Here’s an important trend in the investment world right now: the recent buyouts of small-cap biotech companies like Idenix (NASDAQ: IDIX) and Intermune (NASDAQ: ITMN). Why so many pharma deals?

Merck, one of the world’s largest drug companies in the world, has agreed to pay about $3.85 billion to acquire Idenix Pharmaceuticals. Idenix is the developer of an important drug for hepatitis C, a disease that affects millions and can result in liver failure. That purchase price is more than triple the closing price of Idenix shares on the preceding Friday.

Idenix has never generated a profit, but its pharmaceutical portfolio is so promising that Merck was willing to pay a hefty premium to acquire the company.

Around the same time, we learned that Intermune, a Brisbane, California-based company will also be gobbled up by a larger rival. Intermune has been developing drugs to address various lung diseases, including the often fatal pulmonary fibrosis.

This attracted the attention of Roche Pharmaceuticals, a Swiss drug maker that already sells widely used medicines for cystic fibrosis and for severe asthma. Roche has announced it plans to buy Intermune for $8.3 billion, a 38% premium to its closing price.

This trend will likely continue. Roche CEO Severin Schwan told the press that the deal “exemplifies the Roche strategy” of targeted acquisitions that match up with the salespeople and research infrastructure it already has. Lots of other top pharmaceutical managers are probably thinking the same way.

Roadrunner Stocks has two biotech companies in the momentum portfolio – ANI Pharmaceuticals (NASDAQ: ANIP) and Anika Therapeutics Inc. (NASDAQ: ANIK). We also have one in the value portfolio – United Therapeutics Corp. (NASDAQ: UTHR).

Any one of these could be an attractive takeover target for a larger company. More importantly, all have established strong track records of developing medicines that will ensure their profitability for years to come.

For example, Anika Therapeutics is a pioneer in developing therapeutic products for tissue protection, healing and repair. Last February, the FDA approved Monovisc, Anika’s single injection supplement to the osteoarthritic joint, used to treat pain and improve joint mobility in patients suffering from osteoarthritis of the knee. The company is profitable (24% return on equity), has 18% insider ownership, and no debt. Looks like a “quality” momentum stock to me!

Also, ANI Pharmaceuticals is a biotechnology company that both develops its own proprietary drugs (e.g., female sexual dysfunction) and provides contract manufacturing services to other drug companies. The company merged with BioSante Pharmaceuticals in 2012.

Valuing Stocks: Look for Predictable Earnings

In How to Value a Stock Using the Income Statement, I discussed the conflict between (1) the theoretically-pure way to measure the value of a business as an ongoing concern – i.e., discounting the company’s annual free cash flows in perpetuity at an interest rate that accounts for business risk – and (2) the practical difficulties of accurately estimating either future business risk or the company’s annual cash flows over the next 10 years let alone in perpetuity.

Given the practical difficulties of accurately estimating a multitude of future data points, a short-cut method that many smart investors use to value a stock is to limit the estimation process to a single number — a snapshot multiple of a company’s current earnings (or EBITDA or free cash flow or book value).

On the surface, estimating a single number is easier than estimating multiple numbers, but the reality is that this distinction is somewhat illusory because several data “inputs” must be estimated in order to generate the single “output” multiple. Most important inputs are future earnings growth and cost of capital (i.e., business risk). Earnings growth may reasonably be estimated from past experience if the company’s business is stable, but business risk is a slippery measure that can easily be overshot or undershot.

Because of the inherent uncertainties in estimation, I previously wrote that: I would only consider using a P/E ratio on stable stocks with a prolonged operating history and a modicum of earnings-growth reliability.

Earnings predictability simply means that a company’s earnings have historically grown in a consistently stable pattern that is likely to continue in the future.  In contrast, a 2008 study found that corporate earnings that are very volatile over the past five years – jumping up and down haphazardly from one quarter to the next – typically signal uncertainty and unpredictable earnings for five years into the future.

Earnings volatility captures the effects of real and unavoidable economic volatility. Intuitively, firms operating in environments subject to large economic shocks are likely to have both more volatile earnings and less predictable earnings.

The volatility of reported earnings also reflects important aspects of the accounting determination of income. One such aspect is the quality of matching of expenses to revenues. Poor matching acts as noise in the economic relation between revenues and expenses, and thus the volatility of reported earnings increases in poor matching. Poor matching is also associated with poor earnings predictability because the matching noise in reported earnings obscures the underlying economic relation that governs the evolution of earnings over successive periods.

Earnings volatility not only reduces earnings predictability, but it also signals a company without a competitive advantage that has no control over pricing or a loyal customer base, but is vulnerable to the whims of a commoditized marketplace. A 2011 study found that the stocks of companies with high earnings uncertainty significantly underperform the stocks of companies with predictable earnings and that high earnings volatility “strongly predicts lower future earnings.”

This helps explain “the greatest anomaly in finance”, where stocks with low betas (a measure of price volatility relative to a benchmark index) have historically outperformed high-beta stocks. Roadrunner’s six-point safety-rating system awards a safety point to low-beta stocks because of this outperformance potential.