Follow Us GraphicFacebook IconTwitter IconLinkedIn Icon
Search Graphic

Expert Financial Analysis and Reporting

Why Biotechnology Investing is So Difficult: Cytokinetics is a Case Study (free article)


I just finished publishing a detailed article for subscribers to my website detailing my view that Cytokinetics offers asymmetric upside potential. I thought that non-subscribers might be interested in a part of that article that went through the trials and tribulations of my long standing buy (two and one half years) on the stock. It offers a not unusual chronicle of the ups and downs of investing in small biotechnology stocks and possible lessons to be learned.

A Look Back at Ups and Downs of Cytokinetics

Cytokinetics has been on a tear since announcing on October 27, 2015 that the phase 2b COSMIC-HF trial produced positive topline results for omecamtiv mecarbil in congestive heart failure. The stock closed at $6.89 on the day before the announcement. Subsequently, the stock is up over 80%. The reason for this is that investors are anticipating that Amgen will move forward into a phase 3 trial. I wrote about this on November 9, 2015 in an article entitled Cytokinetics: I Predict Amgen Will Proceed to Phase 3 Trials with Omecamtiv Mecarbil.

I first recommended Cytokinetics in a report on my website on March 25, 2013 at a price of $6.30. Since then I have never changed my buy opinion on the stock. In the period since March 25, 2013 it has traded as high as $12.99 and as low as $3.07. I want to go over this experience to give an important insight into my approach to investing in biotechnology stocks. I have pointed out many times that I am not a trader. I think that trading is a loser’s game as people get caught up in depressions and manias that ebb and flow with all stocks and biotechnology stocks in particular. As a result, traders get caught up in these mood swings and usually buy high and sell low. I focus not so much on the current price as on the potential for the stock longer term (usually a year or more and often much longer) if the fundamentals come through and as long as these fundamentals remain essentially intact, I don’t try to catch trading moves.

I would also try to make the point that results in a clinical trial that are disappointing or are interpreted as disappointing don’t always mean that a drug has failed and must be written off. A classic example is Acadia’s schizophrenia drug pimavanserin which failed to reach the primary endpoint in two phase 3 trials and was written off for dead resulting in Acadia’s stock price reaching a low of $0.67 in November 2011. Then a well-designed phase 3 trial based on knowledge gained from the two previous disappointing trials resulted in a successful outcome and the stock is currently trading at about $37. If Acadia were 1% of your portfolio in 2011, this move alone would have caused the value of your portfolio to increase by 54% since 2011 even if all other stocks in the portfolio were flat.

Let me also offer the further example of Pharmacyclics. The stock traded between $0.86 and $1.89 over the two year period from late 2007 to late 2009 following failure of its lead product. It then switched its focus to ibrutinib, an inhibitor of the enzyme Bruton's tyrosine kinase. The clinical trial program produced dramatic results in chronic lymphocytic leukemia and to a lesser extent in other B-cell malignancies. On May 21, 2015, the Company was acquired by Abbvie for $261.25 per share or a market value of $17 billion. Now let me hasten to add that the dramatic stock prices recoveries of Acadia and Pharmacyclics are exceptions to the rule and are outliers. Still, the overwhelming point is not to panic if trial results are negative; try to analyze the results to see if there is a path forward. Stocks react instantaneously to topline news, but this is not always the final word on the prospects for a drug.


Getting back to Cytokinetics, there are two particular clinical trial events that I would point you to. The first was a previous phase 2b trial for omecamtiv mecarbil called ATOMIC-AHF that produced some generally positive results, but raised the possibility of some side effects, particularly an increase in the enzyme troponin that can potentially signal that a heart attack has occurred. Adam Feuerstein wrote a negative blog  and suggested that omecamtiv mecarbil caused an increase in troponin levels and this indicated that the drug caused a higher percentage of heart attacks than was seen in the control group. He suggested this was the end for the drug. The ATOMIC-AHF trial results were announced on September 3, 2013 and the stock closed at $7.65 down from $10.47 on the previous trading day.

