In its simplest form, a watchlist is a list of stocks, which as the name implies, you watch. Nothing genius about that. But what is useful is that the watchlist should be comprised of stocks that meet some of your investment criteria, though probably not the price criteria at which you’d be willing to buy. While this post focuses on using a watchlist for listed stocks, it could just as easily be adopted to work across many investment styles, and for investment in private companies by VCs and angel investors.

In my own value focused investing approach, using a watchlist means identifying stocks which have positive and healthy earnings per share (EPS) growth over 5 or more years (over 10 years is really good), a high return on equity (ROE), a strong balance sheet and in a space I can understand. For the time being, that’s largely why I focus on medtech stocks, since insights from working inside the industry means you can leverage your knowledge. Many such stocks can meet this criteria at any one time (typically my watchlist is over 50 stocks), but very few are at a price I’d be willing to pay. So, in the last 6 months since starting to use watchlists, what 3 benefits have I found and do they help to improve returns?

Discipline. Before using watchlists, I would run monthly screens based on the criteria above, then sift through manually to see which stocks met my criteria or investing rules. From an initial list of typically 150-200 stocks, maybe 10-15 would pass through the manual sift. It would feel like I’d uncovered some hidden gold, and eager to press the trigger, I would go ahead and buy. But in this rash of activity, and in my eagerness to not miss out on any big “scores”, it usually meant not properly following my own investment rules. Big mistake. And expensive. It also meant I didn’t focus on any particular sector, again not wanting to miss out. This mode of hyperactivity also plays on the sell-side, detrimentally. I would sell out of situations on short-term negative news, ignoring my own investment rules for selling a stock. Again expensive – missing on any recovery within the longer-term reason for my buy.

Now, since using a watchlist, instead of running a new screen every month across all sectors, I spend time building up my understanding of stocks within one sector – medtech (and a little more broadly, healthcare). I feel as though I can afford to do this since using a watchlist means I can build up a roster of stocks I like over a period of time. These have most of the investment criteria noted above, but are usually more expensive than I’m willing to pay. I can only buy anything on a watchlist once it falls below my pre-determined buy-price target. A bit like going to an auction – know before you get in the room what’s the most your willing to pay for anything, and don’t go beyond this price no matter what. Or else mania gets inflated (along with your ego), and your wallet gets deflated. Rapidly.

Also, as I become less trigger happy, a watchlist enables me to think more closely about each situation, and base any buys on more accumulated knowledge about a smaller and niche focus of stocks. This leads on to the 2nd benefit of using a watchlist…

Patience. I’m no scholar of poetry, not at all. But years ago as a student, I was inspired by Rudyard Kipling’s poem, “IF”. In the opening lines, he writes “If you can keep your head when all about you, Are losing theirs and blaming it on you…” As far as I know, Kipling was no investor, but his words are priceless advice. A watchlist does this – it enables you to have patience, “to keep your head when all about you are losing theirs”. This means you can assess situations quietly (new and existing; buys and sells), away from the noise and the constant stream of internet enabled market chatter.

You get to know your stocks over time, how they respond to market developments, what issues really impact valuation, and where the underlying businesses are heading. Then you just have to wait. Wait until the market presents a buying opportunity. When such a stock situation arises, reassessing it in the light of new information is usually fairly quick – its framed against your existing knowledge of that situation and developments within the sector and competitors.

I also find when such a buying opportunity presents itself, a small dose of simple technical analysis helps me too. Generally this is to try to avoid an imminent catastrophe in the situation which the market may know ahead of time. But regardless of what you think of technical analysis, the important point is the patience afforded by a watchlist gives me the time to do final sanity checks before pulling the buy or sell trigger.

The patience factor also helps me sleep better. There are very few situations where you don’t have at least a little time to think about a new situation or development within a watchlist stock. Signs are usually developed over days or weeks (very rarely, though occasionally over hours). The psychological benefit is the same type as being in the auction room again. If you know ahead of time how you will respond to any range of developments within your watchlist stocks, then responding is much easier when it’s based on considered rational thought, rather than in the grip of a market driven reaction (or worse, hysteria). Having the discipline and patience leads to the third benefit…

Returns. This is where using a watchlist gets really interesting. Too often, when considering a situation, investors thinking is overweight potential return, and underweight risk to capital. I’ve been as guilty of this as any. Particularly when I first started investing in the go-go days of the dot-com boom. On some wonderfully intoxicating days, my portfolio would be up thousands of pounds in a single day. I thought I, young punk of know-nothing investing, had discovered the secret to investing returns: buy the stocks that had steam, a sexy story and ride them out to the sunset, selling onto the next greater fool. To my dismay (and as I now recognize, for my investing education), I was the greater fool. My very occasional fabulous single day returns were dwarfed by annual losses. But I survived. And I got more curious. How to get returns?

Now, several years on, a watchlist is perhaps one of the most valuable parts of my investment toolkit. My returns have improved by: avoiding over-trading; focusing on my chosen niche of medtech and building up a working knowledge of the industry, businesses and stocks; thinking about how I would react to situations ahead of time; and sticking much more closely to my buy and sell rules for stocks. A watchlist creates the environment for me to more effectively be able to do all of these things.

And perhaps most importantly, I can wait until Benjamin Graham’s “Mr Market” (described in his book, the Intelligent Investor) acts irrationally, and take advantage of such timing and pricing opportunities.

So, how has using a watchlist affected my actual returns? Since using one, I’ve only bought 3 stocks. This will be tempting fate, and investment karma being what it is, maybe I shouldn’t disclose. Ahhh, what the heck:

• Medtronic (NYSE: MDT): Buy Aug 16, 2011 @$32.35, trading now $39.94, +23% (S&P 500 comp: +14%)
• Life Technologies (NASDAQ: LIFE): Buy Oct 17, 2011 @$36.92, trading now $46.92, +24% (S&P 500 comp: +13%)
• St Jude Medical Buy (NYSE: STJ): Buy Dec 12, 2011 @$34.91, trading now $43.08, +23% (S&P 500 comp: +10%)

I’m not claiming these three picks prove anything (sample too small, timeframe too short), nor would I expect every stock-pick using a watchlist to work out quite so well. Also, I’m sure now that I’ve shown you returns and how I’ve done with use of a watchlist, by this time next month my portfolio will be in meltdown (there’s another of my psychological biases kicking in again). But at least my investment capital is more likely to live to tell the tale, and I can work within a systematized approach which reduces my less than rational meddling.

And finally, perhaps the most valuable part of using a watchlist is that it brings me closer to Warren Buffett’s two rules of investing: Rule #1 – Don’t lose any money. Rule #2 – Don’t forget Rule #1.

This post is by Raman Minhas. He is a medtech enthusiast, CEO of ATPBio, and works with entrepreneurial companies, providing partnering, licensing and financing support. He is also an investor in medtech stocks, using a value based approach.

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Recently I had the chance to discuss this with a successful angel investor and financier, Peter Mountford. Over two decades, Peter has invested in an array of early stage companies, across different sectors, and lived to tell the tale. He’s helped companies with financings, listings and shells, and is an experienced Chairman and non-executive director of private and public companies. He is also the Chairman of Heropreneurs, an organisation formed to help ex-service men and women become entrepreneurs.  This cross-sector experience and diverse skills set gives a rare viewpoint valuable to both entrepreneurs and other investors.

Peter’s portfolio companies have included GW Pharmaceuticals plc (developer of cannabinoid pharmaceuticals for pain relief), RWS Holdings plc (Europe’s largest technical translations business), Buildspan (distributor of consumables into the construction industry), Bradwell Aggregates/ Karrimix (aggregates supplier), WJ Furse (lighting protection equipment), Cipher Surgical (surgical medical devices) and Exomedica (developer of medical technologies).

