Programming Biology and its Assymmetric Optionality

New Era

The ability to discover the ultimate laws of nature makes physics the king of science. In fact, physics has been so influential that it has inhibited progress in other scientific disciplines by attracting many of our most intelligent scientists. However, with time progressing, inventing or finding something new within physics relative to other subjects is perhaps tougher and that is a motivation for gifted students to pursue new scientific paths. I believe one of these paths is biology, especially the cross-section of biology and technology, as increasing healthcare and agricultural product demand from consumers together with higher compensation for workers should result in a growing biotechnology industry. The business model of biotech is based on science that utilizes biological systems, living organisms or parts of both to develop or create different products in the market. Ideas within genetics, molecular biology and biochemistry to advance medicine, therapeutics, agriculture and industrial production therefore has enormous potential to form the foundation of profitable companies in the 21st century.

The human genome project is one of the most successful experiments in scientific history. Spanning 1990 to 2003, researchers across the world came together to sequence and map the entire human genome. Thanks to this successful experiment, we now have access to the blueprint of building a human.

Starting in Biotechnology is Like Picking Apples

The objective of apple picking is to maximize the quantity of apples while minimizing effort. A smart tactic for bringing home a big bag of apples is therefore choosing low hanging fruit. According to legendary entrepreneur and investor, Peter Thiel, creating a business for new markets rather than competing with existing ones is a great way to harvest apples in business. New markets are created by talented visionaries with problem solving skills used to plug market holes. Most talented people can achieve success within many areas of business and academics, which is why there must be a major opportunity for gifted people to not choose highly compensated positions in banking and tech. I believe biology happens to be an area of opportunity, especially its combination with technology. Successfully manipulating biology can lead to many practical products, which in turn has the potential of creating a new market. Founding biotech firms should therefore be considered as “discovery” fruit hanging low. There are many reasons for why the combination of biology and technology is the future. Firstly, advancements within computer science and technology has made it possible to view organisms and molecules at a micro-scale, which can help design new medications and therapeutics. Secondly, new tools in machine learning makes it possible to automatically test new products and create experiments without human intervention when interacting with organic material. Thirdly, the marginal improvements spanning a long time period within biology and chemistry has led to loads of optionality within biotech. Finally, there is a high demand for medications treating mental health and chronic illness as we all as an increasing demand for healthy organic food. For all of these reasons, the biotech market will increase and larger markets creates network effects. From an investing perspective biotechnology is then a dream opportunity.

Low hanging fruit is easier to reach

The problem with Biotech

Unlike software, which does exactly what it is programmed to do, biology does not, which makes biotech investing comparatively complex to investments in other industries like tech or finance. In addition to being complex, the biotech industry is wide-ranging so there is no person – including experts and not only investors - that has full comprehension of the whole biotech area. Understanding even niche areas often requires a sophisticated background in two or more academic disciplines and on top of an excelling academic background, it helps to have a vision about where society is heading when it comes to regulatory approval of new medications and therapeutics. Take genetics, for example, I am reading a book by writer and PhD holder, Sharon Walker, called Biotechnology demystified and before even getting into genetics, Sharon digs into the most fundamental components of cells including protons, atoms, lipids, electromagnetic bindings and proteins; what I am trying to say is that biotech is complex. Too much detailed knowledge is for expert scientists, but basics are important to avoid getting tricked by scientists telling stories about sunshine and rainbows if you want to invest in biotech. Even when a drug looks promising, it still faces a difficult road ahead. Peter Theil explains the complex path through the regulatory process to the ultimate reward in a wonderful way:

“There is disturbingly little intuition into what biotech companies are worth. If you are able to produce a drug that cures some sizeable disease for which there is no cure at all, that is worth billions, or tens of billions of dollars. And if you don’t succeed it’s worth nothing. You have to get through basic research, preclinical, Phase I, II, and III, and then marketing. So, approaching it analytically, the question is how do you discount [the risk of failure at each step]. If you do half on each step, and there are six steps, that’s 2 to the 6th, or 64. So something worth a billion at the end means you start at [a value of] $16 million. The thing I don’t like about this as an investor is that the numbers are totally arbitrary. They are just made-up numbers. And our feeling with many biotech’s is that people understate these probabilities. They say its half, but maybe it’s just one in 10. And if even if just one of these steps is one in 10, you are really screwed. I would be very nervous to invest in a company where it gets pitched as a series of contingencies that- this has to work, and this has to work, and this has to work.”

