The Secret to Safely Investing in Biotech

Seth Klarman, who has managed the Baupost Group hedge fund since its founding 33 years ago, is a legendary value investor. A sign of the esteem in which he is held is that Margin of Safety, which he wrote in 1991, has become a cult classic. Warren Buffett is rumored to keep a copy near his desk; if you want your own copy, the book, which is out of print, will set you back $1,940 on Amazon. So it has come as something of a shock to Klarman’s bargain-hunting devotees that their hero has emerged in recent years as a wildly successful investor in biotechnology stocks. Biotech? Buffett never touches the stuff. What does Klarman see that the master doesn’t?

Klarman, whose hedge fund today manages $29 billion, wouldn’t respond to questions. But a comment in a letter he sent to his shareholders last year suggests that he has changed with the times. When he sent the letter, he had just quintupled his money in Idenix, a maker of hepatitis C drugs, after it was acquired by Merck, and the biotech portion of his stock portfolio had swollen to 37%. Wrote Klarman: “I am … pleased that this old dog (your Portfolio Manager) is still open (I’m always cautious but open) to learning a few new tricks.”

Klarman was prescient in recognizing that the genomics revolution would supercharge the biotech industry, radically improving the odds of creating successful new drugs. As young biotech firms developed exciting new compounds, larger companies would fight over them, eventually offering billions of dollars for companies that did not yet even have drugs on the market.

That insight paid off big for Klarman and other biotech investors. Over the past five years, iShares Nasdaq Biotechnology (symbol IBB), an exchange-traded fund that tracks the sector, returned a whopping 30.7% annualized, more than twice the gain of Standard & Poor’s 500-stock index.

At the end of 2014, Baupost Group owned seven biotech stocks: Atara Biotherapeutics (ATRA, $40), Forward Pharma (FWP, $30), Keryx Biopharmaceuticals (KERX, $11), Kindred Biosciences (KIN, $7), Paratek Pharmaceuticals (PRTK, $26), Theravance (THRX, $17) and Theravance Biopharma (TBPH, $17). (My fund owns Atara, Forward and Paratek; share prices are as of May 1.)

Klarman often reduces risk by picking stocks that give him several ways to win. Consider Forward Pharma. The Danish firm says it patented its version of dimethyl fumarate (DMF), a drug for treating multiple sclerosis, before rival Biogen did. But only Biogen is selling the drug, called Tecfidera; annual sales are running at a rate of more than $3.2 billion a year. Forward, which is challenging Biogen, was told that it would get a patent in Europe in late May and has received a favorable initial patent-interference ruling from U.S. authorities. Plus, a company official tells me, Forward’s version of DMF releases the drug more slowly than Biogen’s, resulting in fewer side effects.

Quadruple threat. Forward, whose shares have rocketed 72% since going public last October, could win in four ways. It could receive royalties on sales of Tecfidera. Biogen could buy it. Forward’s timed-release drug could turn out to be a hit. A large company could buy a big stake in Forward.

Atara has been another huge winner for Klarman. He bought in when the South San Francisco company was still private, and the stock has nearly quadrupled since Atara went public at $11 last October. Moreover, Baupost nearly doubled its stake in late March. Why the enthusiasm? Atara is working on drugs to treat different kinds of cancers and drugs to stem muscle loss.

So has Klarman really found the secret for making biotech investing safe? The answer is a qualified yes. Just own a portfolio of companies with proven technology and multiple ways to win.