Investors are often renowned for keeping their words brief, so from a recent email exchange and in his own words, here are Peter’s list of common themes he’s identified from successful investments:

1. Great management teams that truly understand their businesses and that have the same objectives as shareholders in the business.  Some management teams just want to raise cash to support their remuneration packages – steer well clear.
2. Businesses that have some sort of unique position in their market place – whether this is a service, technology, or product.  So its got to be “special”.
3. The business model has got to be workable.  No point in selling a product in volume unless a profit can be made from it.
4. Operating in a market that is growing or that can be created.
5. Well funded with strong balance sheets or “easy” access to further funds.
6. More competitive than their competitors, ie have a USP.
7. The right “in price”, ie if you overpay at the start the chances are that you will never recover.
8. The ability of the business to grow in value and achieve an exit either through an outright sale or IPO.
9. Not a start-up!  Although the business could be at a relatively early stage but in this case some of the fundamentals must have already been proven.

As he mentioned in his email, this is a fascinating area and one he could “wax lyrical” for some time. We did discuss it in quite a bit more detail. Different investors could reasonably interpret points in different ways. But after reviewing the list, I think the distilled version does it justice, and may prompt thought and exploration by curious entrepreneurs and investors.

Know Yourself.

What makes angel and other private investors particularly interesting is that they are investing personal funds, rather than earning a fee on managed funds. You live and die by the sword of your investment decisions. This makes the importance of understanding your own temperament and style so important. Probably more than any other individual facet. I’ve certainly found this through my own approach to investing in value based stocks (described in Lessons from Medtech?). Stray from what works for you, or what’s consistent with your own temperament, and you lose money even where others succeed.

And it takes time to get to know yourself, and a willingness for self-examination and revision. Maybe that’s the single thing that all successful investors really have in common?

This post was written by Raman Minhas. Raman is the CEO of ATPBio, a consultancy providing business development and corporate development support to biotech and medtech. He is also a private investor in healthcare value based stocks.

1. Desire vs. Compulsion. To be an entrepreneur, training, contacts and industry experience are all useful. But there are plenty of qualified and capable people who, despite good intentions or desire, never start anything. The fight and compulsion to build your own company has to come from within. Do you have the fight inside you?
2. Manage the risk. Any medtech entrepreneurial venture involves high risk; many entrepreneurs use the analogy of a rollercoaster ride – up, down, up, down, thrills and spills. In medtech risks can be myriad including technical, scientific, developmental, regulatory, market, competitive to name a few. But you have to be comfortable with risk and uncertainty – knowing how to manage risk is key.
3. Be the leader. You have to smooth out the rollercoaster ride for others around you (e.g. company staff); be the leader. And a strong support network is vital – other entrepreneurs, having been through the journey, are often willing to help too. You also need good support from your family – it works much better all around if they are behind you and understand what you’re trying to achieve.
4. According to plan? Building a company NEVER goes according to plan. Investors typically like to hear about a neat, logical company development plan (an “ABCDE route”). Folks who’ve built companies before really appreciate real life is nothing like this, only in hindsight. Investors who’ve built companies themselves, or been through the process a few times as investors, probably understand this too. But it’s still wise to talk to investors in “investor-speak” (ABCDE plan, exit, etc).
5. Passion and drive. You have to have the desire/ drive to make status quo BETTER (e.g. for patients to improve health outcomes, for surgeons to improve treatment options). Often, these rewards will be equal to, or even outweigh, more tangible ones (e.g. financial return). One of personal stories Dr Andrews shared that moved him was that of a 30-somehting year old man, who had suffered for several years with early spinal disc degeneration. His life involved going to work, coming home then resting all night on his sofa. Then the next morning he’d struggle back to work and so on. Following disc replacement surgery, he now cycles miles and says his life “has changed”. You really have to believe in and have passion for what you’re doing. It will keep you going when rest of world says no.
6. Focus, and on using luck. Be flexible and reactive. Respond to market conditions and make use of any “luck” you get. Also think about exit from the outset, so focus products where you have the best commercial opportunity. By way of example, Ranier, as a company initially had expertise and specialist knowledge (and IP) around polyurethane applications in multiple medical device areas. As it became apparent the commercial opportunities were much greater in orthopaedic and spinal applications, the company honed focused on spinal disc implants. Work in other applications was put on the shelf – FOCUS is key.
7. Know your limits. You don’t have to be an inventor or technical expert to build a medtech. An entrepreneur is often a generalist who has to co-ordinate people with specialist skills as a team. Knowing the limits of your own knowledge is much more important than knowing everything. The important thing is to find technologies to commercialize, where you believe in the product and application, and where there’s a good commercial opportunity.
8. Universities as project sources. Good sources of projects are typically within universities. Some are very good at technology transfer, others less so. But getting to know such sources can be priceless (for them and you).
9. Mentors. You need mentors to help you along the way. Someone who’s been there and done it before, someone who’s been through the pain and understands what you will be going through. Being an entrepreneur is a lonely job; you’ll need a few friends along the way.
10. Build a solid company. Build a company with a view to it becoming a solid, self-sustainable and profitable enterprise. This gives you much better options (e.g. exit) as you are not desperate for buyers – you don’t need them. Just keep building your company, beat big competitors with hearts, minds and creativity; the buyers will find you. Not being desperate for buyers also means you can drive a much better deal for you and your shareholders.
11. Innovation within upstarts. In general, big medtechs are not really doing much real innovation now. The tendency is to acquire technology when it’s validated (with at least CE approval) from minnows. This means company development timelines are longer with greater investment needed; the positive flip side is that your company can achieve greater valuation when the technology is validated.
12. Know your buyer. Currently, big medtechs in orthopaedic and cardiovascular have lots of cash for acquisitions. Knowing your potential target buyers and the appetite for pipeline acquisitions can help you: reverse engineer what your buyer wants.
13. Regarding investors. If you’re developing a serious medtech proposition, you will need external equity investment capital, sometimes significant – Ranier has raised over £23 million since 2002. This means as an entrepreneur, you will often end up losing voting control of your company. So, if you can, choose your investors as much as they choose you. You will be in a relationship for a long time and it always gets painful at some point so you have to be able to work things out. And having investors that contribute more than just cash (ideally with some company building or operating experience) can be a huge benefit. If you can get it, patient capital is also a boon (part of Ranier’s ownership includes a family fund).
14. Make it great. Develop a great product with a great mission and great people will join you. While having dinner with Dr Andrews, he excused himself mid-meal to take a phone call from a key member of his scientific advisory board (SAB). The individual is a practicing surgeon, successful entrepreneur and has set up five pioneering spinal surgery centres around the world. He was attracted to the company because of the game-changing technology the company is developing. The SAB member adds incredible value and in the words of the CEO, does “five times more work than we pay him”.
15. Pay it forward. When you make it as an entrepreneur (or even en-route), help those around you – other entrepreneurs starting out or other causes that move you. (Shot from the film “Pay It Forward” starring Haley Joel Osment and Kevin Spacey)

On reading through this list, I realised that actually, the lessons are equally applicable to almost any entrepreneurial venture, medtech or other. And I’ve got one more tip to add: when you find mentors that can help you on your own entrepreneurial journey, and get a chance to talk over dinner, invest in yourself and pick up the tab.

This post was written by Raman Minhas. Raman is the CEO of ATPBio, a consultancy providing business development and corporate development support to medtech and biotech.

The industry sectors considered include diagnostics, picks and shovel companies (e.g. instruments, tools) and suppliers of kit and reagents for commercial and research purposes. As before, the search started with looking for US listed companies with certain attractive investment characteristics. These included a high return on equity (ROE), strong balance sheet with low debt, and a history of positive and steady upwards earnings growth over a decade. This was then overlayed with a requirement for reasonable or low valuation, thereby capturing both growth and value elements.