I wrote a report on September 4 called  Cytokinetics: Clinical Investigators’ Take on ATOMIC-AHF Trial Results in which I went over my interpretation of the trial and argued that the side effect issues were not the death knell that Feuerstein and fellow travelers had indicated. While I was ultimately proven right by results in the recently reported COSMIC-HF trial, the damage to the stock was done. By the end of 2013 and just three months later the stock was down to $6.50.

Omecamtiv mecarbil was largely written off but attention then switched to the Company’s second drug in development tirasemtiv which is targeted at ALS. In anticipation of results from the large phase 2b trial called BENEFIT-ALS the stock traded up to $12.99 on April 24, 2014 the day before topline results were announced but when results were announced on April 25, 2014 the stock was crushed and closed at $4.59 as the primary endpoint was not achieved. As I analyzed the BENEFIT-ALS results over the next few weeks, I concluded that the BENEFIT-ALS trial pointed the way forward to a phase 3 trial. On June 16, 2014 I wrote a report called Cytokinetics: I Think That the Company May Decide to Do A Phase 3 Trial with Tirasemtiv (CYTK, $4.70, Buy)  No one paid any attention and by October 10, 2014 the stock dropped to a low of $3.07.

I don’t want to attribute all of this chaotic price action to events specific to Cytokinetics as there were some significant mood swings for the biotechnology sector along the way that also contributed. Still, I think the results from the three phase 2 trials were the dominant determinant of stock price.

Looking Beyond Fundamentals: The Dark Force of Stock Manipulation

Over the last two years, I have come to believe strongly that there is also a dark force at work in biotechnology investing. I have written frequently about hedge fund manipulation of stocks which makes extensive use of dark pools and other tools. The idea behind the creation of dark pools was to establish markets away from the major exchanges in order to mask trading by major institutions. The objective was to prevent other investors from running ahead of orders of the major institutions. Unfortunately, as suggested by the name, it also allows hedge funds to trade among themselves without scrutiny. There are now 48 dark pools; Goldman Sachs, Morgan Stanley and other major brokerages all run dark pools. It is estimated that 70% of all stock trading including trading of small companies like Cytokinetics are done in these dark pools outside of the major exchanges and in which hedge funds can trade happily among themselves to manipulate prices without concern about scrutiny from regulators or other investors.

Hedge funds also use naked shorting extensively. SEC regulations require that a short seller borrow shares of a like amount from investors who are long the stock within 3 days (with certain exceptions for market makers). Unfortunately, the SEC chooses to ignore its own regulations so that hedge funds in practice can short as many shares as they want without any effort to borrow the shares. These are counterfeit shares which then enter the trading arena alongside registered, legal shares. In addition, Bernie Madoff (he of the Ponzi scheme) was instrumental in getting a rule passed that allows hedge funds to short on downticks. Let me give you some perspective on this with an example. Let’s say that a hedge fund decided to naked short 100,000 shares of a stock at $10. The hedge fund creates 100,000 counterfeit shares and receives a million dollars just by hitting a button on a computer. As long as a group of collaborating hedge funds can drive the price lower, the hedge fund doesn’t have to bother to cover the short. The Holy Grail for these hedge funds is to drive a company into bankruptcy.

A third key element of hedge fund manipulation is high frequency trading. The aim of high frequency trading is to detect an institutional order entering the system and trade ahead of the order. Michael Lewis’ book “Flash Boys, A Wall Street Revolt is an excellent read explaining high frequency trading and dark pools. High frequency trading has the ability to execute trades in nanoseconds. Indeed, computers can execute 150 trades (buy, sell, buy, buy, sell and so on) in the blink of an eye. There are complex algorithms that govern this trading that are written by some of the most brilliant mathematicians on earth. I can’t even pretend to understand these “allos” but their powerful effects are readily apparent not only on individual stocks but the overall market (the latter is a whole another story).

