Why I stay away from “playing short squeeze” on biotech companies – a cautionary tale on heavy equity dilution at biotech companies

Short squeeze saga continues – particularly today with a short segment on CNBC. They hosted a biotech “strategist” and the strategist laid out a few companies that could be ripe for a short squeeze – he mentioned a few names, including KPTI.

Chasing short squeeze has become a very fun sport that many traders like to play, and it is a fair game that punishes people who over-stayed on consensus / secular trades.

However, I don’t think biotech companies are great companies to play short squeezes. I tried with $VIR, and sold out immediately as soon as I remembered a few things that are SPECIFIC to biotech companies that are very different from others.

The key specific issues about biotech companies that makes these companies poor candidates for short squeezes are as follows – they contribute to essentially having infinite potential shares for biotech and even global pharmas.

BIOTECHS ARE ALWAYS PRINTING MORE PAPERS / SHARES

Short squeeze only happens if there are limited amount of shares – this essentially does not work with biotech companies. While biotech companies do have limited number of shares outstanding, they tend to be share printing MACHINES when they are pre-revenue or post-revenue.

The share issuance does take place a lot more in early stage, but we have seen even diversified, global pharmaceutical companies with profits issue shares to fund acquisitions – equity issuance of a mature company is almost unheard of non-pharma/biotech industries.

AstraZeneca is a $100bn+ global pharmaceutical company with very rich operating margin, but has done massive equity issuances for M&A TWICE over the past five years.

Most recently, they issued $25.9bn of equity to acquire Alexion.

A few years ago, they issued $3.5bn of equity to to acquire Enhertu – it is growing into a blockbuster drug, but sizable equity issuance was extremely surprising for investors.

Therefore, biotech/pharma management teams are very willing to issue more shares opportunistically – continuously increasing share count when they see greater demand for their stock.

BIOTECH INVESTORS/MANAGEMENT TEAMS ARE LESS SENSITIVE TO SHAREHOLDER DILUTION

I don’t think this is just specific to biotech, but more for fast growth industries in general. Many of the companies are cash burning and in order to minimize cash burn and attract talent to accelerate growth, they issue a lot of equity to employees, which results in shareholder dilution. Obviously mature companies give share-based compensation, but it is less dramatic than high growth industry.

As constant equity issuance is part of the normal operations, many of these companies and their investors are less sensitive to shareholder dilution. Also as many companies are running on net loss, investors do not care about EPS and increasing share count actually makes EPS better because you are dividing the net loss with greater number of shares.

This investor dynamic can make it easier for the board to issue more equity particularly given that R&D is an expensive endeavor.

“YOU RAISE WHEN YOU CAN, BUT WHEN YOU WANT TO”

Above saying is something I heard over and over when I ask management teams for rationale behind specific raise even though they had many years of cash runway on balance sheet.

This means market dynamics drive the timing for capital raise and because biotech companies always need more cash, they are always ready to raise equity.

These pre-revenue biotech companies have been fabulous piñatas (clients) for investment banks because they constantly raise money – in this game, EVERYONE THAT CONTRIBUTES TO DECISION-MAKING PROCESS FOR CAPITAL RAISE IS INCENTIVIZED TO ISSUE MORE STOCK, and therefore it is an EXTREMELY WELL-OILED MACHINE.

When the stock squeezes, the companies will be able to quickly take advantage of that situation and raise more equity. In these cases, it is EXTREMELY EASY FOR short sellers to get out because of how equity placement works in share offering.

For equity follow-on offerings, most of the allocations go to institutional investors who primarily constitute the short sellers. These short sellers just get the equity allocation through their relationship with investment banks and return those shares and close out their short position – without needing to buy much from the public market (which is essentially required for the squeeze to take place).

CONCLUSION

Playing short squeeze is a very hard game. As discussed in my other article, the group think is real – my former boss told me that he screens best short ideas by going through high short interest companies. In retrospect, that is a crazy idea, but that definitely contributed to the massive short squeezes that we saw in brick-and-mortal retail companies like GameStop ($GME).

I lost money on trying to play squeeze on $VIR, and I wanted to share my rationale for why I just walked away and cut my losses. You can keep playing short squeezes, but I am staying away from biotech companies. Best of luck to you all!

*not investment advice