An Index to Track the Untrackable

On March 2nd of this year, the Tel Aviv Stock Exchange inaugurated its biomedical companies index, which features 26 firms whose primary business is life science research and development, biotechnology, pharmaceuticals or medical devices.

The companies on the index all have a market cap of at least NIS 50 million and at least 20% of their shares are held by the public.

Conspicuously absent from the index are pharma giants Teva and Perrigo. At the TASE, this is explained as an effort to create an index that will represent the Israeli biotechnology sector, which means the high-tech piece of the pharmaceutical industry.

Teva and Perrigo are large and established and their inclusion could be detrimental to the goal of the index, they said.

At this point, it's impossible to "invest in the index" as no one has issued exchange traded notes tracking the Biomed index. The stock exchange isn't issuing approvals for the notes because it wants to give the index a trial period of three months to see how it functions.

If the enthusiasm for biomed stocks continues in the coming months, it seems likely that any notes or exchange traded fund based on the index would see success.

Drug companies can be divided into two groups: generic firms that copy existing drugs and the so-called "ethical" firms, which develop drugs. The ethical firms operate in a much riskier market at the beginning, as they must invest large amounts of money over many years to develop a drug. Sometimes 14 years can pass before a new drug project actually comes to fruition and receives approval for sale.

During the development phase, the company burns money and investors don't see any fruits of their investment. A company that manages to invent a new drug and defend it with a patent can achieve tremendous financial success, however, on the condition of course that it has developed a drug that will be widely sold, such as Viagra. Others can achieve success even if the number of the consumers of the drug is limited.

Dreams of success are the engine that motivates many companies to invest large quantities of resources and capital - a dynamic that recalls oil exploration.

"It's the toughest field that I have followed," says Ori Hershkovitz, a global health care fund analyst for the Sphere group. "I've been working in the field for more than a few years, surrounded by consultants with doctorates, and I consult with doctors around the country, and nonetheless, I don't have tools at my fingertips to analyze biomed firms. Every firm is different, and the method of analysis that works with one firm fails with another firm. God help the person who starts trading and investing without understanding."

The sick along with the healthy?

The new Biomed index and expectations of exchange traded notes prompt the question as to how it's best to invest in the life science field. On one hand, buying the entire index is similar to the activity of a venture capital fund. The fund invests in several firms on the assumption that a few of them will achieve a breakthrough and generate profits that will cover the cost of the investments in the companies that fail. However, there are those who oppose such an approach and think investing in biomed firms should be done only after research to separate the wheat from the chaff.

As with any field connected to biomed, the answers are as varied as the number of people you ask. The deputy CEO for business development at the IBI investment firm, Ela Alkalai, who followed the life science field for many years, agrees that buying the index is similar to the activity of a venture capital fund.

"As in every field, there will always be a stock that performs better than the index," she says, but adds that "the problem is that it's almost impossible to choose correctly because the index contains many fields of knowledge. It includes companies that make medical equipment such as Mazor Technologies, Exalenz or Given Imaging. Each one of them is a different show entirely. Even a physician or other professional will find it difficult to choose correctly."

By contrast, Hershkovitz believes there is no reason to invest in the entire Biomed index, rather the best companies should be carefully identified for investment. Biomed analyst Steven Tepper at Harel Finance thinks the Biomed index and venture capital funds are at best "cousins."

"The venture capital fund examines hundreds of companies and decides to invest in the most promising companies, similar to a mutual fund which tries to choose the best companies. On the other hand, the exchange traded note gets into the same group of companies whose prospects for success have not been examined by anyone, but are in the index after complying with financial criteria."

Unique pricing model

How do you evaluate a biomed company? The process isn't simple. In established industrial enterprises there are revenues and expenses and projections on revenue growth. Everything goes into a formula called discounted cash flow, or DCF, which attempts to project the cash flow the company will achieve in the future and capitalizes it to the present to gauge the company's present value. In pricing a medical start-up, however, or even an established biomed firm, there is a high degree of uncertainty which requires assumptions on top of assumptions.

Alkalai explains that the value derived in pricing a biomed company is very limited, since the analysis requires answers to dozens of questions each of which is a world unto itself. Among the questions, for example, are what the market potential is, what market share the company will achieve, what the sales price of the product will be, who the competition is, whether the product is better and whether the product will be covered by national health systems and insurance.

One solution to the complex situation is reliance on interim benchmarks.

"This enormous uncertainty creates large discrepancies among analyses," says Alkalai. "At the same time, there is little financial research on these companies. So [sometimes] an individual survey becomes a benchmark for the whole market. The sector is much more heavily influenced by the investors' mood, meaning a love or aversion with regard to risk in the field at a specific time rather than the mathematics of a specific evaluation model. In 2008, no one wanted to buy anything, but in 2009, there were stocks that shot up by 300%. That's a barometer of the financial mood of the investors."



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