Above, Thiel basically describes how drug development follows a binomial event structure with a final binary outcome; either the drug works or it does not. In a 2021 Motley Fools article, for example, the US Bio Trade Association estimates that around 9.6% of drugs and vaccines makes it through the entire regulatory process after successful clinical trials[1]. Investing in a binary approval process spanning lots of steps means you will lose the initial investment most of the time. However, developing drugs is option like with a super high upside so the big hit should make up for all the bad ones. It is therefore important to consider the initial capital with high probability as a sunk cost, but with asymmetric opportunity on the upside. In other words, there is some low hanging fruit for those who conduct biotech research. Besides a bumpy road through the regulatory approval process, an additional problem with biotechnology is that potential cures demand access to genetic information, which is a thorny topic requiring philosophical debate. However, perhaps cryptography tools like blockchain technology solves these privacy issues.

Holding assets with assymmetric payouts is great for an investment portfolio

Biotech Total Market Size

The US market size for biotech was 497 billion dollars in 2020 according to a biotech industry report written by Sumant Ugalmugle and Rupali Swain[2]. In the same report, Sumant and Rupali also projected a total market size of almost 1 trillion dollars within the following decade and since US accounts for 5 percent of the total world population, it means that the total biotech market size could easily surpass 10 trillion dollars if market size scales linearly with population. There are multiple reasons for an expanding market size. For example, with aging demographics around the world and with people being lifted out of poverty, the demand for biotech companies will increase not only for medical reasons, but also to protect our environment and expand our agricultural industry. My view is that the market size could be much larger given biotech’s extreme optionality. The main growth areas in biotechnology comes from solving problems related to health/well-being, food/energy supply, environmental protection and chemicals.

Biotech is an industry with growth potential

Biotech Growth Areas

A major part of the growth potential in biotech arises from producing medications and therapeutics to treat chronic and mental health disorders. In 2018, CDC presented a paper stating that over 50% of the US population suffers from at least one chronic medical condition.[3] Issues like diabetes or heart problems are so common now and lessening the pain of chronic illness is a valuable service to society, especially with people living longer. Many biotech companies are therefore continuously producing research and development to treat these chronic issues. In economics 101, inelasticity is a term used to describe goods for which demand is indifferent to price yielding suppliers almost unlimited pricing power. Certain medications are inelastic goods, as patients would pay almost anything to receive a lifesaving or chronic problem treatment. That means developing drugs to cure certain illnesses has high profit potential if the illness impacts a large portion of the population. In addition to chronic health issues, at least 7% of the US population suffered from mental health problems in 2017 per the National Institute of Mental Health[4]. Among all mental health issues, depression seems to be the most major problem and it impacts the young. In a survey by the National Institute of Mental Health, around 13% aged 18-25 suffers from depression problems. From an investing perspective, millennials growing older is a potential revenue driver, as millennials will use their increase in earnings to seek treatment for their mental and chronic health problems. There are already some innovative biotech companies that are experimenting with drugs to treat mental disorders including psychedelics. There are also other profitable opportunities within biotech such as curing an “uncurable” disease. COVID-19 is a great example of the uncurable type of “optionality”; just look at the soaring stock prices of Moderna and Pfizer spanning 2019 and 2020. Separately, these two biotech companies developed a new type of vaccine based on mRNA technology. Worth noting is that building mRNA medications required endless years of research. There is also interesting projects being launched with gene editing technology like CRISPR. In addition to treating health issues, the increasing population size in combination with more people being lifted out of poverty will create pressure on agricultural production to produce more and healthier food. Innovative biotech firms can solve problems related to agricultural production. The increasing population will also increase pressure on the environment. Biotech companies can help develop technology that creates sustainable alternatives to chemicals and plastics limiting pollution.