The companies that made the cut were: AmerisourceBergen (NYSE: ABC); Haemonetics (NYSE: HAE); IDEXX Laboratories (NASDAQ: IDXX); Johnson and Johnson (NYSE: JNJ); Kinetic Concepts (NYSE: KCI); Life Technologies (NASDAQ: LIFE); McKesson (NYSE: MCK); Patterson Companies (NASDAQ: PDCO); ResMed (NYSE: RMD); and Henry Schein (NASDAQ: HSIC). Two slight anomalies from this group include KCI which only has data from 2002 and LIFE which actually had negative earnings in 2001 but began its upward trend from then (though neither of these detracts from showing EPS growth over time). The link below goes to a graph of the 10 year earnings of the highlighted companies:

EPS History Medtech Supplies 2001-2011

The compound annual growth rate (CAGR) of EPS for these stocks ranged from 10% from HAE through to 27% for both KCI and LIFE, with a mean average of 17% (Note, these are not CAGRs for stock performance, but still present quite impressive fundamentals. Also, growth rates for LIFE were calculated from 2002, the first year in the period with positive EPS). These stocks were then reviewed to identify opportunities which were also good value at current prices (based on PE ratio, EV/EBITDA, and PCF) highlighting LIFE which I added to my portfolio. LIFE was formed from the merger of Invitrogen and Applied Biosciences in November 2008. Its business focus is providing tools, reagents and services for the life sciences research market (both scientific and commercial). The other stocks from the screen were  added to a watchlist since they have already exhibited growth and quality factors. Then it’s just a case of being patient and waiting until specific value situations present themselves.

Importantly, as with invasive medtechs highlighted in the previous article, none of the companies in this group are dependent on binary type events affecting a small number of assets. They’ve each been selling products or services into a commercial marketplace from very early on in their respective histories. This commercial reality forces a company to focus on not just what is a potentially great idea, but actually test it in the market and see what’s selling; What will cause customers (whether patients, healthcare providers or pharma) to part with cold, hard cash?

There’s no reason why biotechs cannot act in the same way. Admittedly, they may not have a rich pipeline of products to offer early on, but core expertise can still be monetized in multiple ways. Early on in life, biotechs can use multiple sources of non-dilutive funding (also useful as a proxy for commercial market testing) and fee-for-service or risk shared collaborations on non-core programs. Other creative ways of getting much further on less include developing assets as far as possible in a pre-company (academic or other company) environment so that while the company may be new, the assets may have significant development work behind them already (this will be discussed in a future blog on frugal innovation). Perhaps biotechs could adopt a new industry mantra? “De-risk, validate, repeat”.

For a deeper view on investor challenges within biotech, why the industry has gotten so cash hungry, and what it can do to reverse the trend, Bruce Booth (Atlas Venture and @LifeSciVC) has written a simply excellent piece: “Culprits of Biotech’s Malaise: Let’s Also Look in the Mirror”.

Finally, a new development occurred this month with one of the selected watchlist companies, Kinetic Concepts. KCI develops and markets woundcare and regenerative medicine products with sales of $2billion and earnings of around $300 million and growing. The company was highlighted in the previous article as being subject to a private equity bid from ConvaTec that ultimately fell apart due to financing pressures, though its valuation held up fairly well due to its robust revenues and earnings. However, KCI is now working out a new financing deal to enable a leveraged buyout to proceed with the original private equity bidders including Apax. This again highlights the value of having strong revenues and earnings growth – both from a valuation perspective and by providing alternative options with new investors (both financial and for M&A). It’s also raises a question to all involved in trying to build great companies with scalable products: Is it enough just to build a great asset to sell – Or should the focus be on building a great company (with earnings growth) and then the buyers will come?

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Related article: Lessons from Medtech?

Nothing in this post is an investment recommendation. Investors should do their own research.

This post was written by Raman Minhas. Raman is the CEO of ATPBio, a consultancy providing business development and corporate development support to biotech and medtech.

In public companies, investors will look for value, growth or some combination where they are largely passive shareholders. In private and early stage growth companies, investors take much larger controlling stakes, various rights (such as preference shares) and are usually involved in helping to actively build the companies.

When researching companies for my own (modest) stock portfolio, I look for a combination of value and growth, with some quality thrown in for good measure. Specifically, the search starts with companies that have relatively low valuation multiples (PE, EV/EBITDA, PCF), high return on equity (ROE), low debt and importantly a history of several years of growing earnings per share (EPS) at a steady and fairly predictable rate. This indicates such a company has a strong investment “moat”, or barriers to entry, which will reduce the chance of competitors eroding their edge over time.

When looking for such investments within the healthcare space, I found that medtech companies stood out. By breaking down the healthcare space into sub-sectors, my search this month specifically involved looking at medtech companies developing and supplying invasive technologies (such as heart implants, valves, stents, orthopaedic and spinal implants, and invasive surgical tools). While trawling through this group looking for potential watch-list stocks, I found an unusually high ratio of companies which had good EPS history over 10 years, high ROE and low debt. Also, though only a few were very good value, most were at reasonable valuations (with PE<15). A margin of safety (a phrase coined by Benjamin Graham and oft used by Warren Buffett) is always attractive so it’s a case of simply adding such stocks to a watch-list and waiting until specific situations become available at discounted prices.

The stocks which came out of the search and were added to my watch-list were Medtronic (NYSE: MDT), Baxter (NYSE: BAX), Stryker (NYSE: SYK), Becton Dickinson (NYSE: BDX), St Jude Medical (NYSE: STJ), Zimmer (NYSE: ZMH), Edwards Lifesciences (NYSE: EW), C R Bard (NYSE: BCR), Varian Medical Systems (NYSE: VAR), Dentsply International (NASDAQ: XRAY), Integra LifeSciences (NASDAQ: IART). (Of these only MDT had sufficient value for me to buy, though I’m happy to wait for others). These stocks were selected in large part due to their solid EPS history over 10 years. You may argue that’s a long time to establish a reputation, but ultimately investors are free to put their money where they feel they’ll get the best risk adjusted return. And any company that is listed, or plans to be one day, will be competing for attention with such stalwarts exhibiting growth AND value. The link below opens a graph showing the 10 yr EPS history of the stocks that made the cut:

EPS History for selected US Medtech, 2001-2011

For the eleven companies selected, EPS growth over 10 years ranged from 9% CAGR for BAX right through to 21% CAGR for VAR, with a mean average for the group of 15% CAGR. These growth rates for EPS are quite impressive, especially when compared to the broader economy over the same timeframe. Interestingly, their EPS also fared very well in the 2008/2009 market rout. However, the point is not to suggest one should buy blindly into such stocks and expect future growth rates. Clearly, there is selection bias here and we are looking back at actual performance rather than looking forward to what could happen. Rather, the point is by looking for companies with certain of the traits mentioned, you have a higher likelihood to capture growth. And if you wait to buy at the right time, when you also capture value, then you protect your downside better. What’s also interesting is that although the companies selected exhibit the most favorable EPS histories, the vast majority of the others in the sub-sector were still profitable – another point for biotechs to ponder. (NB. These are EPS growth rates to demonstrate predictable earnings. They are not the growth rates on capital that investors would have experienced – some would have done better, and some worse, depending on valuation multiples prevailing over the period and prices paid at time of purchases).

