Premise and rationale

Share prices of drug and biotech stocks arguably can be broken down into two major components: the capital markets’ estimates of the value of assets that are well characterized (i.e. on-market, filed, and late-stage developmental projects), plus the markets’ estimates of the value of assets about which relatively little is known (i.e. pre-phase III projects). For simplicity, we refer to early, pre-phase III developmental projects collectively as the ‘Hidden Pipeline’

To estimate the values of hidden pipelines as a percentage of share prices, we subtract from each company’s enterprise value an estimate of the present value of everything else – marketed products, products filed for regulatory approval, products in phase III development, and all non-pharma lines of business. On average, hidden pipelines account for nearly a third of share prices, and the percentage of share price explained by hidden pipelines ranges from a low of 14, to a high of more than 74 percent (Exhibit 1)

In theory, if the capital markets had equal amounts and qualities of information on these companies’ hidden and non-hidden operations, we would expect that knowing what’s in the hidden pipeline would take us roughly one-third of the way to explaining relative share price movements among these companies over time. However because the markets have substantially more information regarding non-hidden operations than they have regarding hidden pipelines, the valuations of hidden pipelines are much rougher guesses. By extension, this implies that the hidden pipeline valuations are inherently far more volatile than the valuations of non-hidden operations, and by further extension that hidden pipelines explain substantially more than one-third of relative performance among these stocks

Price versus Value …

Having solved for the market capitalization of a company’s hidden pipeline, the question becomes whether or not the assigned market value closely reflects the hidden pipeline’s true economic value. To estimate pipelines’ true (relative) economic values, we rely heavily on patent data which, unlike traditional channels of disclosure, offer a reasonably consistent and complete[1] picture of companies’ hidden pipelines

After assigning all active[2] patents to their corresponding parent companies, we take three key additional steps: 1) each patent is quality weighted[3]; 2) patents are segregated into those that correspond to either known (e.g. marketed, filed, or late stage projects) or hidden (pre-phase III) products / projects; and 3) each ‘hidden’ patent is assigned to disease, mechanism, and/or physical (chemical / biochemical characterization) categories[4]. The result is a company-by-company database that characterizes the sizes (numbers of quality-adjusted patents) and relative values (quality-adjusted patents, weighted further by the relative economic values of the disease areas in which the company conducts research) of the analyzed companies’ hidden pipelines

To determine which companies’ pipelines appear relatively over- or undervalued, we simply compare the market capitalization (price) of each company’s hidden pipeline to the apparent (relative) economic value of that company’s hidden pipeline

Exhibits 2 and 3 summarize the results. In Exhibit 2, column (b) provides our estimate of the market capitalization of the hidden pipeline[5], and for reference column (c) shows hidden pipeline capitalization as a percent of total enterprise value. Column (d) gives each company’s hidden pipeline value as a percent of the total hidden pipeline value for all companies. Using BMY as an example, BMY’s $25.4B hidden pipeline capitalization is about 3 percent of the $843B combined capitalization for all 23 companies’ hidden pipelines. In column (e) we express the quality- and sales-weighted amount of innovation in each company’s hidden pipeline, as a percent of the total quality- and sales-weighted innovation in all 23 companies’ hidden pipelines (BMY has 12 percent of total innovation across the 23 companies, but only 3 percent of the market value). Column (f) is the ratio of columns e & d; i.e. column (f) is the share of peer group innovation in a given company’s hidden pipeline, divided by that company’s share of total peer group hidden pipeline market value. Companies with larger shares of innovation than of market value (e.g. BMY) have hidden pipelines that are apparently undervalued, and vice versa[6]. Exhibit 3 depicts the data in Exhibit 2 graphically, comparing each company’s share of the peer group’s quality- and sales-adjusted hidden pipeline (y-axis), to its share of the total peer group’s hidden pipeline capitalization (x-axis). Companies that depart significantly from the 45 degree ‘normal’ have hidden pipelines that are apparently under- (above the normal line) or overvalued (below the normal line)

VRTX, BMY, SNY and MKGAY have hidden pipelines that appear undervalued[7]; CELG, BIIB, REGN, SHPG, NVO, GILD, and ALXN have hidden pipelines that appear overvalued[8]

Implied performance, and actual performance to date

Implied performance is simply the percentage change in relative share price that would bring a given company’s hidden pipeline valuation to par. Fundamentally, the idea is that a given hidden pipeline, adjusted for the sales potential reflected in its therapeutic area mix and the quality-adjusted volume of total innovation, should have the same or nearly the same economic value[9] as an ‘average’ pipeline with the same therapeutic area mix, and quality-adjusted volume of innovation

Results are provided in Exhibit 4, both with and without sales weighting of hidden pipeline values. Using BMY as an example, based only on the amount and quality of innovation in BMY’s hidden pipeline, and assuming only that this amount and quality of innovation ultimately is valued at par with other ‘Hidden Pipelines’ of comparable amounts and quality of innovation, we would expect BMY to outperform its peers by roughly 77 percent. If in addition, we adjust our estimate of the value of BMY’s hidden pipeline to account for the mix of therapeutic areas BMY is pursuing, we would expect BMY to outperform its peers by roughly 80 percent. Conversely if NVS’ hidden pipeline were valued at par, we would expect NVS to underperform by roughly 17 percent (ignoring therapeutic area mix) or, adjusting for the therapeutic area mix of NVS’ pipeline we would expect underperformance v. peers of roughly 19 percent

Exhibit 5 provides the actual relative performance of a drug / biotech portfolio whose stock selection is based entirely on hidden pipeline valuation (all names with ≥ 20 percent implied share price gain are held long). Performance figures are provided for the entire period since we first published the method (Nov 2012) and for each interval between updates. Since inception, returns to stocks chosen based on hidden pipeline valuations are roughly 1.55x peer group returns (1.52x equally weighted; 1.58x cap weighted)