5 Rules for Speculating in Biotech

This article published with permission from InvestmentU.com.

Perhaps more than any other sector, biotech is the toughest to game. When a company like Microsoft (Nasdaq: MSFT) releases a new product like Windows 8, people either buy it or they don’t. (Apparently, they don’t.) In biotech, releasing a product and hoping that people buy it is the last step in the process.

Before a company gets to the point of releasing a product, it must go through years of clinical trials, during which time all kinds of bad things can happen. The drug might not work, it might have horrible side effects or the company could run out of money, to name just a few.

Then, after years of trials and raising money, it has to face FDA approval. If the FDA has any unanswered questions, the drug will be rejected and the company will either have to provide the answers or run a new trial.

Finally, after FDA approval (and only one in 1,000 drugs from the earliest stages of clinical trials gets approved), the company releases the product and hopes that patients will buy it.

Because it can be difficult to figure out which companies and products are going to be successful … the rewards for success can be huge.

Blue chip biotech firms like Celgene (Nasdaq: CELG) and Biogen Idec (Nasdaq: BIIB) were once small-cap stocks trading in the low single digits. Anyone who bought shares years ago and held on is surely wealthy today.

So keep the following rules in mind when you’re searching for the next Celgene among the smaller-cap names:

1. Safety counts

The FDA is very conservative when it comes to safety. Most drugs will have side effects, especially cancer drugs, so you can’t avoid them altogether. But pay attention to severe adverse effects in clinical trials. The company may try to explain away the reactions but the FDA likely won’t accept that argument.

2. Phase II is the sweet spot

There are typically three phases of clinical trials. If a drug has good safety and efficacy results in phase II, that’s when investors often get excited about the drug. Therefore, you should consider selling into their excitement and exit the trade.

Once a drug progresses into phase III trials, there are enormous costs that go with it, and there’s always the risk that the drug will not duplicate the earlier successful results in a larger trial. And then there is the additional risk with FDA approval and success in the marketplace.

Many early investors in biotech firms, such as venture capitalists, sell their shares after a positive phase II trial. It’s a tough thing to do emotionally, because if you believe the company has the next great drug, the last thing you want to do is sell the stock before it even hits the market. But odds are you don’t have the next great drug. All you have is a drug that had strong phase II results. And that’s a very long way from being the next blockbuster.

3. Beware of salesmen selling snake oil

It’s unfortunate, but the biotech sector is filled with smooth-talking CEOs who can convince you their technology is the next great thing. Typically, the more boastful a CEO sounds, the more risk there is.

Take a company like ImmunoGen (Nasdaq: IMGN), whose T-DM1 for breast cancer is likely to be approved in March. CEO Daniel Junius — who I’ve spoken to several times (most recently at a cocktail reception in January) — is quietly confident about his drug’s prospects, but with no pompousness or guarantees.

T-DM1 appears to be a great drug that will help a lot of women and hopefully expand beyond breast cancer someday.

Compare that to the CEO I met a few years ago whose melanoma drug was in phase III trials.

“The drug is going to get approved,” he told me. “Look, it’s either water, or it’s not water. And we know it’s not water.”

He was right: water wouldn’t have harmed patients the way his drug did. They had to stop the trial early because patients who were on the drug were dying at a much faster rate than those on the placebo.

4. Placebo-controlled/double-blind is best

If you’re invested in a company that’s running a phase III trial, particularly in cancer, you’d like to see the trial design be placebo-controlled and double-blinded. That means the patients are divided into groups receiving the drug, and others receiving either a placebo or the standard of care. (In cancer trials it will be the standard of care, since it’s unethical to give a patient a placebo in that situation.) That way, the results of the drug can be compared to those receiving either no treatment or what is typically given to patients with the disease.

Additionally, neither the patients nor the company know who’s receiving which treatment. This increases the odds the results will be impartial and statistically significant.

5. Cash is king

These trials are expensive. Your company better have lots of cash on its balance sheet to pay for them (as well as to set up sales and marketing teams if the drug is approved). If it doesn’t have the cash, it will have to raise some, which it’ll usually do by selling shares and diluting shareholders.

Often, to reduce risk and the cash burn, a company will partner with a larger drugmaker, who will pay the smaller company some cash up front, milestones and royalties on any sales of the drug. In return, the larger company will keep the majority of the revenue. It’s a good way for the smaller company to reduce its risk and get some more cash on its balance sheet.

There is great money to be made in biotech if you know what you’re doing and can avoid the traps. Following the above five rules should give you an advantage over most investors who simply hear about a great drug and assume it’s going to be the next big thing. It usually won’t be, and they’ll get burned. And if you follow my advice, they may have even bought their shares from you.

Marc Lichtenfeld is the Senior Analyst at InvestmentU.com. See more articles by Marc here.