3 Ways to Be a Smarter Biotech Investor

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Picking winning stocks isn't easy, especially in biotechnology where the ebb and flow of news tied to drug trials can cause breathtaking share price pops and drops. Although that means that biotech stocks can be risky, the right knowledge can help improve the odds of finding the right investment. We asked three Motley Fool analysts to tell us what they think are critical steps to finding winning biotech stocks. Read on to learn what advice they think can help you make the best investment

Selena Maranjian: It's not unreasonable to just steer clear of the biotech sector if you're not well versed in science and the healthcare realm. You might, instead, just opt for a biotech-oriented exchange-traded fund such as theiShares Nasdaq Biotechnology ETF, which will park you in a bunch of biotechs so that you can profit as the sector grows. You might still want to select individual biotech stocks on your own. If so, know this: Smart biotech investors have sensible expectations.

For example, though you'll run across many exciting companies working on cures for diseases that afflict millions of people, you'll need to be patient. It can take a decade or more for a drug to progress from an initial idea to an approved drug on the market. And it's far from a sure thing that it will happen, too. According to recentdatafrom the Tufts Center for the Study of Drug Development, only about 12% of drugs that enter the clinical testing phase eventually win FDA approval. Expect the clinical testing process to take years, too, as there are three main phases, involving smaller and larger groups of people with and without the condition being targeted, as the compound's safety and efficacy is assessed.

The folks at Tufts also noted a rising cost to develop drugs, with the average cost soaring above $2.5 billion. That's worth noting because it affects how biotech companies operate. Few small companies can afford the whole process, especially if they have a number of drugs in development, so they often partner with big, deep-pocketed pharmaceutical companies, forking over a share of profits in exchange for support through development.

Look for companies with promising pipelines, ideally with several drugs in late-stage trials. Hope for test results showing great efficacy and few side effects. A competing drug might show better results or fewer side effects and could derail rosy projections. Biotech investing is not for the faint of heart; but for those with sensible expectations, it can be quite rewarding.

George Budwell: Biotech is rife with so-called "story stocks," or stocks that receive an inordinate amount of media attention causing them to trade mainly on their potential rather than fundamentals. Given the diversity of game-changing new products emanating from the industry these days, overly enthusiastic retail investors and stock promoters alike have taken advantage of this trend by trumpeting unrealistic value propositions for stocks with huge risks. Unfortunately, many unsuspecting investors have gotten caught up in these compelling "get rich quick" stories, only to lose large sums of money in the process.

The now defunct Dendreon Corp. and its prostate cancer treatment Provenge is a prime example of this problem, and nicely illustrates why investors should avoid highly touted clinical-stage biotechs like the plague. As a refresher, Dendreon's stock skyrocketed some 370% following Provenge's much-heralded approval as a breakthrough in prostate cancer treatment.

Once problems with manufacturing, poor management, and superior new treatments arose, though, shares cratered -- with the company declaring bankruptcy only four years after Provenge was launched in the U.S. Dendreon's multibillion-dollar valuation, at its former highs, was thus a product of hype. That's why I tend to sidestep smaller biotechs, especially when they attract a crowd.

Brian Orelli: The appeal of biotech -- the potential for stocks to double or more overnight -- is also what can get investors in trouble. As binary events -- FDA approvals or clinical trial results -- approach, more investors pile into the stock, which can drive up the price, resulting in lower returns after the binary event, but the same theoretical risk.

Understanding this simple equation will make you a better biotech investor:

Price-Positive * Likelihood-Positive + Price-Negative * Likelihood-Negative = Fair current price

If a stock is expected to be worth $20 after its drug is approved, $5 if the drug is rejected, and there's a 60% chance of approval, the current value should be $20*0.6 + $5*0.4 = $14. If you can buy it for less than that price, it's a good deal if you're willing to take on the 40% chance of losing money. If you pay more than $14, the potential reward doesn't justify the risk you're taking on.

Complicating things, drug approvals are not entirely binary; the stock price may be different depending on what the company has to do after a rejection. You can add another potential price (or more) to the equation. Just make sure your likelihood terms all add up to one -- so it could look something like this: $20*0.5 + $10*0.2 + $5*0.3

The hard part, of course, is coming up with the potential prices and the likelihood that the binary event will turn out positive. Using other companies at the same stage that the biotech will be in after a positive binary event can help set the potential market cap; then, just divide by the number of shares to get the share price. For the negative price, using cash per share is the most conservative, although if the company has other assets, the value might end up being higher.

The hardest component is the likelihood of success. Researching and understanding everything there is to know about the drug and the clinical trial or FDA approval process can help, but it's ultimately an estimation. In some cases, you might not be able to put a good estimation on the likelihood of success. Perhaps the FDA decision is unprecedented, or the previous clinical trial was too small to gain real insight. In those cases, being extremely conservative with your expectations, or sitting on the sidelines altogether, is usually the best plan.

The article 3 Ways to Be a Smarter Biotech Investor originally appeared on Fool.com.

Selena, George, and Brian do not have positions in the companies mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.

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