3 Questions to Ask Before You Buy a Biotech Stock

Source: Celgene Corporation.

The biotech industry is notorious for its pop and drop nature. Biotech stocks can soar or burst based on whims and whispers surrounding clinical trials, FDA approvals, and competitive threats. As a result, picking the right biotech stock to own can seem daunting.

With that in mind, I put together this list of three must-ask questions every investor should have answers to before clicking the buy button on a biotech stock. Read on to learn how knowing the answers to these three questions can improve your chances for investment success.

No. 1: Currently approved drugs?Before I consider buying any biotech stock, I always look to see if management has proven that it can successfully usher a drug through clinical trials and FDA regulators. A been-there-done-that management team is more likely than not to sidestep potential mistakes, leverage existing resources, and pick candidates for their pipeline that have a better shot at success.

If a company does have products on the market, I like to see whether or not sales for those products are climbing. That's important because it offers insight into whether rising sales will offer up increasingly more financial flexibility that the company can reinvest in next-generation drugs. If sales are leveling out or dropping off, it could be a warning that research spending cuts that could derail future growth may lie ahead.

As an example, let's consider Celgene Corporation .

Celgene's top-selling drug is Revlimid, a $5 billion per year second-line therapy for multiple myeloma. Revlimid's blockbuster status and rapid growth -- sales were up 16.3% last year -- indicate that Celgene's management team knows how to execute. But Revlimid isn't Celgene's only success.

Thanks to Revlimid's financial fire power, Celgene has also launched the third-line multiple myleoma drug Pomalyst, the cancer drug Abraxane, and the psoriasis drug Otezla. Growth for each of those drugs is so strong that each of them has a good shot at becoming another billion-dollar blockbuster.

Of course, having a product line-up like that doesn't matter much if patents are about to expire. So, always scan the company's annual report to make sure that patent protection will keep the money flowing for years to come. Since Celgene's top sellers are covered by patents into the 2020s, it's hard to argue against the idea that Celgene has one of the best product portfolios in the business.

No. 2: Rock-solid financials?A stable of existing top-selling drugs can be compelling, but only if company leadership is managing the business intelligently. Moreover, many of the most intriguing biotechnology companies have yet to win approval for any products, and that can make evaluating them even trickier.

That's why I like to consider how the company's financials stack up, too.

One of the easiest ways to do this is to look at the company's balance sheet. If a company is flush with cash and doesn't have any debt, it has a much better chance of avoiding the need to tap lenders or issue more stock, which can dilute investors.

For example, let's consider how the balance sheet looks for two very different companies: Celgene and MannKind Corporation .

As of the end of December, Celgene is sitting on cash and cash-like securities of more than $7.5 billion. That's a solid grubstake, but its even more impressive when we consider that the company had just$3.9 billion in cash at the end of 2013.

Celgene also rates high marks for keeping its short-term debt in check.

The company's current ratio, a measure of a company's ability to pay its short-term financial obligations if debtors come knocking, is an industry-leading 4.6. Since anything north of 1 is good, there doesn't appear to be much to worry about, here.

The situation is a bit different at MannKind.

MannKind is the maker of the promising inhaled insulin drug Afrezza that won FDA approval last year. Thanks to a licensing deal it cut with Sanofi last summer, MannKind's financial situation is improving; however, a quick look at its balance sheet still raises some red flags.

Specifically, MannKind has $120.8 million in cash, but after adjusting back out the accounting impact of collaboration revenue from Sanofi, it also has $203 million in short-term debt.As a result, MannKind's current ratio is just 0.50, and that could suggest this company may have some financial challenges down the road if Afrezza sales are slow to materialize.

No. 3: Promising pipeline?The final question investors should ask before buying a biotech is whether or not the pipeline is healthy enough to kick off a steady stream of future winners.

It's critical that pipelines are flush with promising ideas, because patent protection and innovation means drugmakers have a limited window of opportunity to capitalize on their existing products.

There are a lot of different ways to evaluate pipelines, but I tend to focus on phase 2 and phase 3 programs, and generally ignore phase 1. That's because 90% or more of drugs entering phase 1 trials end up in the dustbin.

It's also helpful to consider the indications these drugs are targeting. Specialty medicine for the treatment of autoimmune disorders, oncology, and rare diseases are attractive because they historically command higher price tags that can make them more profitable. Therapies for rare diseases for which there are few existing treatment options are also attractive. And future growth and patent protection can come from label expansion, so drugs that are being studied for multiple indications across various phases of trials are intriguing, too.

For example, in February, Celgene's Revlimid just won FDA approval for use as a first-line therapy for multiple myeloma, and that has Celgene forecasting that Revlimid's sales will grow to between $5.6 billion and $5.7 billion this year. Additionally, Celgene is working on a slate of label expansion studies for Abraxane and Otezla, and it has a promising drug that could one day treat Crohn's disease, too.

Tying it togetherEven the best biotech stocks are bound to have fits and starts along the way, but evaluating biotech stocks in this manner can help keep you from making mistakes when they do. At a minimum, knowing the risks and opportunities associated with current products, the balance sheet, and the pipeline should keep you focused more on leaders, and over the long haul, that could prove to be very profit-friendly.

The article 3 Questions to Ask Before You Buy a Biotech Stock originally appeared on Fool.com.

Todd Campbell is long Celgene. Todd owns E.B. Capital Markets, LLC. E.B. Capital's clients may or may not have positions in the companies mentioned. The Motley Fool recommends Celgene. 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.

Copyright 1995 - 2015 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.