Market sectors

Sector Diversification

Before discussing how to invest in biotech, we must first discuss diversification, as biotech is one of many subsectors of the stock market. Investing in various subsectors achieves portfolio diversification, as each subsector is exposed to some unique idiosyncratic factors. That means certain subsectors perform better in different kinds of market environments. Being exposed to a few sectors rather than just one therefore most likely increases expected return per unit of risk. The US stock market capitalization was $46.7 trillion dollars on Jun 30th 2021, and is heavily concentrated, as the top 500 US companies account for around 80% of the total market cap.[5] The largest factor that impact the US stock market is defined as market risk, which is how much an individual company moves in relation to a large stock index. This risk is called Beta risk and some investor want more Beta risk than others. Only investing passively in a general market index like the S&P 500, Russel 2000 or MSCI world means having a beta exposure of 1, although there are slight differences in how these indices perform. Russel 2000, for example, generally includes potential growth firms and MSCI world contains companies from across the world, while the S&P 500 contain the largest and most “stable” companies in the US. The amount of companies included in each index the overall performance of the index is considered diversifies with a beta exposure of 1. There are many different equity subsectors such as industrials, transportation, consumer staples and banking. Each subsector is often synonymous with certain idiosyncratic risks and when idiosyncratic risk you are no longer just exposed to the market, which means your portfolio will have a beta that is greater or lesser than 1. These idiosyncratic risks explain excess return at the subsector and company level. The biotech industry, for example, tends to have more idiosyncratic risks for regulatory and deep technology reasons. Biotech firms often include medical treatment and therefore require approval before being able to administer drugs to people. Biotech firms also require a lot of capital for R&D purposes. Discounting future cash flow based on medications or therapeutics is difficult because it is difficult to know if the idea behind a treatment is practical and needs that final regulatory approval. However, it is this difficulty that also leads to excess return if you invest in the “right” biotechnology company.

Cells

Investing in Biotech companies

The perhaps optimal approach for achieving high returns within the biotech space is leveraging private markets. The reason behind investing in private markets is that optionality is higher when companies are smaller, as company executives are free to explore and pivot without constraints. In addition, most biotech companies stay private before there is a clear opportunity to raise a lot of capital in the public markets, which often takes place after the successful drug development. Sadly, for regulatory reasons, private market investing in the US can only be accessed by individuals considered professional investors, which leaves public markets as the only option for most of us. Much of the optionality is reduced when a biotech firm enters the public market, but there are still opportunities for those interested in investing. Given that biotechnology investing is complex with binary outcomes, the best approach for a private investor to get exposure to is perhaps through a biotech ETF, which consists of a basket of biotech companies. If the total market value of Biotechnology is projected to increase, then an ETF following the development should see increase in flows. Personally, I follow a barbell approach meaning that I like to put in a small amount of money to potentially achieve a high upside. At the moment, I am considering biotechnology companies that deal with mental health, chronic disease and genetics, which consist of many unsolved problems. I want to contribute not only by writing nice posts on Instagram, but to use the capital I have to assist in R&D of new drugs so that people can live happy lives.

Medication

Conclusion

Hard working researchers and firms with vast resources have generated marginal improvements over the past 100 years, which is why we can now solve issues related to our health, agriculture and environment. As new biotech companies are created, the market capitalization of the whole biotech space should increase even if estimating the value of singular biotech firms is extremely difficult, as curing an uncurable disease is worth billions of dollars, but if the drug fails the company is worth nothing. The best approach to generate exposure to biotech is therefore to either have unique insights into a company or to use a basket ETF approach. The cool thing about biotech investing is that it can generate a high rate of return and at the same time help create a better world by funding drugs that can manage chronic diseases and lower mental health problems. The big picture question is whether biological science can be transformed into an information science. As Peter Theil says, can something that seems chaotic, fractal, and generally random be transformed into something more deterministic and more controlled?

[1] https://www.fool.com/investing/2021/05/13/3-mistakes-to-avoid-when-investing-biotech-stocks/ [2] https://www.gminsights.com/industry-analysis/biotechnology-market [3] https://www.cdc.gov/pcd/issues/2020/20_0130.htm#:~:text=In%202018%2C%2051.8%25%20of%20US,those%20living%20in%20rural%20areas. [4] https://www.nimh.nih.gov/health/statistics/major-depression [5] https://siblisresearch.com/data/us-stock-market-value/#:~:text=The%20total%20market%20capitalization%20of%20the%20U.S.%20stock,U.S.%20Market%28read%20more%20about%20OTC%20markets%20from%20here.%29