The Biggest Red Flag for Biotech Investors

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Biotechnology can be an absolute minefield for investors due to its inherent complexity. The process of developing a medical product, navigating treacherous regulatory pathways, and subsequently convincing doctors to prescribe it is a daunting task, to say the least.

Aside from the clinical, regulatory, and marketing issues, biotech investors face additional serious challenges stemming from problems associated with running a business with high cash outflow. Because it takes a boatload of money to bring a new drug to market ($5 billion on average, according to some estimates), for instance, management teams at clinical-stage companies are generally under enormous pressure simply to keep the business afloat.

These pressures can -- and do -- often lead to troublesome activities within the industry,with some even wiping out early shareholders. With this in mind, let's consider the biggest sign that your biotech stock might be making all the wrong moves.

Is this the biggest red flag?A funny part about the biotech industry is that investors tend to get worked up over issues such as insider sales. No one likes to see a top executive selling stock ahead of a pivotal event. But the truth is that most sales are planned months in advance via SEC Rule 10b5-1. Put simply, insider sales largely have nothing to do with the progress of a company's clinical pipeline or commercialization activities.

Indeed, Gilead Sciences' CEO John Martin has taken quite a bit of flack from investors for selling large chunks of shares at regular intervals throughout the years. Nonetheless, the stock and the company have performed admirably during his tenure:

The real danger, by contrast, lies in how a company markets itself to retail investors. Said plainly, many small-cap biotechs are little more than hype machines designed to sell stock to average investors looking to get rich quick. High levels of promotional activity can thus be a major red flag, particularly in smaller companies seeking fresh sources of capital.

What to look out for in small-cap biotechsLike most publicly traded companies, biotechs often prefer large institutional investors that are willing to hold on to their shares for long periods of time. When management teams are unable to convince Wall Street to invest, though, they frequently turn toward retail investors as their primary source of cash.

Galena Biopharma, for example, was accused of using marketing firms to push their stock to lay investors, presumably causing its share price to soar last year. When this rather questionable activity became public against the backdrop of several insider sales, it resulted in an SEC investigation, the CEO stepping down, and the share price cratering:

Unfortunately, similar situations have played out time and again, especially as the entire healthcare sector continues to shoot higher -- attracting even greater numbers of individual investors unfamiliar with the often cruel ways of biotech.

This isn't to say you should avoid the industry entirely. To avoid being blindsided, there are a couple of key things to watch for in any biotech stock. First is the frequency of press releases, as well as their necessity. Companies looking to sell stock often take a shotgun approach to public relations, announcing almost anything that could be considered "material" to potential investors.

Solid companies like Gilead generally only issue press releases for major events. So radio silence from your favorite small-cap biotech is not necessarily a bad thing.

Next up, you should always comb through the SEC filings to check if management is involved with any stock promoters or marketing firms. Such groups do sometimes hire writers that fail to disclose their biased interest in the equity in order to push out overly optimistic articles into the public realm, presumably influencing the public's perception of the company.

Foolish final thoughtsIt's extremely easy to get caught up in the thought of striking it rich on a small-cap biotech developing a potential game-changing drug or medical device. The hard fact, however, is that a staggering 83% of all small-cap biotechs lost investors money over the last 12 months.

At the same time, the industry has gone through an IPO bonanza fueled by investors' fanciful dreams of unicorns and fairy tales -- meaning there is probably a lot more unscrupulous promotional activity coming down the pike.

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George Budwell owns shares of Gilead Sciences. The Motley Fool recommends Gilead Sciences. The Motley Fool owns shares of Gilead Sciences. 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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