How To Avoid The Dumbest Mistake Of 2009

Last year, several large hedge funds made one of the dumbest moves I’ve ever seen.

The result will probably be the wipeout of their shareholders and their reputations. The tragedy is centered on one of the most popular stories in all of biotechnology… the story of Sequenom (SQNM).

Last year, Sequenom was perfecting a technology to collect a fetus’ genetic information directly from its mother’s blood. A breakthrough here could spawn a new generation of faster, cheaper, and less-invasive prenatal diagnostic tests.

Current procedures involve sticking needles into the womb to extract fetal cells. These procedures are accurate, but they’re expensive. They also carry the risk of miscarriage.

You can imagine the excitement when Sequenom announced 100% detection rates and few false positives in its earliest clinical trials for its Down syndrome test.

Wall Street analysts published frothy sales models and predicted Sequenom would become the dominant player in the existing $2 billion prenatal diagnostic market. Even bigger, they predicted the company would triple industry sales as more patients signed up for the test.

During the bear market of 2008, Sequenom stock skyrocketed from $5 to $10 to $15… finally peaking around $25 in the third quarter.

I was skeptical of the whole thing. First, the early test results included less than 900 patients. That’s way too small a number to warrant such confidence. And the company decided to move forward with a commercial launch in June 2009, despite the small trials.

The second red flag came when the company said it would develop a DNA-based test to complement its RNA test. The announcement came on the heels of a failed bid for a patent portfolio related to prenatal testing. Sequenom claimed its new test had nothing to do with intellectual property rights, but it smelled fishy.

Nevertheless Sequenom emerged as the latest hedge fund fad. Ridgeback Capital scooped up more than 10 million shares, a 17.4% stake. The position represented more than 90% of Ridgeback’s total capital. And RA Capital poured 50% of its fund into Sequenom, securing a 10% stake.

You can see where this is going…

As much as I like to find incredible growth stocks for my readers, I sat on the sidelines during Sequenom’s rally. I told my friends to do the same. Expectations were way too high. The stock offered little reward for taking on a whole lot of risk. It had too many “torpedo factors” - too many things that could go catastrophically wrong. For example, Sequenom could have been “torpedoed” by reports of false positives or negatives. Or by a patent dispute. Or by a few rogue employees…

On April 30, Sequenom announced it was throwing out all data related to its Down syndrome test. It cited “employee mishandling” of data and launched an internal investigation for possible fraud. It couldn’t rule out the possibility that the rest of its testing portfolio (ranging from cystic fibrosis to sex determination) was tainted as well. Sequenom’s stock plummeted 80% overnight.

I have nothing against the people at Ridgeback or RA Capital. But I don’t see how they will survive this year. It’s just crazy to put a huge chunk of a portfolio into just one stock… especially a biotech stock.

And Sequenom? Its future is also in doubt. The multiyear delay will give its competitors plenty of time to get their own technology to market.

Before you buy any stock - especially a biotech - develop a set of “torpedo factors” that could sink the stock. Even if it survives that torpedo test, never, ever place more than 10% of your portfolio into it. Most people would do best to never put more than 2% of their portfolio into a speculative stock.

Companies with Sequenom-like potential can turn out to be “once in a lifetime” investments. But remember your torpedo factors. Keep your position sizes small. And always keep in mind the classic investor’s question: “How much do I lose if I’m wrong?”

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