I believe that the combination of dark pools, naked shorting and high frequency trading can allow hedge funds to control the price of a stock either on the upside or downside. Let’s consider the recent situation of KaloBios. The Company announced that it was going to liquidate as no buyer could be found for the Company. Then the notorious Martin Shkreli, a shady hedge fund operative turned biotech entrepreneur, stepped in to buy 70% of the Company at prices somewhere between $0.90 and $2.00. See my free report KaloBios: The Fascinating Story of the Takeover of the Company by Martin Shkreli and His Hedge Fund Buddies for more details.

The 6 trading days following the announcement of the Shkreli involvement are eye opening in what hedge funds can do. The stock soared from $2.00 to as high as $45 in an intraday trade. KaloBios only has 4.0 million registered shares outstanding and the Shkreli group bought about 2.8 million before announcing that they had taken a position so that maybe the float was 1.2 million. However, trading volume in the six trading days after Shkreli went public was 62 million shares. This suggests to me although the evidence is obviously circumstantial that the combination of dark pools, naked shorting (in this case shorts being squeezed and forced to cover counterfeit shares) and high frequency trading allowed this stock to be manipulated. No fundamental investor on the planet can explain how the involvement of the notorious Shkreli in a bankrupt company could cause a 20 fold increase in the stock price.

In contrast to KaloBios, most of the hedge fund schemes that I have seen involve efforts to drive a stock price down. I don’t pretend to understand what was done in the KaloBios situation. I bring it up to show that hedge funds can create enormous trading volume (how can 4 million shares possibly result in trading volume of 62 million shares in just 6 trading days) and result in the stock of a company about to be liquidated surge from $0.90 to $45. What I am most familiar and which is much more frequent is an essential hedge fund strategy called “walking a stock down”. In this scam, hedge funds use dark pools, naked shorting and high frequency trading to take out all offers for the stock (involving issuing of counterfeit shares) and then methodically short the stock down in small incremental moves. They often have the power to set the price wherever they want.

Global Links Corporation is an example of how wholesale counterfeiting of shares can decimate a company’s stock price. Global Links was a company that provided computer services to the real estate industry. By early 2005, the stock price had dropped to a fraction of a cent as a result of aggressive shorting. At that point, an investor, Robert Simpson, purchased 100+% of Global Links’ 1,158,064 issued and outstanding shares. He immediately took delivery of his shares and filed the appropriate forms with the SEC, disclosing he owned all of the company’s stock. His total investment was $5,205. The stock was bought at a share price was $.00434. The day after he acquired all of the company’s shares, the volume on the over-the-counter market was 37 million shares. The following day saw 22 million shares change hands — all without Simpson trading a single share. This shows how naked shorting increases the share count by staggering proportions; we likely saw the same striking effect in the KaloBios scam.

Manipulation of Cytokinetics’ Stock Price

As I have stated before, I have no objective evidence of hedge fund manipulation of stock prices but the circumstantial evidence is overwhelming. To some extent, it affects virtually all small biotechnology stocks. In the case of Cytokinetics, I think we can see the effects of manipulation after the phase 2b trial results of ATOMIC-AHF and BENEFIT-ALS. The devastation of stock prices after a disappointing trial results is now so engrained in investors that we take it as just normal. I suggest that it is not. As I previously explained, analysis of both of these trials suggested that there was a clear path forward toward development of both drugs, but the coordinated short selling of hedge funds drove prices to levels that were reflective of failure for both drugs.

The manipulation by hedge funds creates another dimension to biotechnology investing that has become (unfortunately) a critical consideration for investors. Stocks are severely punished (out of proportion) if clinical trial results or other issues raise concerns; unfortunately this seems to occur at some point or another with almost all drugs in development. On the other hand, when positive news is released, the hedge funds also have a strategy to limit damage to their portfolios if they are already short the stock. Upon release of positive news, they allow enthusiasm to run its course and carry the stock higher. Then they come in to heavily short the stock in a strategy to drive the stock down and make it appear that good news is bad news; the goal is to shake investors’ confidence. Think about how many times you have seen this happen.