Taking a slightly different tack, how does this apply to companies in the private space? While at the Biotech in Europe Investor Forum in Zurich last week, I attended the medtech panel discussion. One of the key traits that separate medtech from biotech companies, highlighted by the panel, is that medtech companies think about commercial issues much, much sooner. And by that I mean driving revenues early and getting to profit. This does mean that a company eventually gets valued on some kind of valuation multiple and looses the potential to earn a “future promise” valuation. Though such a valuation multiple can still richly reward investors, as demonstrated by Kintec Concepts (NYSE: KCI) a company focused on developing and marketing woundcare, regenerative medicine and therapeutic support systems. I wrote about KCI as a potential value and growth play back in 2009 when it was valued at $27 versus $65 today. In July this year, ConvaTec, a private equity group, made a $6 billion bid for KCI, valuing the company at over 10x EV/EBITDA. This has since fallen to about 8.5x as the deal collapsed due to financing challenges. Importantly, though, KCI’s value is still underpinned by its earnings. It also makes for a much more reliable and predictable approach for investors to earn a return rather than waiting for a binary event which can make or kill an asset (and often a company).

And timelines to such revenues are often much shorter too than biotech. You may say the value proposition is different, and biotech is a much higher risk, higher reward game. True. Though, there may also be an element of “shooting for the stars”. For biotechs, earning some revenue through exploiting core expertise could help align scientific and commercial goals. This could be through exploiting a platform, partnering (as many do) or even services (risk-shared or straight fees). And importantly it would demonstrate to investors that management is commercially focused. There is, of course, huge importance for a company to be focused, but it can still retain scientific focus while finding multiple ways to monetize its core expertise. The focus becomes more business like – how do we make money out of what we know?

Finally, while reading the Medtronic SEC 10K annual report, I came across an acquisition which highlighted that a medtech commercial mindset can lead to enviable returns for investors. In 2010, Medtronic acquired Ardian for $800 million upfront, plus commercial milestone payments up to 2015, for treatment of resistant hypertension. Although Ardian’s device has to go through a further trial for FDA approval, it has already received CE approval in Europe and is commercially available in Australia. The fascinating technology developed by Ardian “…uses a catheter to deliver radio-frequency waves to shut down overactive nerves near the kidneys, suspected to be one cause of what’s known as “resistant hypertension.”

Perhaps more fascinatingly, Ardian was founded in 2003, had a total of $66 million investment over the independent life of the company and was sold for $800m million seven years later. High reward doesn’t always need super high risk.

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This is the first of two articles looking at investment characteristics of medtech. The next related article will review the EPS histories of non-invasive medtech companies – including diagnostics, instrumentation (testing and monitoring) and other tools.

Nothing in this post is an investment recommendation. Investors should do their own research.

This post was written by Raman Minhas. Raman is the CEO of ATPBio, a consultancy providing business development and corporate development support to biotech and medtech.

After all, there is usually a reason why the majority are doing what they doing.  Some things are, quite simply, a better bet than others.   In today’s highly connected world, information asymmetry is declining, and everyone assessing a particular asset will likely have similar information available to make the assessment, and as a consequence more likely than not will form a similar judgment.  It is this kind of rational assessment of risk that has led to pharmaceutical companies favoring some indications over others: trials in cancer and rheumatoid arthritis proliferate, while new forays into coronary heart disease and sepsis have almost ceased completely.  Quite evidently, that is a sensible reading of past performance of assets in these respective areas.

But other factors re-enforce this initial polarization.  You can short-circuit the need for expensive and time-consuming diligence around a class of assets if you just follow the crowd.  In effect, the actions of others look like votes in favor of a particular drug target, indication or asset class.   You might even trust the majority view better than your own analysis.  In this way, the incisive movement of the thought-leaders is rapidly re-enforced by the following crowd.

And for every “smart sheep” that follows the leaders knowing they have made a sensible judgment call, there are ten “sleepy sheep” who follow for a less noble reason.  Safety.  Even if you thought the leaders were headed for a cliff, you can relax in the knowledge that your boss cannot fault you for following such a large crowd.  By contrast, striking out on your own is fraught with danger – if it goes wrong, you will carry the can alone.

What a sight!  A group of thought-leader “shepherds” all going in the same direction because they share the same information sources, surrounded by a flock of following “sheep” (whether smart or sleepy).  Should you join them?

You might think the answer to that question depends on whether they are headed for a cliff or towards the Promised Land.  But the decision isn’t that simple.  For a start, there is no way to know where their eventual destination lies: indeed, the best available analysis of the direction in which to head has already been performed by the “shepherds”.  So it is pretty unlikely that your outside analysis can repeatedly do a better job of assessing the real value associated with a particular type of asset.  For the most part, therefore, you can’t easily use your own assessment of the situation to decide whether to follow or not.

But there is another issue to consider: competition.  Assume for now that the rational assessment of the thought-leader is correct and clinical development programmes in RA are more likely to be successful than those in sepsis.   Once everyone accepts that position, and directs their resources towards RA assets, two things happen: the price of securing a candidate asset in the ‘popular’ field goes up (and the average quality of what is available falls); and the exit values for the successful programmes are suppressed by the parallel success of the competition.  After all, if, by the time your Phase II trial reads out positively three new products have reached the market, then the bar for commercial success has risen and the value of your asset has fallen (conceivably it could even have been rendered worthless).

There are currently 229 active clinical development programmes in RA that are in Phase II or beyond.  By the same criteria, there are only 6 active programmes in sepsis.  Just how much greater does the chance of a positive trial read-out have to be in RA than in sepsis to justify such extreme “asset favoritism”?

Even if the market for a successful RA drug is 5-times larger than for a sepsis drug (its hard to assess the market for a successful sepsis drug, since there are no real-world examples), then the chance of a successful read-out in an RA programme would still need to be more than 8-times higher than for sepsis.

Maybe that’s a fair assessment – historically, sepsis trials have repeatedly failed, while at least some RA trials have been successful.  But how extreme can this imbalance become before the “sensible money” starts to switch to the unfashionable option?

That tipping point may already have passed.  The “sleepy sheep”, who follow because they cannot be severely faulted for doing so, will keep the momentum firmly in favor of the conservative option long after a rational analysis suggests that the weight of competition has made an area commercially unattractive.

The real question, then, is not a simple comparison of the risks associated with an asset assessed in isolation.  The context is important too.  If everyone else is trying to develop the same product then the bigger risk is that, despite being successful, your product is no longer competitive.   Where the competition is hottest, success is no longer enough – you have to “win big” to win at all.  By contrast, a much more modest victory in an uncontested landscape is likely to reap a worthwhile prize.

But if we are going to seriously consider previously unattractive areas, such as sepsis, we need to understand why they became unpopular in the first place.   Perhaps the reasons that trials in a particular area were relatively unsuccessful ten years ago has gone away with improved understanding of the disease in the intervening years?  Perhaps we can see a clever solution to the particular problem that has previously contributed to the high failure rate?  In the case of sepsis, for example, improvements in clinical trial design may finally allow success where previously failure was the norm.  Indeed, this reveals another, much subtler, force that drives “asset favoritism”: the more trials that are done in an area, the more knowledge builds up that informs future trial design.  In short, just being popular means the tools available in that area are likely to be better honed.

Commercial investors, with their eyes firmly on future returns seem slow to react to the dangers of “asset favoritism”.  One venture capital investor recently said to me “Mentioning sepsis, even if it is to tell me you are NOT going to do trials in that area, is enough to be shown the door – if you thought about doing sepsis long enough to reject the idea, then you spent too long thinking about sepsis.”  With such extreme prejudice it’s hard to see the current imbalances evening themselves out any time soon.

But maybe others, with a different agenda, can help.  The UK government recently announced a scheme to fund research into biomarkers and clinical trial design in sepsis.  Perhaps charities, such as the British Heart Foundation, can bring their not inconsiderable muscle to bear on similar issues that hamper investment in potential cardiovascular drugs.

