Financial filings can be long and challenging to get through, let alone digest if you don’t have a degree in finance. But basic literacy in reading these documents is essential for biotech and cancer investing.
When selecting companies for long-term investing, you should ideally use fundamental analysis. If you can sort out a company’s cash flows and accurately predict growth potential, you can work out the undervalued equities.
But in many cancer stocks, we have a big problem. Most of the companies we’re interested in don’t have any approved products for sale. It’s one thing to pay attention to the news, but a whole other game to incorporate this into an entire investment case. As such, we find ourselves relying on the expertise of others to determine whether our bets are safe. But this takes the control from our hands, placing them in strangers on the Internet. This is a recipe for becoming a bagholder, as the decisions are out of your hands until it’s too late.
But we’ve all been at the beginning stages of this stuff. You open an SEC filing, and you’re smashed with table after table of numbers. And they are routinely over 100 pages, depending on the size of the company in question.
But you don’t need to pay attention to everything to gain a sense of the investment potential of a cancer stock. Certainly, you can find a lot of information that won’t make much difference in the near term. But these filings contain key insights into the current financial state of the company, as well. And you ignore these signs at your own peril. No matter how good a company’s science is, if their finances are not in order, then you will be taking on a high-risk investment.
Minimize risk in investing: Look for the big things
First, you’ll need to find the filings themselves. The SEC stores these documents on their website, but I find it buggy. Company pages will also have the filings, but many of them do not have well-designed websites. Personally, I like to use Seeking Alpha’s database for this, since it’s easy to find both the documents and commentary. Here is an example of their SEC filing database:
To get here, you search for a given stock (in this case Advaxis) and go to its page. This will bring you here. Click on “Key Data,” and you will be able to access “SEC Filings.” Generally what we’re looking for is the 10-Q, the quarterly report. You’ll find a lot of 8-k forms in these databases. These are for conveying important information, like the announcement of a piece of news. Annual reports are also found here; they are the 10-k forms.
But quarterly filings are usually the most up-to-date financials that you’ll be able to find on the company. If you can’t find recent quarterly financials, then it’s best to stay away from this company, as they do not conform to regulations and can get away with fleecing you.
In the 10-q, you will find all kinds of boilerplate and regulatory language relating to claims made within the document and potential risks involved with the company. You already know the major risks with a clinical-stage biotech company: no products, and no promise that there will ever be a product.
What we really want to know are the numbers. Does the company have enough cash to manage its expenses? How long will the cash last until they need to identify new sources of financing?
The financial statements contain almost everything you need to know, from a numbers perspective. Here you’ll find statements on the company’s current assets, liabilities, and cash flows. You should familiarize yourself with the workings of these statements, as they’ll be critical for understanding more deeply. And today I want to provide you with some key information that you can use to pull some significant data about a company. This will help you get better at pulling together the financial end of your due diligence.
And a disclaimer: I am not a finance professional. I am not some kind of consultant in investing. I am here to impart what I know about cancer investing. And to that end, you may find you need more information. You may find this guide to be incomplete. That’s great! Let me know in the comments what I missed or what else I can help you understand.
Arguably the most important aspect of building an investing thesis is the asset portfolio of the company. A company can’t operate without funds. And you need to know where those are coming from so you can minimize how many times they come to you for money. This portrait starts with an assessment of the company’s asset balance. Here is the example of Advaxis:
This is a typical example of a condensed balance sheet, and it tells you a lot. In essence, this breaks down how much money the company is holding. Importantly, it tells you what form they’re holding money in. Going down this particular list:
- Cash and equivalents – This is either idle cash the company has sitting in the coffers or money that can be freed up in short order. For example, they could be very short-term, highly liquid investments usable within days.
- Restricted cash – Cash already reserved for some specific purpose. It’s important to know why the company has this money locked down, particularly if the amount is large.
