Editor’s Note: Investors kill biotech stocks when the Food and Drug Administration (FDA) doesn’t approve a new drug. You can take advantage of Mr. Market’s overreaction and pick up good companies for cheap when this happens, says Dr. George Huang, editor of new Stansberry Research trading service the S&A FDA Report.

How to Short Sell a Biotech

Dr. George Huang

“I believe the investors who bought the stock near $2 yesterday just fed quarters to the slot machine...”These were my words of warning to S&A FDA Report subscribers back in early May. The company in question is Discovery Labs (DSCO), an incompetent biotech trying to win approval for its lead drug Surfaxin.

Investors crush biotech stocks when FDA decisions don’t go their way. Our FDA Report strategy is to take advantage of the market’s harsh reactions by picking up good companies on the cheap. Trading biotechs during such turbulent times can be very lucrative, if you know what you’re doing…

When we looked back at the last seven years, we found high-quality biotechs can generate one-year average returns of 75% after a negative FDA decision. Of course, low-quality companies usually only have farther to fall…

At the end of April, the FDA rejected Discovery Lab’s Surfaxin for the third time in as many years – setting the drug’s hope for approval back several months. The company’s stock fell 50% that day.

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Like many FDA Report subscribers, I was itching for a juicy trade. And on May 5, Discovery said it wouldn’t need to conduct any more clinical trials. It claimed that after resolving minor manufacturing issues, final approval would come in September.

But I knew more trouble would come. You see, the company didn’t have any of the qualities we look for in a good biotech trade: a low price, a promising pipeline, an easy answer for the FDA, and good management…

At about $200 million in market cap, and about $50 million in cash, the company was not cheap. I knew Discovery would need another round of financing before it recorded any revenue from Surfaxin, which is the only substantial drug in its pipeline.

Given its clinical data portfolio, Surfaxin – which treats respiratory distress syndrome in premature infants – unquestionably works. The problem is, Discovery can’t manufacture the drug to the FDA’s liking. All three rejections focus on the company’s inability to meet FDA manufacturing standards.

And after three rejections, and promises of quick approvals each time, I don’t trust Discovery’s management one bit.

You would think after the third setback, the market would be thinking the same thing. It wasn’t. Gullible investors flocked back and drove the stock up 30%.

Then sure enough, last week, the other shoe dropped. After speaking with the FDA, Discovery learned it wouldn’t even be able to submit its response until September, let alone have the drug approved as it originally announced.

Investors who were tempted into buying the stock after the setback are already down about 15%. But I believe more pain is in store for Discovery shareholders…

Surfaxin may or may not get approval by December. But in this difficult market, an approval will likely meet with a yawn. Any setback, on the other hand, will no doubt lead to another massive drop. The downside risk is way too high. Any hint of another hiccup, and Discovery will find its shares cut in half.

When we pick up bruised biotechs, we only buy if we see four things: a good price, quality managers, plenty of drugs in development, and an easy resolution to the FDA’s concerns. With Discovery, we found just the opposite…

The company has questionable management, shaky finances, and no drug pipeline. Throw in a picky FDA unlikely to accept whatever Discovery has to offer, and you have the perfect recipe for another share-price meltdown.

Good investing,

George

Source: How to Short Sell a Biotech