After the news release of Roche’s merger proposal for the remaining stake in Genentech today, I thought the time was right to complete my previous post.

To reiterate, there were two important pieces of information that I found useful after completing my study. First, the loss in market cap amongst the small cap companies comprising the NBI and second, the large loss in market cap sustained by the pharmaceutical companies in the DRG.

The loss of market cap in the pharmaceutical industry over the past couple years underscores the need and pressure these companies are under to fill their pipelines. There will continue to be expiring patents on blockbuster drugs over the next few years and if my memory serves me well, the total revenue lost due to patent expiries, will reach approximately $90 billion. This is a significant sum of money, even to big pharma. Scientific research and drug development are lengthy processes so I don’t think their revenue streams will be replaced anytime soon.

Although big pharma companies are touted by some analysts as being “dirt cheap” at the moment, I personally remain uninterested as an investor. I prefer to remain on the side of being “courted”. What do I mean by this? That the fruits of your investment strategy would be much better served by investing in potential companies in which big pharma has an interest in acquiring. I would go so far as to say that in the majority of companies engaging in merger and acquisition (M&A) activity, only one winner emerges… the company being acquired. It’s also typical to see large premiums paid by the acquiring company to small cap biotechs, or to any size biotech for that matter.

Growth via acquisition rarely creates shareholder value, so this is the main reason I prefer not to invest in big pharma. Genentech became the largest biotech in the world and created enormous value for its shareholders via organic or internal growth. The only exception to creating growth via acquisition (at least in drug development) would be if a big pharma company acquired a portfolio of drugs from a small biotech company which later turned out to be some breakthrough therapy for a large disease indication like Alzheimer’s.

At this point, you might be asking the question, then why would M&A activity occur if this were true? The short answer would be - to prevent the company from completely falling by the wayside, at least competitively speaking. I believe M&A activity initially evolves due to the need for consolidation to take place within an industry because of contracting earnings multiples, redundancies in operations, stifled innovation, and just simple inefficiencies. At least these are the reasons CEO’s generally state during conference calls to shareholders upon merger announcements.

In order for big pharma to replenish pipelines and gain access to new technologies being developed by the more innovative biotech companies, they will either have to engage in outright acquisitions, or negotiate partnership deals with biotech companies. In any event, any leverage in the market place in terms of deal-making, lies on the side of biotech companies.

So how do we sum all of this up? To some readers well versed in biotech investing, I understand what I’m about to say will sound almost “cliche” as you’ve heard this before, but I’m going to say it anyway. Bottom line is that - big pharma is at the crossroads in terms of accessing new drugs and technology and faces the reality that there is no solution other than to either acquire or partner deals with biotech (the innovators). Additionally, small cap biotechs (as a group) currently trade at valuations more attractive than they were during the bear market in 2002. For investors in small cap biotechs, this bodes well as there’s larger potential spreads for premiums to be paid to the companies being acquired. My theory on this idea stems from what I’ve observed when there was a flurry of acquisitions by big pharma beginning in 2002.

Obviously, the difficulty lies in knowing which companies currently possess unrecognized value. And of course this cannot always be known until further development of the technology or drug takes place. The key to investing in the biotech industry is understanding that which can be known, and then applying probabilistic measures to that which we cannot know or predict with much certainty. If your familiar with the application of using a Monte Carlo simulator, that’s great. I myself tend to shy away from the model’s mathematical approach in the prediction of possible outcomes, and instead rely on my intuitive thinking, which hopefully also possesses some innate characteristics of logic and reason in the face of uncertainty.

Now that we’ve discussed the method which I use to value development-stage biotechs, and reviewed the current situation with big pharma and how it fits into the picture with biotech, we can move on to analyzing specific companies in which I believe warrant coverage.