In the end, it is in everybody’s interest that the imbalances that have built up in the biotech world, with an ever greater fraction of the available capital chasing a narrow group of product candidates, are brought back into equilibrium.  If they are not, average returns will surely decline further, which is bad for investors.  And whole areas of medicine, where the need for new products is acute, are left underserved, which is bad for patients.  Markets are meant to match solutions to problems, but the heavy burden of the ever larger flock of “sleepy sheep” threatens the efficient functioning of this particular marketplace.

This post is by Dr David Grainger. David runs a research lab in the Department of Medicine, Cambridge UK, where this blog first appeared on his lab website, GraingerLab. He is also a biotech entrepreneur and a principal at ATPBio.

We are all too familiar with how the economics for big pharma have changed in the last few years. Factors include:

• patent expiries (existing and imminent)
• declining R&D productivity (as measured by more dollars for fewer approved products)
• heathcare payor pressures as governments search for budget cuts in all areas
• paucity of future blockbusters in the pipeline

Biotech has often been suggested as a saviour with the suggestion that a focused research style based on deep insights, rather than wide pools of area expertise and serendipity, would lead to greater R&D productivity. After over 30 years of trying, there doesn’t seem to be any conclusive evidence that biotech’s research approach has had any more success. Yet, there is still cause for hope, though for reasons driven by necessity and economics rather than just science.

Biotechs by their nature start out (and often remain) as small, nimble companies having to find a niche within a much greater ecosystem. As with any small organism or business, you survive by being really good at a focused area or developing niche expertise. You simply do not have the resources to compete with the big players.

Considering target markets, despite the top-line attractiveness of blockbusters, biotechs often target niche indications. While these may be small and initially only have sales potential in the hundreds of millions of dollars, that can still make a big difference to a small company. The equation for big pharma is much tougher as they need new drugs, for growth or to replace patent expiries, to generate greater sales to move the performance needle. And yet some drugs which start of in niche (or even orphan) indications, gain approval and then widen their market opportunity through label extension. Some examples include:

• Amgen’s erythropoietin stimulating agent, or ESA, franchise, including Epogen (also know as epoetin) and Aranesp. Epogen was initially approved in 1989 for anaemia in patients with end stage renal disease, selling $100 million in 1989. By 1997, the American Society of Clinical Oncology (ASCO) and American Society of Hematology (ASH) were considering an “evidence based clinical practe guideline on the use of epoetin in cancer patients”. Since Amgen had licensed non-chronic kidney applications to J&J (developed as Procrit), they further capitalised on growing use of Epogen in cancer anaemia by developing Aranesp, approved in 2001. By 2010, Epogen and Aranesp had combined sales of around $5 billion, from Amgen 2010 10K SEC filing.
• Other orphan drugs can end up being priced so richly that even these can lead to blockbuster status eventually. An example is Genzyme’s Gauchers disease franchise and Cerezyme which has over $1 billion in sales (and in no small part driving Sanofi-Aventis acquisition of Genzyme this year for $20 billion).
• Another example of growth through label-extension use includes Cephalon’s drug for sleep disorders, Modafinil or Provigil (trade name). This was originally approved by the FDA in 1998 for improved wakefulness in patients with narcolepsy. In 2004, this label was expanded for approval to “improve wakefulness in patients with excessive sleepiness (ES) associated with obstructive sleep apnea/ hypopnea syndrome (OSAHS) and shift work disorders (SWD)”. Provigil sales were $25 million 1999, the year of launch, and had grown to $1.12 billion by 2010. Nuvigil, a single-isomer formulation of Provigil, was approved in 2009, and developed to extend the sleep disorder franchise. This had 2010 sales of $186 million. Provigil and Nuvigil comprised around 46% of total Cephalon sales by 2010 (data from Cephalon 2010 SEC 10-K filings). Provigil’s growth through the company’s earlier history provided a significant cashflow bedrock to enable further pipeline development. Interestingly, Teva is acquiring Cephalon for $6.8 billion. When one considers contribution to sales, and how its helped pipeline growth, Provigil has played a major part in supporting this transaction.
  

Other factors supporting a niche focus include the increasing hurdle with phase II failures. Reporting in Nature Reviews Drug Discovery, the Centre for Medicines Research found that “Phase II success rates for new development projects have fallen from 28% (2006–2007) to 18% (2008–2009)”. In his blog reviewing what’s behind the phase II failures, Derek Lowe (In the Pipeline) notes that four therapeutic areas accounted for over 70% of the failures – cardiovascular, CNS, metabolic diseases (diabetes) and oncology. He recognises oncology and CNS as traditional high risk areas and diabetes is a tough well-served market with high existing standard of care (making the efficacy barrier higher). Yet in cardiovascular, he suggests staying away from the big, obvious plays:

…that’s interesting, since that area has traditionally had one of the better trial success rates. Perhaps that one is also suffering from the standard of care being pretty good (and often generic, or soon to be). So the high-success-rate mechanisms of the old days are well covered, leaving you to try your luck in the riskier ideas, while still trying to beat some pretty good (and pretty cheap) drugs. . .

In an article from Bloomberg, Datamonitor reports that antibiotic R&D spend and revenue is expected to decline. The report anticipates that by 2019 only two antibiotics will have sales of over $500 million – Levaquin from J&J and Cubicin from Cubist Pharmaceuticals. Yet in my own research I’m coming across early stage companies (about to enter or already in the clinic) where the business model is built around niche and/ or orphan indications for infectious diseases. Again this enables a situation where a company with even quite lowly sales (by pharma standards) – say a few hundred million dollars – could still turn into a significant commercial success for both the company and investors. 

As well as being nimble and niche focused with target markets, biotechs have always had to be extremely careful with cashflow management, even more so in the current environment. They don’t have the luxury of a few high selling products to support ongoing R&D and pipeline development, so judicious use of any funds raised is essential. Hence the rise of the semi-virtual and virtual model of biotechs – where core expertise and control (e.g. program development, managerial, financial) is kept in house, yet other skill sets are outsourced as required. This is not typical in the pharma approach, yet in biotech can lead to improved use of invested funds and greater bang for your buck. One of the most fascinating examples of this recently is Ferrokin Biosciences – a California based biotech focused on a niche space of congenital anemias. A recent article from The Atlantic describes just how far they’ve taken virtual:

FerroKin is seven employees who work from home, and a collection of about 60 vendors and contractors who supply all the disparate pieces of the drug-development process. Rienhoff, a physician and former venture capitalist, founded it in 2007 as a start-up, a virtual biotech company. Since then, his team has picked up talent and resources as needed, raising $27 million and seeing a drug from development into Phase 2 clinical trials.

and extolling the virtues of this approach, it further states:

The low cost structure of companies such as FerroKin—old-fashioned drug development can eat up hundreds of millions of dollars—translates into more variety in the market, and more niche drugs targeting neglected or rare diseases.

  When we return once again to the pharma challenge of refilling pipeline, an obvious source for this (apart from internal development) is through partnering or M&A with biotechs. I’ve already mentioned a couple of recent deals where biotechs took a step-wise niche approach and eventually got bought out by their much bigger pharma brethren (Genzyme/ Sanofi-Aventis, Cephalon/ Teva) and this trend looks set to continue and grow. Infact, when one considers that in recent times 2 of the largest biotechs have been acquired by big pharma (Genentech and Genzyme), then you realise that actually, any biotech with product, sales and pipeline prospects could be fair game.

