5 Steps To Buying Biotech Stocks

By Todd Campbell Markets Fool.com

Image source: Getty Images.

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Biotech investing is risky. Very risky.

Historically, only 10% of drugs in clinical trials make it to market, and with steep odds like that, it's easy to understand why biotech stocks are more prone to significant pops and drops than stocks in other industries.

Because of all this, biotech companies are risky in fact, theyre the riskiest healthcare stocks. But fortunately, heres a quick little guide to help you pick the best biotech stocks.Clinical trial uncertainty means that there are no sure things when it comes to biotech investing, but if you follow these five steps, you may boost your odds of finding good stocks.

No. 1: Avoid the drug hype

Because it's hard to develop new game-changing medicines, small successes can lead to big rallies in stocks even if those successes occur in early-stage trials. While it may be tempting to buy news of a phase 1 trial success, investors are often better off sitting on the sidelines until results roll in from larger phase 2 and phase 3 trials.

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In most cases, the FDA won't consider a drug for approval until it's proved itself to be effective and safe in a phase 3 study, and since phase 1 and phase 2 trials are typically exploratory and involve only a limited number of patients, they aren't necessarily a good proxy for phase 3 success.

Any number of efficacy and safety roadblocks can emerge in late-stage studies that didn't show up in earlier-stage studies, and when that happens, a biotech's shares can fall precipitously. Rather than take the risk ofcozying up to a high-flyer only to see your investment wiped out by a mid- or late-stage stumble, wait for the drug to prove itself in phase 2 or phase 3 before buying.

No. 2: Watch for biotech stock cash burn

A promising drug pipeline may be alluring, but if that company's balance sheet isn't flush with cash, a stock offering that dilutes your ownership may be on the horizon.

To evaluate a biotech's financial footing,add together the company's quarterly cash and cash equivalents and divide that figure by the company's quarterly total operating expenses.Doing this will give you an idea about how long the company's cash stockpile will last.

A company's cash and equivalents is disclosed in its quarterly balance sheet, and operating expenses can be found in the company's quarterly income statement. If the calculation suggests that the company may face a cash crunch within a year or two, it's likely management will need to tap equity markets or debt markets for additional financing.

That's not necessarily a bad thing. After all, drug development isn't cheap. But it could signal a red flag, especially if a lot of shares would need to be issued to raise a substantial amount of money or expensive debt leads to sky-high quarterly interest payments.

Also, while some clinical-stage biotech stocks may report revenue from collaboration or licensing deals, it may be best to avoid extrapolating that revenue into the future. Often, revenue from these agreements can vary widely fromquarter to quarter, and therefore, it's risky to count on it.

No. 3: Avoid new biotech companies (look for experience)

There's no guarantee that a company that's successfully developed a top-selling drug in the past will do so again in the future, but experienced management can avoid pitfalls that may otherwise derail less experienced peers.

In considering management, look for leaders who have a history of ushering drugs through the FDA and unlocking shareholder value either through M&A or profit growth. Solid management teams understand the challenges associated with drug development, the benefits of selling to larger peers at the right time, and the necessity to approach spending judiciously.

While management changes over time, a few examples of highly successful leaders worth following include billionaire healthcare entrepreneur Phillip Frost, CEO of Opko Health (NASDAQ: OPK), and Mark Alles, CEO of Celgene Corporation (NASDAQ: CELG).

Frost is best known for selling IVAX Labs to Teva Pharmaceutical for $7.4 billion in 2006 and for serving as chairman of generic-drug giant Teva Pharmaceutical, but investors may want to focus on what Frost's up to now.

At Opko Health, Frost's orchestrating a flurry of M&A deals that he hopes will turn Opko Health into a top-tier diversified healthcare company. His deal-making has landed Opko Health intriguing drugs, including the recently FDA-approved vitamin D prohormone Rayaldee, and a market-leading position in lab services via the specialty lab company Bio-Reference Labs.

Over at Celgene, Alles has been a key cog in the launch of multiple top-selling drugs, including the $6 billion multiple myeloma drug Revlimid. Before launching Revlimid in 2005, Alles joined Celgene as vice president of global marketing in 2004. Alles has also had a hand in the commercial success of Celgene's Abraxane, Pomalyst, and, most recently, Otezla. Pomalyst is already a billion-dollar blockbuster, Abraxane is nearly a billion-dollar blockbuster, and Otezla is nicely on track to become a billion-dollar blockbuster.

Admittedly, there's no telling if these two leaders -- or anyone else -- can repeat their previous successes, but experience may improve their odds.

No. 4: Investing advantage

It can cost hundreds of millions of dollars to successfully create and commercialize a new drug, so company's that already rake in billions of dollars in sales from commercial-stage drugs have a significant advantage over clinical-stage companies.

Blockbuster drugs produce cash flow that can keep R&D efforts humming along, and that can be used to license drugs in development or buy competitors lock, stock, and barrel.

One of the most successful examples of this is Gilead Sciences' (NASDAQ: GILD) $11 billion acquisition of hepatitis C drug developer Pharmasset in 2012. Thanks to billions of dollars in revenue for top-selling HIV medications,Gilead Sciences was able to outbid its peers and get its hands on the drugs that eventually became the megablockbusters Sovaldi and Harvoni. Sovaldi and Harvoni have gone on to add tens of billions in sales to Gilead Sciences' top line, includingnearly $20 billion in 2015 alone.

While deep-pocketed companies like Gilead Sciences have an advantage, investors should remember that biotech research moves quickly and patents on existing medicines don't last forever.Drugs that are racking up blockbuster sales today can see those sales disappear rapidly once patents expire, and cheaper generics are introduced. Because of that risk, always consult a company's annual report to find out when patents expire. Doing so can help keep you from buying a biotech stock right before its cash flow is about to dry up.

No. 5: Patience

Biotech stocks' volatility means that investors in even the best stocks can be whipsawed by quarter-to-quarter or year-to-year returns.

While it may be frustrating to buy a biotech stock with a solid balance sheet, proven leadership, and top-notch products only to see its share price fall, overreacting to a biotech stock's slumping share price could make you miss out on big long-term gains.

For example, if you bought Celgene shares on the day that Revlimid won approval in 2005, you'd be sitting on a 624% return. However, you would have had to suffer through 28 separate months in which Celgene's share price fell by more than 5%, including five separate months when shares lost more than 15% of their value.

Similarly, if youbought Regeneron Pharmaceuticals' (NASDAQ: REGN) in 2011 after the FDA's advisory committee unanimously voted to recommend for approval the company's wet age-related macular degeneration drug Eylea, you'd be sitting on a 619% return. However, you'd have had to sit through 17 different monthly declines of 5% or more (including a 22% drop earlier this year) to have gotten that return.

Althoughsticking with winning stocks through the tough times can be difficult, the rewards of maintaining your discipline can be significant. After all, investing with a long-term focus has been proven time and time again to be a better approach than short-term trading.

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The author(s) may have a position in any stocks mentioned. The Motley Fool owns and recommends shares of Apple.

Todd Campbell owns shares of Celgene and Gilead Sciences.Todd owns E.B. Capital Markets, LLC. E.B. Capital's clients may have positions in the companies mentioned.Like this article? Follow him onTwitter where he goes by the handle@ebcapitalto see more articles like this.The Motley Fool owns shares of and recommends Celgene and Gilead Sciences. The Motley Fool has the following options: short October 2016 $95 puts on Celgene and short October 2016 $85 calls on Gilead Sciences. The Motley Fool recommends Teva Pharmaceutical Industries. 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.