On Tuesday I said I don’t like investing in early stage biotech.
I don’t like investing in early stage biotech for the same reason that Obama’s healthcare plan is looking dodgy… and for the same reason that used car dealers have a bad rep… and for the same reason equity crowdfunding is a waste of money.
The first person to figure this out was a 16th century banker called Thomas Gresham. He was an advisor to Queen Elizabeth I, who wanted to know why credit was collapsing in England.
Queen Elizabeth’s father, Henry VIII, had replaced 40% of the silver in the coins with cheaper metals in order to save money. Soon enough the people realised what was going on, and started to hoard the old silver currency. Eventually nothing but the bad currency was left in circulation, which shrunk the money supply and led to the collapse in credit in the economy.
Gresham advised Elizabeth “that good and bad coin cannot circulate together.” Later on, a 19th century economist re-stated this as Gresham’s law: the bad money drives out the good.
If you’re looking for it, you’ll see variants of Gresham’s Law all over the place. I’ll show you how it applies to biotech investing in a moment. But first I want to talk about the market for used cars. That’s another famous version of it.
The Fed Chairwoman Janet Yellen’s husband, George Akerlof, won a Nobel Prize in economics for this one. He said that the market for used cars is all messed up. Because one side of the deal (ie the car dealer) knows more than the other side of the deal (ie the car buyer), the market won’t work properly. Since the buyer doesn’t know whether the car is reliable or not, he has to assume it isn’t. The end result is that only unreliable cars end up getting sold. The bad money drives out the good.
In Washington, policy nerds are starting to worry about Obama’s healthcare plan – Obamacare. The problem is that the big insurers are pulling out, which is leading to higher premiums. Higher premiums are discouraging healthy people from taking out health insurance. That means only those who really need insurance take out a policy. That pushes premiums up even higher. Again, the bad money drives out the good.
Equity crowdfunding is a bit like investing in shares. It’s where ordinary people buy equity in promising young businesses. But unlike in the stock markets, where companies are forced to disclose detailed financial information four times a year, equity crowdfunding companies don’t have to share any information with investors. Like with used cars, investors can’t tell which companies are good and which are bad. According to the FCA, the net result is that:
“It is very likely that you will lose all your money. Most investments are in shares or debt securities in start-up companies and will result in a 100% loss of capital as most start-up businesses fail.”
The bad money drives out the good.
How to spring the trap
And that brings me to early-stage biotech investing. There are lots of biotech companies which aren’t yet making any sales, let alone profits, let alone dividends. They’re working on new cures. And they’re waiting for the big payday, when their drug gets approved by the FDA or they get bought by a bigger pharma company.
Lots of great companies and important drugs have started out that way. But on the whole, I’m very wary of investing in these sorts of businesses. It goes back to the problem of the used cars, or personal health insurance. Biotech is very difficult for ordinary investors to understand deeply. The companies know a lot more than the investors. And where you have this type of mismatch in information, trouble usually follows. The worry is that, in early stage biotech, the bad money will drive out the good. That the best biotech startups will use a different model to fund themselves. Leaving investors with the dross.
Tom Bulford’s thought about this problem. He’s figured out a smarter way to invest in biotech, and his subscribers are thanking him for it.
That’s it from me. Have a great weekend all!
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