David Snow, CEO of Medco Health a pharmacy benefits manager (PBM) discusses with Reuters that No biotech is too large to buy. Given the payor pressures, he sees the growth potential of biotech as more important than ever. Interesting perspective when you consider that as a PBM, Medco serves 65 million members and profit more by using lower cost medicines (including generics). According to the business overview in the 2011 10-K filing:

…Medco making medicine smarter™ for more than 65 million members. Medco provides clinically-driven pharmacy services designed to improve the quality of care and lower total healthcare costs for private and public employers, health plans, labor unions and government agencies of all sizes, and for individuals served by Medicare Part D Prescription Drug Plans.

And when you find one of the shrewdest, smartest investors of our time, Carl Icahn, pursuing biotechs as an activist investor, you begin to appreciate how much value could be locked up within certain companies in the sector. He’s made near enough a billion dollars on shaking up investments in Biogen Idec and Genzyme.

In summary, if this is pharma’s perfect storm, where are biotech’s greatest opportunities? Put simply, go lean, go niche, go stepwise and with a plan for revenue. Don’t build for M&A; if you do the rest well, it will come anyway.

Related articles:

To be or not to be: The Pros and Cons of the Virtual Biotech Company

The New Reality Starts to Hit Home

This post is by Raman Minhas. Raman is the CEO of ATPBio, a consultancy supporting biotech funding through VC, big pharma investors and partnering.

Disclaimer: At the time of writing, the author holds shares in Amgen and Teva. Nothing in this blog is an investment recommendation. Readers should do their own research.

Supergen (SUPG) is a NASDAQ listed biotech with a market cap of $170 million (at time of writing). Astex Therapeutics is a private UK biotech and previously a Fierce 15 Winner (2006). In the deal, SuperGen is acquiring Astex, with Astex shareholders getting 35% equity in the new combined entity, $25 million cash up front, and $30 million cash or stock to be paid over the next 30 months. The new company will be called Astex Pharmaceuticals (with NASDAQ ticker of ASTX).

Since founding in 1999, Astex has received substantial investor support from several top-tier UK VCs. How did the investors do? A back of the envelope calculation suggests the following – As current Astex shareholders will have 35% of the post-merger entity, at SuperGen’s current valuation of around $170 million, this suggest a valuation for Astex of nearly $150 million (i.e. Combined value is $170m/ 0.65 = $262 million, hence Astex 35% shares = 262-170 = $92million. Add to that the $25million upfront cash, and $30million cash or stock to be paid over 30 months = $147million). This assumes no liquidation preference for investors.

From their website, Astex have had about £80million of investment since 1999 (equivalent to around $130-$150 million, depending on when investments were made, and a fluctuating dollar: pound exchange rate over the period). So really, at present this deal does not offer much more than just a return OF investment, rather than any upside for investors. Though, this is a way to get some liquidity now with further ability to sell down shares in a public traded company.

What is perhaps more interesting is that the combined entity now looks quite substantial and is itself much more likely to become a target for M&A in a year or two. From the press release, key facets of the new company include:

• $120 million in cash and cash equivalents
• A revenue stream from its product Dacogen®, marketed in North America by Eisai and in the rest of the world by Johnson & Johnson
• A clinical pipeline with 7 drugs in development – 4 at phase II, and 3 currently partnered with big pharma
• Validation and scalability through partnerships with big pharma including GSK, J&J, Novartis, AstraZeneca and Eisai
• Nearly $2 billion in headline value future potential milestones plus royalties
• A technology platform which has driven much of the partnering with big pharma
• Operations in the US and the UK

The pipeline is not that dissimilar to Plexxikon, who were recently acquired by Daiichi Sankyo for $805 million plus up to $130 million in near-term milestones. The fact that they will have both a US and and EU base may make them particularly attractive to another Japanese group.

It will be interesting to watch. What was important for Astex is that they continued to ring the changes. They have an expensive engine that, whilst very productive, does require frequent injections of cash to sustain it whilst the phase II products progress.

Biotech funding takes many forms. As with many promising yet cash hungry biotechs, this is a cross between an endurance race and a relay race. VC investors – tired yet still hopeful – have handed the baton onto the final runner in the public markets. How will she run? 

This post is by Raman Minhas and Nigel Crockett. Raman is the CEO of ATPBio, a consultancy supporting biotech funding through VC, big pharma investors and partnering. Nigel is a Director at Tukan Partners, a consultancy providing biotech business development. He is also a principal at ATPBio.

Disclaimer: Nothing in this blog post is an investment recommendation. Investors should do their own research.

Over the last decade or so, however, this framework has changed substantially, at least for the majority of indications.  Increasingly, regulatory authorities and clinicians alike are inclined to consider the risk:benefit equation at the level of the individual rather than the population.  Does every individual receiving the medication receive more benefit than harm?  Because of the usual profile of the distribution of risk and benefit over a population treated with a drug, often with a few individuals suffering a disproportionate fraction of the total harm, while the majority gain a lesser benefit, means that the two equations are very different in impact.

Consider a drug that has severe side-effects in small number but significant benefits for rest – it doesn’t take much imagination, there are plenty of real-world examples: anti-integrins, such as Raptiva™ and Tysabri™, cause extremely rare re-activation of JC virus leading to PML and death, but offer clinically valuable improvement in the symptoms of debilitating autoimmune conditions; cox-2 inhibitors, such Vioxx and Celebrex increase the risk of a fatal myocardial infarction in a small number, while offering real clinical benefits in rheumatoid arthritis.  It is extremely difficult to weight the balance between a few fatal events and a large and distributed benefit.  If you are the individual who bears the negative consequences you are entitled to feel that the risk:benefit equation has been miscalculated, even if there was no way to know ahead of time who would suffer.   Increasingly, particularly in the US, the courts have shared this view helping to shape the consensus that drugs must offer more benefit than harm to each individual rather than to society as a whole.

For sure, there are forces pushing in the opposite direction: if you ask patients with a debilitating disease before they start taking a new medicine whether they are prepared to take the risk of a rare, severe side-effect in return for the likelihood of improved quality of life and the answer is invariably ‘yes’.   The dissatisfaction with the outcome is usually a post hoc response to the realization that you are the individual who lost the lottery.  These positive pressures from patients and patient advocacy groups have resulted in the re-introduction of both anti-integrins and cox2 inhibitors but the safety concerns for the individual continue to dominate the debate over their use, which remains significantly less than it would have been a decade or two ago.

Safety (for decades the elephant in the drug discovery room) has never been a bigger issue than it is today.  Billions have been spent on predictive toxicology paradigms designed to identify the merest hint of risk at an early stage in the drug discovery pipeline, before the costs are ratcheted up in later stage clinical development (which remains the only sure-fire way to properly quantify both harm and benefit).

The impact of this drive for safety on the productivity of big pharma R&D operations has been well documented, not least in my recent article, Too Much Safety.   The triple whammy of over-zealous regulators halting development of promising medications on the basis of debatable signs of harm, of drug owners reacting to this by pulling promising product candidates from their pipelines at earlier and earlier stages at the first hint of safety issue, and of clinicians reluctant to prescribe any product that might offer a negative risk:benefit equation to even a tiny fraction of their patients has strangled the drug development industry.  We are seeing the greatest retrenchment ever seen, as the behemoths of drug development, who we rely on completely for the next generation of improved medicines, reduce their expenditure on development of novel (and highly risky) new first-in-class medicines in favour of branded generics and other medium-value products that leverage their accumulated expertise in healthcare sales and marketing.

One thoroughly implausible solution to this worrying state of affairs is to hope for a resetting of the public attitude towards risk.   A return to a world that remembers the horror of disease unopposed by the modern pharmaceutical industry, a world with child mortality rates that touch almost every household.  A populace that recognizes that individually bearing the small risk of a severe negative outcome is a small price to pay for a miraculous cure.  While its possible that things (things generally, not just in healthcare) may get sufficiently bad one day in the future that such a “global reset” of attitudes does eventually take place, it is no kind of business model for the healthcare industry to sit and wait for such an event.  Where can we look for actions we can take to improve the commercial proposition for developing new first-in-class drug products that really make a material improvement to human health?