The takeaway from this argument on hedge fund manipulation is that in many cases, the upside from a positive clinical result is often muted while disappointing results are exaggerated into a catastrophic price decline. This swings the reward/ risk benefit sharply in favor of short selling hedge funds and away from fundamental investors. There is a positive side however as in the case of omecamtiv mecarbil and tirasemtiv trial results, it creates a sharply depressed stock price not reflective of the fundamental outlook. If investment courage is both warranted and maintained, this can lead to extraordinary returns. Think back to the Acadia and Pharmacyclics examples.

Cytokinetics has been seriously affected by hedge fund manipulation in my opinion. Fortunately for investors, strong financial planning (well timed equity raises and partnering) kept the Company well funded so that it could ride through the storms and continue clinical development of omecamtiv mecarbil and tirasemtiv to the chagrin of hedge funds. The Company also has respected management and investors have been well educated on the novelty and promise of its technology base; this helped investors to maintain confidence in the dark days. Unfortunately, this is not always the case. If hedge funds can drive companies to a point where companies have to do a distressed financing at depressed prices, they can cause enormous dilution to shareholders while covering their short positions on equity offerings (this is illegal but is widely practiced) to their great benefit. And as I have said before, the Holy Grail is to drive a company into bankruptcy as was almost the case with KaloBios before Shkreli stepped in and turned the table upside down on some hedge funds.

What I am telling you is that investing in small biotechnology stocks (and not just biotechnology but throughout the breadth of the stock market) has been rigged by short selling hedge funds. Many people dismiss this idea as ridiculous, but the circumstantial evidence is overwhelming. When I first started my website that focuses on small biotechnology companies about three years ago, I was dismissive of the idea but I have seen and experienced too much. If this idea is new to you and you find it credible, the obvious question in why invest in any small stock. Maybe you shouldn’t. Still as can be seen in the cases of Acadia, Pharmacyclics and potentially Cytokinetics, there is still the potential for unbelievable returns. The point I am making is that if you do choose to invest in a rigged market you first have to recognize that it is rigged. Then you have to understand how the rigging is done and figure it out. In a case of sharks eating each other, Schiele found out how to do this in the KaloBios situation and cleverly turned it to his advantage.

Am I Out of My Mind?

Some investors think that I am conjuring up a “Who shot JFK conspiracy theory?” They scoff that how can the massive conspiracy that I am alleging go on without regulators or law enforcement stepping in. I must admit that I am also puzzled by this. However, the Madoff Ponzi scheme was alleged 15 years before Madoff was brought to justice (incidentally his firm was also heavily involved in naked shorting). On the political front, Shellie Silver and colleagues in New York state government have been involved in massive criminal activity for two decades and only now has Silver been brought to justice.

There are people who agree with me, most notably Jim Cramer the founder of and well known commentator on CNBC. In a video that appears on You Tube  Cramer explained how he had manipulated stocks and urged other hedge fund managers to follow his lead because it was profitable and fun. The activities of his protégé Adam Feuerstein have caught the attention of the Washington Post. While not accusing Feuerstein of any wrong doing, in an extensive researched article  they pointed to a strong correlation between his articles and aggressive short selling. The Washington non-profit watchdog group Citizens for Responsibility and Ethics in Washington went a step further and called for an SEC investigation of and Feuerstein. Maybe I am dead wrong, but I am not alone in my suspicions.

If you agree with me on this hedge fund scheme, you may want to sign this petition to urge the Obama administration to aggressively investigate and prosecute naked short selling and stock price manipulation in the equity markets. Click on this link.



Tagged as , , , , + Categorized as Smith On Stocks Blog


  1. The link link to sign the petition shows that it’s closed and cannot be signed.


You must be logged in, or you must subscribe to post a comment.