 years. These will remain important but they could be bolstered by research in cellular therapy, gene therapy and other technologies now in a nascent state. I see a bright future for innovation.

Unfortunately, in the last decade there has emerged another risk factor in the market. This relates to the enormous increase in the impact of hedge funds in the market. Some (many, most) are driven by the quest for short term gains above all else. They have at their disposal tools such as illegal naked shorting, high frequency trading and dark pools. This seems to allow hedge funds to manipulate stocks in general and emerging biotechnology stocks in particular. The growing awareness of investors of this sinister force does raise the possibility for greater investor risk aversion. I will discuss this shortly.

SmithOnStocks Investing Strategy

Before going on, I want to reiterate my strategy for investing in small biotechnology stocks. I am much more driven by drug development efforts than commercial products so that many of the companies I follow have no approved drugs. I research biotechnology and pharmaceutical companies of all sizes, but most of my focus is on small companies ranging in size from as small as $50 million in market capitalization to about $1+ billion. There is much less analyst and investor attention on these stocks which can lead to pricing inefficiencies. There is also considerable risk as the investment thesis for the stocks often hinges on the outcome of a single clinical trial, the dreaded binary event. While I don’t have precise statistics, my impression is that more than half of late stage clinical trials fail. This investment scenario give rise to what I call asymmetric investing.

Asymmetric Investing

What do I mean by asymmetric investing? Some investors have made enormous returns by looking for asymmetric investment opportunities. These stem from finding upcoming events that are not well understood and which have the potential to cause dramatic stock movements in the case of a positive outcome. The chance for such a positive outcome may be modest, but if it does occur the potential reward dramatically offsets the risk of being wrong. Perhaps the upside opportunity is a several fold increase in the stock price and the downside is losing much or all of one’s money. These characteristics are similar to an option, but have the advantage that there is not the time element. One can be right on thinking that leads to an option investment and still lose all or much of your money if the option expires prior to an anticipated event. Asymmetric investing is not devoid of time risk, but it is much less than with an option.

For an asymmetric opportunity to exist there has to be lack of awareness or extreme skepticism that a positive outcome can occur. Small biotechnology companies fit this approach because most Wall Street analyst coverage in biotechnology is focused on larger biotechnology names that are earnings driven. In addition, the large number of trial failures conducted by small biotechnology companies has produced a pervasive skepticism as to whether any clinical trials will succeed. Asymmetric investing does not mean that an investor is smart enough to predict with certainty clinical trial outcomes. The premise is that the event has a reasonable chance of occurring, is unexpected, and if it does occur; the upside potential dramatically offsets the risk of losing much or all of the investment if the outcome is negative.

When I write my articles I always think that each idea will be successful, but I know that some will fail. At least, that is how it has worked in the past. It has been my experience that one winner will significantly offset the loss of several losers (an asymmetric outcome) and I aspire to be right more than half of the time. I tend to take small positions in many companies so that I am not overly exposed to any one stock and in the aggregate, emerging biotech is about 5% of my portfolio. A blowup can typically result in a 50 to 90% stock price decline. No one position is so large that if the stock blows up, it will have a major impact on my portfolio. However, if the outcome is positive the asymmetry that I am looking for can cause a noticeable effect on my portfolio.

Trading Versus Investing

I want to emphasize that if you are looking to trade the biotech stocks that I am involved with, my articles are probably not for you. I am generally locked in on an event or series of events that will prove me right or wrong and these can take some time to unfold (certainly months and sometimes a year or more). Along the way, unavoidably there will be many uncertainties and surprises that lead to sharp up and down movements in stock price and periods when a stock is just plain boring. I tend to ignore these and as long as the reasons that I bought the stock remain in place, I just shrug my shoulders and hang in there. I know that some people try to trade swings in the market and stocks in an attempt to enhance their total return. I have actually tried on occasion to do this as I suspect everyone else has. However, I found that it just didn’t work well for me.

Keep in Mind that Stocks are Not Companies; they are Commodities

When I started on Wall Street over 30 years ago, investing was much more the result of people making investment decisions based on a view of the growth prospects of a company and volatility was not as dramatic on a day to day basis. However, markets always have been and always will be driven by investor psychology that can lead to overvaluations and sharp corrections. One readily recalls the great world stock markets crash that started in October 1928, the Tulip Bulb Bubble of the early 1600s and the South Sea Bubble of the early 1700s as market declines of many times greater magnitude that this recent January correction.

Stocks are little pieces of paper (actually they are now binary code) whose price is determined by where the most aggressive buyer and the most aggressive seller meet in the market. While we would like to think that we can value stocks based on our analysis of the fundamental business, we must realize that stocks are commodities. Like any commodity, gold for example, there is not an intrinsic value. Investment sentiment is shaped and sometimes overwhelmed by a limited number of issues like China and the price of oil that affect the ability of investors to accept risk.

The most important factor in the daily price of a stock is what happened to the price yesterday. Moreover, the shrillest voice in the crowd (stock market) often has the most impact. For example, if we are all sitting in a darkened movie theater and one person yells fire, soon another person will yell fire and in not too long a period of time most people in the theater will be rushing for the exit. Human psychology is extremely important in stock prices and we can quickly go from euphoria to despair. In January, there have been a lot of people yelling fire.

Communication of Information on Stocks Has Changed Dramatically

This roller coaster of emotions always has made the market volatile and always will, but there is things that are very different in today’s markets from when I started my career over 30 years ago. News of course travels faster. When I wrote my first report on Wall Street (it was a recommendation of a fish tank manufacturer) the information was communicated through a written report mailed to clients. I remember getting a call from a client about the report some weeks later saying that he had just seen the report and wanted to talk about it. Today, reports are transmitted instantaneously over the internet.