Is the solution better predictive toxicology paradigms?  Maybe if we could genuinely weed out risky product candidates with better specificity (that is, without throwing away so many promising programmes that are stained by a single concerning finding) things might improve a little.  But there is another source of improved safety that might be easier to tap (not least because billions of dollars have already been spent trying to optimize predictive toxicology approaches, so we have to assume the current crop are not far away from being as good as current technology and knowledge allow).  Ironically, the easiest route to improving drug safety might come from a re-evaluation of our approach to screening for efficacy in animal models.

Lets consider (in qualitative terms, since a quantitative analysis is impossible) what happens to average harm and average efficacy of all compounds still under consideration as potential products through a fairly typical drug discovery and development pathway.

At the very start of the project all possible molecules (large or small), or at least those that are readily available to the pharmaceutical industry in terms of compound or antibody libraries, represent the field of plausible candidate drugs.  Any such compound chosen at random would, if dosed in humans, have a pretty high chance of causing a degree of harm (and for a small molecule library, that harm might be substantial).  By contrast, that same randomly chosen compound has an almost zero chance of actually doing something useful.  This is illustrated in figure 1 below: at the beginning of the project (left hand side of the graph) the risk of harm (red line) is high, but the risk of benefit (green line) is low on average for each candidate compound.

Fig. 1. A qualitative model of the downside (red) and upside (green) risk of molecules remaining in the pipeline through various stages of the drug development pathway.  Each step in the path is intended  to either reduce risk of harm or increase likelihood of benefit (or both).  Unfortunately, the way we use animal models of disease (pink shaded box) may be unintentionally increasing the risk of safety problems.

During early screening, things change rapidly.  Assays such as cell viability screen out many of the ultra-nasty compounds, while screens for a particular molecular interaction thought to be important for efficacy in a particular indication raise the likelihood that the positive hits might offer benefit.  Lead optimization, with a focus on pharmaceutical properties might reduce the risk a bit further by eliminating compounds with more subtle toxic effects, but doesn’t really move the needle in terms of likelihood of eventual efficacy in the clinic.

Once the compounds go into animals, further toxic effects not revealed by sophisticated in vitro screening and in silico modeling will likely be revealed, providing a step change in average safety, again without materially affecting likelihood of efficacy.

But the really interesting thing is what happens when compounds are put through non-clinical efficacy models (the region shaded pink in the figure).  The objective is to pick compounds that are likely to have real efficacy against the disease in question, and a lot of time and effort goes in to considering the positive and negative predictive value of various animal models for any given indication.  A compound that shows efficacy in a well-validated animal model is suddenly much more likely to eventually show benefit in the modeled disease – hence the big step up in the green line.

You might think such selection on the basis of efficacy would have no effect on the likelihood of harm (after all, why should examining effects in an in vivo model of a disease tell you more about the potential for harm than carefully designed toxicology studies in the same species?).  So the red line should be flat – yes?  No.  Or at least I argue that its not – instead there is a significant INCREASE in risk.  It is this proposed increase that lies at the centre of the thesis I’m putting forward in this article.

The impact of selection during clinical development is also shown, and is probably fairly uncontentious: risk is largely eliminated early (mostly in Phase I), while eventual proof of efficacy mostly occurs late, just before approval.  The products that eventually reach the pharmacopoeia are almost all effective (to some degree) but carry a small residual risk that is difficult, and increasingly expensive, to eliminate entirely.

If the accepted wisdom (and indeed the whole purpose of the drug development pathway) is to elicit a monotonic decline in average risk coincident with a monotonic increase in chance of efficacy, why have I postulated increased risk with increased chance of benefit during animal model screening?

Because animal models are usually designed to be much more rapid and aggressive than the disease they are modeling.  It stands to reason that they should be that way: they are meant to be a quick and easy way to look for efficacy.  Typical experiments might have half a dozen animals per group developing a disease, such as rheumatoid arthritis, over a few weeks.  Contrast that with even a fairly early Phase II trial with the best part of a hundred subjects and three to six months of treatment, let alone a full phase III study design in hundreds of patients lasting a year or more.  The idea is to predict the outcome of the latter trial (which is vast and expensive) from the outcome of the former animal study (which is, relatively, cheap and quick).

Like a distorting mirror at the fairground, the animal model is a twisted reflection of the Phase III study.  And this contraction in size and duration is essential: without the ability to put dozens (or industry-wide, thousands) of different promising compounds through such an efficacy screen it would be impossible to select compounds with an adequate chance of showing efficacy in the expensive clinical studies.

But there is a price to pay for the contraction of time and scale.  Not just one price but two.  The first price, widely recognized and willingly paid, is that the animal model may not be completely predictive of outcome in the clinic.  After all, it’s a rat and its not the “real” disease.  You can’t expect perfection, but you can stack the odds by looking in several models with differing positive and negative predictive powers.  Deciding what constitutes a “developable” efficacy profile from such animal model data is an art akin to reading tea-leaves, but it is a closely guarded proprietary skill of any self-respecting pharma company, which differs from company to company, and is no doubt regarded locally in each company as better than the rest.

The second price, by contrast, has largely slipped under the radar.  Getting a positive result in an aggressive (rapidly progressing) model of disease in just a few animals is a very high hurdle.  You have to have a strong biological activity of some kind.  A subtle, slowly acting nudge that, over time, builds into a cure has hardly a chance of hitting this particular jackpot.  And having such a strong biological activity usually means you have to hit crucial pathways, orchestrating major in vivo responses, which, in turn, means a higher likelihood of side-effects or those dreaded low frequency, high impact toxic events.  The analogy is simple: today’s animal models require you to throw a boulder into the pond – with waves fanning out into multiple related systems, rather than targeting the right pressure point with a small pebble that strikes hard where it hits but leaves little more than a gentle ripple propagating away from the epicenter.  The gentle but sustained pressure that might be the ideal treatment for the human disease has an imperceptible effect on the raging disease processes in the animal models.

The impact of this selection criterion on the pharmacopeia is clearly illustrated in rheumatoid arthritis: steroids are a great example of the boulder thrown in the pond, while anti-TNFs (the modern pharmaceutical industry’s major contribution to RA treatment) are typified by their Lazarus effect – they have the powerful effect in hours or days that’s need to be shine out in the contracted temporal and spatial dimensions of animal model world.  By contrast, most RA patients even today are actually treated with methotrexate – a throw-back to the days before molecular screening and animal models.  Methotrexate takes weeks or months to have an effect, but for many patients it does have real clinical benefit over many years.  Yet methotrexate has little or no effect on the animal models that dominate drug discovery in RA today, such as collagen-induced arthritis used in treatment model (a model that illustrates very nicely the concept of a quickly progressing, aggressive disease that phenocopies the joint histology seen in human RA, but bears no resemblance to the natural history or time course of the disease).

Of course, methotrexate is not a drug to hold up as a paradigm for a modified drug discovery framework – it’s side-effects make it difficult to use in the clinic and difficult to tolerate for the patient.   But the moral of this story is that a modern methotrexate equivalent, free from the side-effects, would be discarded in favour of apparently stronger and more effective medicines.  Medicine that, more likely than not, would eventually fail to reach the market due to the risk of side-effects.

In short, the increasing weight put on animal models of efficacy in modern drug development has subtly tipped the balance in favour of progressing agents that carry a higher risk of eventually losing out to the current fetish for zero risk drug products (whether they are culled by the regulator, by their owners or, most painfully of all, by the physicians who fear to prescribe them after approval).

