(Yicai Global) May 24 -- Retail investors unfamiliar with the biotech industry must be cautious when making investment decisions and may consider investing in biotech firms lining up for listing in Hong Kong when the sector becomes fully mature, warned Charles Li, chief executive officer of Hong Kong Exchanges and Clearing Ltd., HKEX.

"There is a lot of excitement in our market over the new rules we introduced earlier this month to welcome new economy and pre-revenue biotech companies," said Li on his blog yesterday, while explaining "ups and downs of biotech."

"We have a lot of retail investors in our market and a strong regulatory regime that strives to protect investors as much as possible -- but there are still inherent risks when investing in any company," he said. "Biotech, in particular, is one field where companies could become a wild success or flame out into nothing, quickly."

Compared with other industries, investing in biotech involves some particular risks, Li said. Biotech companies face a long research and development cycle in developing products. It could take three to four years or even 10 years to develop a new drug and ultimately receive an approval to sell it in the market.

Moreover, these products are strictly regulated by the governments as they involve public health. It is almost impossible for biotech firms to generate revenues before they receive production approvals. Therefore, they need substantial funds to research and develop products, said Li, adding biotech companies also face high risks of R&D failures.

Investing in biotech could also involve two types of market risks: stock price volatility and insider trading. Whether biotech companies can successfully develop new products and secure approvals for such products will determine their survival, Li said. Any information about product R&D and the regulatory approval processes can easily cause share prices to fluctuate sharply.

The biotech sector is also significantly more susceptible to insider trading than other sectors since the sector requires very specific expertise and has severe information asymmetry, he warned.

Why to List Them?

Li also explained why HKEX list such biotech companies despite all those risks. "There is growing demand for new healthcare products and services to meet the needs of China's middle class, which numbers some 400 million people," he said. "Because of their potential to change people's lives, heal ailments, cure diseases, and allow us to live healthier, happier and longer, it is important that we connect the capital market with the biotech industry so emerging companies in need of investment have access to capital."

Though HKEX has set an entry bar on biotech companies seeking a flotation and requires that pre-revenue biotech firms shall have a market cap of no less than HKD1.5 billion (USD191 million) upon floating, the biggest difficulty lies in evaluation, Ren Xiufen, managing director of the corporate financing division of Yunfeng Financial Group Ltd., told Yicai Global.

Discounted cash flow, DCF, analysis is currently the most widely used method of valuing companies. However, such method requires that companies have income and profits, so it is very difficult to determine biotech firms' valuation using the DCF method, Ren said.

For biotech companies, valuation is not a very difficult problem as industry experts usually value a biopharmaceutical firm by considering their drugs' chance of success in the market, an industry insider told Yicai Global.

However, such valuation methods are very complicated, and analysts with professional expertise are needed to carry out research as even a small deviation could have a big impact, the insider said, adding that biotech is, therefore, not a sector that retail investors can easily enter.

Editor: Mevlut Katik