Obviously increased speed of communication began to cause quicker and more volatile moves and a growing focus on short term events. Investors who could gain access to actionable information quicker could realize greater returns. Beginning in the 1980s hedge funds who specialized in rapid trading began to emerge. This accelerated greatly in the 1990s and today hedge funds are a major factor in the market. They claim that their speed and aggressiveness can produce superior returns. As I will discuss shortly, some (many, most) hedge funds are not adverse to bending or breaking securities laws to get an edge.

The rise of social media has been a phenomenon that has exploded in just the four years of so that I have been writing my blog. Blog venues like Seeking Alpha, iHub and internet chatrooms have created a global village of thoughts on individual stocks. On balance this is a positive but there is also the potential for investors (e.g. shorts) to use these forums to spread rumors and this indeed is an important component of stock manipulations schemes.

Stock Trading is no Longer Just About Company Business Prospects

The rise of hedge funds more than ever has made the stocks of companies just little pieces of paper and the value of that paper is all that matters to some hedge funds.

Throughout most of my career I believed that the price of a stock was determined by how participants in the market judged the business outlook for a company. Indeed, even three years ago when I began writing blogs on the internet, this was my belief. However, I have now come to believe that much of the trading that goes on (especially in the short term) is heavily influenced by trading tools and techniques that are independent of the fundamental outlook for a company and that they can have a dramatic effect on stock prices. I am not very knowledgeable on trading strategies and most of the following observations are from a 30,000 foot point of view so that my observations are based on hypotheses rather than objective evidence. Keep this in mind as you read the following paragraphs. Let’s start with dark pools.

Dark pools are private exchanges for trading securities that are not accessible to the public. They were formed to allow block trading between institutions who want to execute large trades without the broad market being aware of their activity. The thought process was that this would have less impact on the prices of stocks as trades are being executed. There is little transparency in dark pools so that trading activity can be hidden or disguised from investors and I might add regulators. At last count, there were 49 dark pools operated by large brokerage firms, large banks and other institutions involved in stock trading. The problem with dark pools is that they provide a venue for hedge funds to trade stocks back and forth without anyone knowing. Trade execution details are only released to the consolidated tape after a delay. It is estimated that 70% of daily volume even for small biotechnology stocks is done in dark pools.  Michael Lewis’ bestseller “Flash Boys: A Wall Street Revolt,” is an interesting read on dark pools.

Another key factor to consider is high frequency trading that uses powerful computers to transact a large number of orders at close to the speed of light. The original idea was to use complex algorithms written by some of the brightest mathematicians in the world to spot trends in the blink of an eye and to trade on them. However, high frequency trading can also be used to start trends and all too often we see this with small stocks as high frequency traders use a series of trades to “walk a stock down” or “walk a stock up”. Again about 70% of daily stock exchange trading is done by high frequency traders and interestingly about 70% of the stock trading in emerging biotechnology stocks is also done in dark pools. The Michael Lewis book just cited also gives an excellent introduction to high frequency trading.

Dark pools and high frequency trading have made naked shorting an extremely profitable strategy for some (most?) hedge funds. Traders who legitimately want to short a stock (and there is a place for shorting in the market) must borrow a stock, or determine that it can be borrowed, before they sell it short. However, there are loopholes in regulations that allow naked shorting, but more importantly, the combination of dark pools and high frequency trading operates on a much higher technological plane than regulatory agencies can understand. As a result, naked shorting can be done with impunity by hedge funds. This allows them to create counterfeit shares to match any offers to buy in the market. Someone wanting to buy the stock gives them money and in return gets counterfeit shares of stock. Hedge funds can literally create an unlimited number of shares in any given company. This is extremely lucrative because the hedge fund punches a button, creates counterfeit shares and is given cash in return. I would suggest reading my article Illegal Naked Short Selling Appears to Lie at the Heart of an Extensive Stock Manipulation Scheme for a more in-depth discussion.

In the case of small biotechnology companies, a group of hedge funds acting as a group (I call them a wolfpack) can have a major impact on stock prices at any time. How many times have you seen a Company that is targeted by a wolfpack report good news only to see the stock trade down on heavy volume? Alarmingly, when concerns arise about a company, particularly a small biotechnology company, and the wolfpack can drive the price to unbelievably low levels. I think that we are seeing this in many (most) of the stocks that I follow.

How profitable can the use of insider trading and naked shorting be? I would suggest that you go to Netflix and find a Frontline series program called To Catch a Trader that describes the actions of a famous hedge fund trader. This trader was a small time options trader at an obscure, shady Wall Street brokerage firm with no particular investment acumen. However, after founding his firm, he had a long record of 60% per year returns in the market and has accumulated a personal fortune of around $10 billion. I think all of us would agree that it would be impossible for any legitimate trader to consistently achieve these types of returns and indeed this seems to have been the case.

The television program To Catch a Trader describes how his right hand man and other employees of the fund have been convicted of insider trading; to date he has somehow escaped prosecution. This particular fund manager also seems to be a major practitioner of naked shorting. I would suggest reading this report to see how he and other fund managers used naked shorting to manipulate Dendreon in the 2005 to 2008 time frame.

There is a new series on Showtime called Billions which seems to be based on this trader. Like the Frontline program it focuses on insider trading as the reason the “fictional” trader in the show did so well. However, I believe that most hedge funds who trade illegally make most of their illicit gains through naked shorting rather than insider trading. Money is the God worshiped on Wall Street and there are many, many hedge funds who revere and emulate this portfolio manager. This has given rise to wolf packs of hedge funds who prey on stocks.

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