We need animal models of efficacy, just as we need animal models of toxicology (figure 2).  Without their contraction of time and study size, the pipeline for late stage development would dry up almost overnight.  But perhaps  we have got the balance wrong: for years, we have optimized for quicker, more aggressive models that still predict efficacy because that optimizes the green line in the figure – we can put more molecules through a quicker, cheaper model after all.  Yet by turning up the degree of contraction of time and reduction of resource, the hidden penalty of demanding higher and higher levels of biological impact to see a positive outcome is leading to the loss of promising candidates that act more slowly or less aggressively, and which in the long game, may be the only classes of molecules that can meet modern society’s demands for zero risk pharmaceuticals.

Fig. 2. How the model might look with a re-balancing of the way animal models are designed and interpreted.   Compared to the old model (thin lines) we may be less certain of the upside potential but more certain of the long-term safety potential.

The basic, and perhaps surprising, message is simple enough: meeting modern demands for ever improving safety as a commercially viable proposition may require new focus on our animal models of efficacy.  Counter-intuitive as it seems, this may be the source of much of our current inefficiency in clinical development.   In years to come, we may look back and laugh at the days in the first years of the 21^st Century when it was considered the norm to invest in 3 month long GLP toxicology studies before starting a Phase II programme, but still be relying on results from a two week treatment of an aggressive animal model to select for efficacy.  If you shoot with a blunderbuss, after all, you are most likely to hit an elephant.

This blog post by Dr David Grainger is the second of two considering safer medicines. The first post is Too Much Safety? David runs a research lab in the Department of Medicine, Cambridge UK, where this blog first appeared on his lab website, GraingerLab. He is also a biotech entrepreneur and a principal at ATPBio.

On the 1^st February 2011, one of the largest and most successful global pharmaceutical companies, Pfizer, announced the closure of its Sandwich (Kent, UK) site, with the loss of the 2,400 jobs.

Some, such as John Gapper at the Financial Times, see this as another step on the road to the complete out-sourcing of drug discovery by the major pharmaceutical companies.   And even the most bullish industry commentators don’t see this as the last downsizing of R&D in the sector.

The trend to reducing big pharma R&D spend on “conventional” drug discovery seems inevitable.  The return on this investment is likely to be punishingly low (if you calculate it properly, it is the return seen 10 years from now set against today’s R&D expenses that you need to project, not today’s returns, based on R&D done a decade or more ago, on today’s investment).  But the bigger question has to be “why is this?”  Its easy to assume its because big pharma are not very good at early stage discovery, and that out-sourcing will lead to an efficiency gain – better pipelines at lower costs.

To a degree, it probably will do (that is, after all, what you get for out-sourcing many non-core activities – and discovering blockbusters is not the core competency of big pharma: their competencies are in marketing and in late stage clinical development).  But there is a much bigger factor in play here…

Society’s attitude to the risk:benefit trade-off in medicines has changed beyond all recognition in 20 years.  In fact, society’s attitude to risk in all its forms has changed in this period, with wide ranging and almost entirely negative consequences.   Whereas risk was once seen as part of life in every sphere, today the focus is on removing risk – whatever the cost of doing so.

Investment in new rail infrastructure following the Hatfield rail crash in October 2000 was just one high profile example of this trend: while any accident is regrettable (and much worse than that if you or your family happen to be involved), a response that involves spending millions to try and prevent a similar event ever from happening again can only driven by political expediency.  By any rational measure, the same investment could have saved many more lives had it been directed at almost any other project.

Sometimes the cost of reducing risk is more indirect, and therefore less obvious.  Laudable attempts to eliminate discrimination (whether on the grounds of race, gender or sexual orientation) from the Police force are a good example: the positive effects of the policy are easy enough to measure, but the cost (in terms of paperwork to be filled in to monitor behavior) are largely hidden.  How many less criminals are we prepared to catch in order to be certain that undesirable discrimination is almost entirely eliminated?

Sometimes this apparently sensible elimination of risk harms the very people it is designed to protect.  Half a century ago, county agricultural shows in the UK were a highlight of the calendar for the  working classes – a chance for a day out without breaking the family budget.  Today they are very different affairs: modern toilet facilities are provided,  while the whole event is heavily policed to ensure public order.  In short, the quality and safety of the event has been improved in every area.  But as a result the price has gone up until it is all but out of reach for the people who valued it as part of their community fabric.  No-one did more than the last Labour government to take away opportunity for the poorest in society simply by legislating to drive up standards.

One of the biggest problems with eliminating risk is the non-linear relationship between cost and benefit.  No matter what area of life you examine, as you approach ‘completely safe’, each tiny improvement in safety comes at an increasingly high price.  Squeezing out the last drops of risk costs exponentially more.

This risk reduction mantra has dominated the regulatory agenda for pharmaceuticals as well.   Regulatory authorities are on a crusade to reduce risk as far as humanly possible on behalf of a grateful populace.  And that is the dominant factor that makes investing in new medicines such a poor long term investment.

Who could question the objective of making medicines safer and safer (or, for that matter making railways safer or reducing police discriminatory behavior)?  We all should.  The consequence is that developing new medicines is becoming economically unsustainable.

Who will suffer?  You and me.  The drug companies will morph into something else, using their current cash cows to achieve that transition (and we see the first phases of these changes happening already: GSK, for example, are increasingly focused on over-the-counter products and vaccines rather than traditional patent-protected medicines).  But if the big drug companies withdraw from the front line of drug discovery, we are left with fewer new medicines.

Like the unintended consequences of government policies to drive up standards that disenfranchise those too poor to afford the resulting level of quality, in the same way reduced registrations of new drugs is an unintended consequence of demanding ever greater levels of safety.

Unfortunately, the cost of improving safety still further are largely hidden – it’s the loss of an otherwise beneficial drug from the development pipeline because the implications (in terms of money and time) of demonstrating safety to the current threshold required by the regulatory authorities simply makes continuing to invest in that product too risky.   The attrition rate during clinical development ratchets higher: both because drug candidates genuinely fail to meet the new standards of safety, but almost as often because the cost of demonstrating the required level of safety is simply prohibitive.  Increasingly, there are vast areas of medicine where the economic model for a product is now so unattractive, no-one even contemplates initiating a discovery or development process in that field.

This attrition then manifests itself in the falling returns on capital from big pharma and in the low rates of new approvals for genuinely first-in-class medicines.  If you demand “completely zero risk”, perfectly good medicines, with perfectly sound risk:benefit trade-offs start to get rejected by regulatory authorities and, before long, get killed by their owners at an early stage before they consume too much of the massive R&D costs of late stage development.

Of course, its easier for policy makers and commentators on the industry to blame falling approvals and falling returns on capital on the structural inefficiencies of research in a large company environment.  For outsiders, its simpler to assume the problem is that big pharma just are not good enough at drug discovery and development.  Its just too obvious that improving safety is a desirable goal, while the costs of the relentless pursuit of that objective are just too well hidden.

But if you want to understand why Pfizer took the decision they did, and why John Gapper at the FT predicted the decline in R&D at big pharma, you need to look at society’s attitude to risk and how this is reflected in the actions of regulatory agencies that are, in the end, public servants.  Without a sea change in how we approach drug regulation (and indeed much else in life) in the future, the current trend will be the tip of the iceberg.  As investment in new medicines bleeds away, many of those currently employed in the industry will find themselves looking for a career outside of healthcare, and many of those with incurable illnesses will lament the lack of progress.  Bizarre as it seems, demanding ever safer drugs really could cost you not only your job but also your life!

This blog post is by Dr David Grainger. David runs a research lab in the Department of Medicine, Cambridge UK, where this blog first appeared on his lab website, GraingerLab. He is also biotech entrepreneur and a principal at ATPBio.