3 Easy Ways to Fail When Investing in Biotech Stocks

By Markets Fool.com

The biotech sector has the potential for outsized returns, but also extra risk not seen with larger pharmaceutical companies (and larger companies in general).

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Sometimes the easiest way to make money is to follow Warren Buffett's advice and not lose it in the first place. We asked some of The Motley Fool's biotech experts to weigh in on common mistakes investors make when investing in the industry.

Brian Orelli: It's easy to get emotional about biotech companies. Investors set out to make money, but once they learn more about the disease a company's drug treats, they often become passionate about the disease and lose sight of the bigger picture.

There is, of course, nothing wrong with altruism. But most people would be best off if they separated their "donations" from their "investments." If you care passionately about the fight against a disease, consider donating to a nonprofit that supports the effort rather than investing in companies that develop products used to treat the disease.

Passion can cloud your judgment about the likelihood that a drug will be approved. The Food and Drug Administration isn't nearly as compassionate; the agency's reviewers tend to see things in black and white.

Dendreon is a good example of this. Investors fell so in love with the idea of Provenge extending prostate cancer patients' lives that they lost sight of the fact that the company didn't have enough data to get the treatment approved the first time around.

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When kids are involved, it's even easier to get sucked in. Diseases such as Duchenne muscular dystrophy are heartbreaking, but that doesn't mean investors in BioMarin Pharmaceutical and Sarepta Therapeutics should expect the FDA to go easy on their DMD drugs.

: Biotech stocks aren't for the faint of heart, but some best practices can help you avoid companies headed for failure.

One statistic that doesn't get mentioned nearly enough is that more than 90% of drugs that enter phase 1 clinical trials never make it to market. Researchers say 30% of drugs fail during phase 1, while 60% of those that advance fail during phase 2. That means the odds are stacked against biotech stocks from the get-go.

It also means investors betting on companies with pipelines that are limited to preclinical or phase 1 drugs are taking on more than their fair share of risk. A better policy could be to wait until drugs enter phase 3. Of course, there's no guarantee of success in those late-stage trials, either: About 30% to 40% of drugs that reach phase 3 trials still end up in the waste bin. Still, by waiting to that point to buy, you have significantly decreased the odds that a pipeline failure will result in big investment loss.

Dan Caplinger:One pitfall applies to companies of all types but is particularly problematic with biotech stocks. If a company doesn't have enough cash on its balance sheet to finance its operations until it can become sustainably profitable, then it must find ways to raise that cash. Most of the time, a small company's options for raisingcapital will prove harmful for long-term shareholders.

Specifically, most small companies can't afford to use straight debt financing to get cash, as the interest rates needed for such loans would be too high for the company to maintain. As a result, many biotechs and other small companies instead offer equity, either through a straight secondary offering of shares or by using an equity kicker to a debt instrument, such as a convertible bond offering. Inevitably, the price at which the company offers additional shares is below the prevailing trading price -- often considerably below -- and the offering therefore pushes the share price down. More important, a greater numbers ofshares outstanding means you have to share the biotech's eventual success with a greater number of investors, and that makes the risk-reward proposition for a biotech stock far less favorable.

The answer is to look at a biotech's balance sheet and make sure it has ample cash reserves. That way, the chances of the company diluting your interest are a lot smaller.

The article 3 Easy Ways to Fail When Investing in Biotech Stocks originally appeared on Fool.com.

Brian Orelli andDan Caplinger have no position in any stocks mentioned. Todd Campbell owns shares of BioMarin Pharmaceuticals, which The Motley Fool recommends. 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.