If you regularly scan the list of the biggest gainers and losers in any given quarter, you'll notice that many of the stocks are in the biotechnology sector. Share prices for these speculative biotech stocks can move up or down 30% or 40% -- in a day! That kind of move usually comes with the news of success or failure of a key drug in development. Find a winning biotech drug and you could see your investment swell 200% or even 300% over time. Bet on a loser and your investment may be wiped out.
Sounds scary, doesn't it? That's why many investors shun biotech stocks, while others swear by them. But there is a middle way. You can deploy several strategies that reduce the risk -- but also reduce the upside -- while gaining access to this important sector.
Why Biotech?
Major drug companies such as Merck (NYSE: MRK) and Pfizer (NYSE: PFE) haven't had a lot of recent success in their drug development process. And many key profitable drugs, such as Lipitor, are set to lose patent protection soon. Forget about growth prospects for these major companies, what about shrinkage prospects?
Merck and Pfizer are expected to see sales fall roughly 2% in 2011, with forecasts for even bigger drops in coming years. Their only path to growth is to partner up with small biotech firms that are working on tomorrow's blockbuster drugs. The big drug companies can offer to help market and distribute a biotech's drugs or they can acquire the company outright. Those are the typical exit strategies for most biotech firms.
Playing the Phases
To gain approval from the Food & Drug Administration (FDA), a biotech drug must be tested in three successively larger clinical trials, known as 'phases.' The first hurdle simply needs to prove that a drug has a positive impact on a patient. The second phase examines how that drug fares in a larger trial against placebos. The third -- and most challenging -- study subjects the drug to a much larger trial, where safety, toxicity and efficacy are all measured.
Unless you possess a tremendous amount of medical and pharmaceutical industry knowledge, you should probably steer clear of any biotech firms that are still in either pre-clinical or Phase 1 trials. Positive results from those early tests can send a stock soaring, but many of those same drugs fail to replicate their promising results as the Phase 2 and Phase 3 trials get underway. These days, the FDA is tougher than ever, concerned not just with safety, but also whether a new drug is notably better than an existing drug already on the market. Even if they're positive, early testing results are still too risky to bank on.
When a company releases positive Phase 2 trial data, investors start to get excited. This is when you should start paying attention. You'll want to see proof that the drug trial has turned up unequivocally strong results. Earlier in 2010, companies such as Arena Pharmaceuticals (Nasdaq: ARNA), Orexigen (Nasdaq: OREX) and Vivus (Nasdaq: VVUS) captured significant investor buzz with new drugs that helped fight obesity. Investors figured the size of the potential market was enormous. However, they overlooked the fact that the drugs had a few troubling side effects and yielded only modest results for weight loss. Later in the year, all three stocks were crushed when the FDA ruled against approval.
Once a biotech drug has secured positive results from Phase 2 testing, things really get interesting. That's when investors start to handicap the likelihood of ultimate success, the potential size of the market opportunity and the potential for partnerships with, or an outright sale to, a major drug company. The key is to find companies targeting unmet or underserved needs.
Savient Pharmaceuticals (Nasdaq: SVNT) serves as an interesting example. It has received FDA approval for the treatment of advanced forms of gout, a crippling form of arthritis. Investors bid up shares of the company, figuring a suitor would pay $20 or even $25 a share for the company. Unfortunately, no such suitor emerged. Savient eventually announced it would build its own sales force to sell the drug. Shares took a big hit on that news, which tells you that hoped-for partners may never materialize. However, a number of biotech watchers find shares to be appealing -- even without a sale of the company -- based on strong trial results or market potential.
The Pros and Cons of Biotech
Before jumping into biotech stocks, you should become better educated about the many pros and cons about the sector. For example, you'll learn to become aware of a company's financial strength: If a biotech firm needs to spend another $100 million to fully test a drug, and only has $50 million in the bank, you'll want to know how they plan to close that funding gap.
When assessing particular stocks and drugs, you'll want to know how other existing drugs are already faring in the market. For example, many popular and effective statins (an enzyme inhibitor for reducing cholesterol) have lost or are losing patent protection. Not only do any new statin drugs in development have to prove that they are even more effective, but they will be facing much cheaper solutions that already exist on the market.
Although the rewards can be enticing, biotechs are not for every investor. If you want to avoid the risk of company specific investing, you can go with exchange-traded funds (ETFs), such as the iShares Nasdaq Biotechnology ETF (Nasdaq: IBB) or the PowerShares Dynamic Biotech ETF (NYSE: PBE). You can also let fund managers do the legwork. Morningstar recommends the Franklin Biotechnology Discovery Fund (Nasdaq: FBDIX). The Fidelity Select Biotechnology Fund (Nasdaq: FBIOX) is also worth a look.
