3 Warning Signs You've Invested in a Dangerous Biotech Stock

By Markets Fool.com

Continue Reading Below

Source: Flickr userepSos .de.

There might not be a bell that will ring to alert investors when they have put their money in the wrong biotech stock, but there are warning signals that can help them avoid owning the most dangerous biotech companies. Our Motley Fool contributors explain what these warning signals are and how to use them to reduce the risks that come along with investing in biotech stocks.

Cheryl Swanson: Biotech is a risky business, and the rapid exit of a CEOcan signal major turbulence ahead, as with the high profile case of Dendreon. If top management's exit is coupled with a heavy debt load -- as was the situation whenDendreon'sCEO John Johnson exited in June of last year -- watch out. The company may be heading straight for the rocks.

When Johnson said his goodbyes, the cancer vaccine maker had $620 million in convertible debt and a market cap of $350 million. Still, the company had seen success in the clinic, and that is often equated with success for biotech investors.

Dendreon was a pioneer in immunotherapy, and its prostate cancer vaccine, Provenge, was once expected to be a blockbuster. Johnson did what he could for the company, including securing marketing authorization for Provenge in the European Union. But the sales ran into trouble right away, due in part to the drug's whopping $93,000 price tag.

Continue Reading Below

Five months after Johnson left, on Nov. 10, the company plunged 81% after it filed for bankruptcy. This is just one instance, and not every CEO departure means imminent failure, but big shifts in management should always raise warning flags, especially when coupled with debt.

Leo Sun: Large pharmaceutical companies are constantly looking to offer marketing partnerships tosmaller biotech companies, which reduce research and development costs at the larger company while injecting the smaller one with cash. But when partnerships are dissolved and drugs are returned to a company, a smaller company (especially one with a narrow pipeline) could be gutted.

For example,GlaxoSmithKline handed the failed Duchenne muscular dystrophy drug drisapersen back toProsensa Holding last January. Since drisapersen was Prosensa's lead candidate, the company's stock plummeted 85% in the two months following the announcement. Fortunately, BioMarin Pharmaceutical agreed in November to acquire Prosensa for up to $840 million, helping shareholders recoup some of their steep losses.

Another example from last year was the end of a partnership betweenRoche and Inovio Pharmaceuticals . Inovio's core pipeline consists of immunotherapies for hepatitis B and C, cancer, and even HIV that are derived from synthetic DNA and delivered via electrical pulses.

The problem is that Inovio has not had a single drug approved since being founded over three decades ago. That's why investors perked up when Roche and Inovio inked two collaborations for prostate cancer and hepatitis B vaccines in September 2013, which included an up-front payment of $10 million and $412.5 million in potential milestone payments. But Roche abandoned the prostate cancer partnership in November, eliminating a large portion of those payments and casting doubts on Inovio's other pipeline candidates.

Therefore, if one of your smaller biotech bets loses a major pharma partnership, it could be time to reevaluate your investment.

Todd Campbell: Relying on the old maxim "cash is king" might keep investors from getting stuck in a soon-to-fail biotech company.

A strong balance sheet is critical to biotech companies, given that most are emerging businesses without approved revenue-producing products and are spending big bucks on research and development. According to the Tufts Center for the Study of Drug Development, it costs drugmakers $1.395 billion to develop one drug; that steep price tag means biotech stocks have little room for mistakes, particularly if research pipelines are a bit thin.

As a result, investors should pay particular attention to biotech stocks' cash burn rate per month. To calculate that rate, simply divide the change in cash for a specific period by the number of months in that period. Once you have the monthly burn rate calculated, you can divide cash on the balance sheet by the rate to see how long the company can spend at that pace before tapping investors or banks for additional capital. I become most nervous when a company has six months or less of cash, particularly if its drugs are still in midstage trials and debt levels already exceed the cash on the books, which could signal that investors and lenders might become increasingly unwilling to provide financing.

The article 3 Warning Signs You've Invested in a Dangerous Biotech Stock originally appeared on Fool.com.

Cheryl Swanson has no position in any stocks mentioned. Leo Sun owns shares of GlaxoSmithKline. Todd Campbell is long BioMarin. The Motley Fool recommends BioMarin Pharmaceuticals. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.