It's awfully tempting to fill your portfolio with biotech stocks. Biotech investors who find the next breakthrough stock are able to double, triple or quadruple their money almost overnight.
For example, shares of Dendreon (Nasdaq: DNDN), a maker of a drug that treats prostate cancer, soared from under $3 in March 2009 to above $20 a month later as tests showed that its drugs helped extend lives. (The shares eventually moved past $50 but have recently plunged as doctors are slow to prescribe the $90,000 drug.)
In the biotech industry, risk clearly equals reward. But companies with drugs that have yet to undergo clinical testing are at the beginning of a very long road before they may secure actual product sales.
Passing the Biotech Drug Test
First, the company must perform 'pre-clinical' testing to prove that the drug isn't fatal and doesn't have serious side effects. Then it must register the drug with the Food & Drug Administration (FDA) to conduct three more phases of rigorous trials, which include:
Phase I -- A bigger trial that looks at the drug's efficacy and safety as compared to a group taking a placebo. The primary focus remains on safety.
Phase II -- Uses a larger sample of patients (often 100-200 people) to see if the drug tangibly improves patient outcomes while also avoiding adverse affects. This is the hardest hurdle for a drug to pass, and many wash out at this point simply because they fail to prove any real benefit.
Phase III -- These are far larger drug trials and can often involve several thousand patients. The tests try to determine if the new drug is clearly better than an existing drug on the market. Due to the sheer size of these tests, firms often need to spend a lot of money to complete them. Luckily, by Phase III, investors start to expect that the drug could eventually reach the market, so raising money can be a bit easier. If all checks out, the drug may soon be on a path for FDA approval.
Simply getting past these clinical hurdles is only part of the problem. The other involves cash.
Securing Biotech Drug Funding
Biotech firms spend tens of millions of dollars to bring a drug to the market. Because of these huge cash needs, most need to keep going back to the public for fresh injections of capital. As an alternative, they can find a strategic partner, usually a large, well-established drug firm, that can pay for the drug's further development in exchange for rights to sell the drug (and pay royalties) if it is approved.
In many instances, such a partnership is a prelude to an outright acquisition of the young biotech firm.
Does Risk Equal Reward?
As companies advance through the clinical trials, the share price upside is no longer as good as an early-stage biotech play. But, on the other hand, risk is also reduced. The key risk following clinical trials is money (beyond the obvious risk that the drug does not get approved). Many promising biotech firms run out of cash before they can reap financial reward.
That's why you need to carefully study the balance sheet of a biotech firm. As a general rule, avoid biotech stocks that have less than one year's worth of cash -- known as the burn rate.
If a company has $20 million in cash and is burning $10 million every quarter (a $40 million burn rate), chances are almost certain that the company will have to raise more funds by selling more shares. This dilutes the value of the shares earlier investors already own. And that has often pushed a stock down very quickly.
[InvestingAnswers Feature: How to Win With Biotech Stocks... and Avoid the Risk]
The Best Way to Play Biotech Stocks
Early-Stage Companies: Early-stage plays require a certain kind of investor with a strong background in this area -- and a healthy appetite for risk. Unless you have the experience to successfully navigate these waters, you might be better served to move on to a less volatile stage in the drug development process.
Middle-Stage Companies: For Phase II biotechs, look for companies with diverse investments in a number of smaller biotechs with drugs in Phase II or later clinical trials. Additionally, look for stocks widely believed to be undervalued by analysts. For example, Ligand Pharmaceuticals (Nasdsaq: LGND) has investments in more than 50 biotechs with drugs in Phase II or later clinical trials. Shares are valued at around $12, but Jeff Cohen, who follows biotechs at Ladenburg Thalmann, thinks all of those stakes are worth a collective $21.
Late-Stage Companies: To find the best Phase III biotechs, look at companies that offer innovation as part of their research and development (R&D). A healthy amount of cash on hand to outpace their burn rates is also a key component.
Celsion Pharmaceuticals (Nasdaq: CLSN), for example, uses heat-sensitive nano particles to precisely place cancer-treatment drugs within tumors. The company has secured patents in the U.S. and Japan and is now currently undergoing 600-patient Phase III trials for the treatment of liver cancer.
The FDA has given Celsion 'fast-track status' for its liver cancer Phase III test, which is a huge endorsement of the technology and may pave the way to an expedited approval.
As it stands, the current cash balance equals about four more quarters using an annualized burn rate of about $23 million. That burn rate would sharply accelerate if and when FDA approval comes. Biotech investors like catalysts, and Celsion's interim update on Phase III trials, due in September, looks like a solid one.
The Investing Answer: Investing in biotechs holds plenty of promise for investors, but also ample peril. Luckily, there are stages of investing that suit all investor types. For the risk averse, taking a position in middle and late-stage companies can help mitigate the downside, while keeping the potential reward. For those with stronger stomachs, early-phase investments offer the greatest potential returns.
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