Successful investing boils down to minimizing risk while maximizing the potential for reward. That's true whether you're investing in stocks, bonds, cryptocurrencies, or anything else. But how you actually go about it can vary based on what your investment is.
Biotech has its own unique requirements for minimizing risk and maximizing the potential for reward. Here are seven essential rules for investing in biotech stocks that should help you increase your chances for success. All you have to remember is B-I-O-T-E-C-H.
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1. Be aware of the stage of the company
The first essential rule for biotech investing makes a difference in how several of the other rules are applied. There are three general categories of biotechs: preclinical stage, clinical stage, and commercial stage.
Preclinical-stage biotechs don't have a product in human testing yet. These will be the most risky stocks to buy, since most preclinical drugs never make it to market. Clinical-stage biotechs can vary from companies with experimental drugs in early, phase 1 clinical studies to those with drugs that are in late-stage phase 3 studies. In general, the farther along a biotech's drugs are in clinical testing, the less risky the stock will be. Keep in mind, however, that over 35% of phase 3 drugs, on average, don't move forward.
Commercial-stage biotechs are usually the least risky investments, because they have one or more products on the market. However, even biotechs with approved drugs can face challenges with their commercial launches. For example, MannKind(NASDAQ: MNKD) won FDA approval for inhaled insulin Afrezza in 2014, but sales for the drug totaled less than $3 million in the first half of 2017.
2. Investigate the disease(s) targeted by the biotech
If you want to gain a solid understanding of a biotech stock, you need to understand the disease(s) that the company is targeting. One important reason for doing this is to get a feel for the market potential for the biotech's drugs. There is a counterintuitive dynamic in the biotech industry, though: Very small markets can sometimes be the most lucrative markets.
Sarepta Therapeutics(NASDAQ: SRPT) is a great example of this dynamic. The biotech primarily focuses on development of treatments for Duchenne muscular dystrophy (DMD), a rare genetic disease that affects less than 20 out of every 100,000 live births. But because insurers and other payers are willing to reimburse at a high rate for Sarepta's Exondys 51 treatment, the biotech made over $51 million in sales during the first half of this year -- much higher than that of MannKind, even though it targets diabetes, a much more prevalent disease.
3. Observe who the competitors are
After investigating the disease(s) targeted by the biotech, you'll want to find out who the company's competitors are. One reason why Sarepta has enjoyed more success than MannKind has, for example, is that it doesn't have any real competition in the U.S. Exondys 51 is the first drug approved in the U.S. for treating DMD. MannKind, on the other hand, faces competition from quite a few large drugmakers with products targeting the diabetes market.
Don't forget to research potential competitors in addition to current competitors. In many cases, other biotechs could be developing experimental drugs targeting the same indications -- and sometimes even using the same mechanism of action. Knowing who the current and potential competitors are is a critical step even if the biotech you're interested in is a well-established company.
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4. Thoroughly review all clinical results -- and what others are saying about them
Biotech stocks live or die based on clinical results, especially clinical-stage biotechs. Keep your eyes open for when the company reports results from any of its clinical studies. When results are announced, thoroughly review them. If you don't understand some of the scientific details, information is often available online to help you decipher the results. It's also important to find out what others are saying about the results.
A good case in point is with phase 2 results presented by Corbus Pharmaceuticals(NASDAQ: CRBP) earlier this year. Corbus announced what it called "positive results" for anabasum in treating cystic fibrosis (CF). However, if you read the report closely and researched what others saw in them, you would quickly learn there were significant questions raised by the phase 2 data about the efficacy of anabasum.
5. Examine who the partners are
One thing I like to do with clinical-stage and preclinical-stage biotechs is to examine who the companies' partners are. When a big pharma company partners with a small biotech, that's often a good sign about the potential for the small biotech -- especially when there's an equity investment included in the deal.
It's also not a bad idea to identify the partners for a big biotech. For example, I view Celgene's (NASDAQ: CELG)wide array of partnership deals, mainly with smaller companies, as a big plus for the company's future prospects. And if Celgene announces a collaboration with a smaller biotech that is accompanied by an equity investment, I definitely flag that biotech for further attention.
6. Check out the financials
Regardless of the size of the biotech stock you're evaluating, be certain to check out the financials in detail. For small companies, pay especially close attention to how much cash is on hand and how quickly they're burning through cash.
For example, MannKind's stock has skyrocketed recently. However, I suspect that momentum-zapping dilution could be on the way from a stock offering, because MannKind only had $43.4 million in cash and cash equivalents at the end of the second quarter and is burning more than $30 million per quarter.
As for big biotechs like Celgene, examining the financials could provide a hint of what could be on the way. Celgene had over $10 billion in cash, cash equivalents, and marketable securities at the end of the second quarter. Even better, its revenue and earnings are growing quickly. This could mean there's a good chance that further acquisitions and/or licensing deals are on the way.
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7. Hope for the best, but prepare for the worst
Finally, while you always should hope for the best, it's wise when investing in biotech stocks to prepare for the worst. MannKind landed a big partner for marketing Afrezza, only to later lose that partner. Sarepta barely won approval for Exondys 51 after an FDA advisory committee voted against approval.
Practically speaking, this rule means that you shouldn't put too much money in one biotech stock. Even with thriving companies like Celgene, there's always the possibility that pipeline candidates could fail. The rewards of investing in biotech stocks can be tremendous, but the risks can be tremendous, too. Remember that biotech investing, like any other kind of investing, all comes down to managing risk.
Keith Speights owns shares of Celgene. The Motley Fool owns shares of and recommends Celgene. The Motley Fool has a disclosure policy.