- Short-term investment securities – Investments that will mature in the near term, often within 270 days. This could be US Treasury bills or promissory notes, for example. The company will describe how these are broken down further in the filing, but in general you can expect these assets to not provide a major source of cash in the very near term.
- Income tax receivable – Money the company expects to receive from the national, state, or local government
- Deferred expense – A cost that has already been incurred but paid for upfront, but the thing paid for has not yet been used up such as a large item that the company will depreciate on the balance sheet over time.
- Prepaid expense – These are expenses paid in advance of actually using a service, such as rent, insurance, or taxes.
Of course, there are other terms that might appear on a balance sheet. One notable absence from this one is receivables, which would be the amount billed by the company to its customers. But since we’re usually talking about companies with no marketed products at this stage, receivables are not in the picture.
Now, the flip side of assets is, of course, liabilities. While proper investing requires knowledge of the liabilities, I don’t personally find this section as essential for my due diligence as the cash flow statement. We’ll get to that in a bit.
But let’s run down the categories in the example provided:
- Accounts payable – Money owed by the company to its suppliers
- Accrued expense – An expense that recognized before actually being paid. This includes items that are highly likely to be paid, such as salaries.
- Deferred revenue – The mirror of deferred expenses. Deferred revenue is money that was received as one lump sum for services that will be rendered over a longer period of time. For example, the company might receive $40 million dollar upfront as part of a partnership, and they will consider it as being received over time to account for the long-term nature of the project. This helps to spread out the initial tax hit from receiving such a large sum of money at one time.
You might also see items like loan interest and costs incurred as part of a collaboration. You will also likely see accrued expenses expressed in different terms, perhaps broken out in more detail. But it’s the same principle.
Statement of operations
In this part of the SEC filing, you will find the revenues accounted against the operating costs of individual large items. I find this section valuable for investing, since it gives you a sense of the company’s priority as far as research and development versus staffing. If your company of interest has a large cost of operations (which varies depending on how much money they have, of course), then it is assuring to know that they’re spending more than half of that on research and development, as opposed to moving for a large marketing team too early. Total loss from operations gives you the first sign of the company’s burn rate, although we’re still not quite there.
Statement of cash flows
This is the money maker section of the entire SEC filing. It tells you how much cash actually left the company, as well as what vehicles the company used to fund operations. How did they shift money around to protect and grow? In the statement of cash flows, you’ll get the actual burn rate for your company of interest. This is the “net cash used in operating activities,” which needs to be offset either with the cash and equivalents on hand, or by selling short-term investments, or by selling new authorized shares of stock.
Yes, you read that right, companies can and do dilute your holdings all the time, as a means to stay cash balanced. It’s not usually the large bulk amounts of stock that you will see as part of a secondary offering, but it can mean ever-increasing encroachment on your investment in a biotech, particularly if this is the company’s only method of funding operations. Investing in a company relatively few options for funding has an increased risk, as a result.
Put it together!
So we plenty we can learn from an SEC filing. You can find more detailed breakdowns of the holdings of the company. You can get a rundown of the history of their investigational products, as well, and some tidbits about data that they may not have presented publicly. But the key message here is burn rate.
How much money are they using every quarter?
How much money do they have right now?
When you know this, you know when the situation to raise new funds is going to become dire. A company that has only enough assets to fund one more quarter of operations is far more likely to go to the dilution well. And since other shareholders know that, they might sell, necessitating more dilution to receive the same amount of funding. This is the kind of situation you want to avoid as a speculative investor.
Of course, what you see on the surface of the company is just the beginning. You will find plenty of companies that you can exclude based only on how much money they have on hand. Or at least you can wait on those ones until other people have already gone through the dilution. But you also need to undertake as much due diligence on the science of the company as possible. That is beyond the scope of this particular article, but now you have the most basic tools to get why these filings are so important. And you can now see that anyone can quickly pull key information from them. So get to it! Basic finance is easy enough to understand, and a sense of the financial health of a company can help you determine if investing right now is a good idea.
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