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Huge fortunes are won and lost in the world of biotech nearly every week. For those new to this world, it can appear both alluring and scary. Biotech investing for beginners isn't for the fainthearted, but the potential rewards are great. Here are three important things to keep in mind if you're contemplating trying out the clinical-stage biotech waters.
1. Flimsy financials
Throw revenue growth, earnings per share, valuation multiples, and pretty much every other financial figure out the window if you're looking to invest in an up-and-coming biotech. These companies typically won't have any revenue or earnings of significance.
For example, Keryx Biopharmaceuticals (NASDAQ: KERX ) reported no revenue for 2012. Not a dime. The company lost $22.7 million last year and even more the year before that. However, those financial results really aren't important at this point.
Biotech investors should focus on cash, though -- in particular, the burn rate for that cash. A company can have a promising product, but that promise fizzles without enough cash to complete clinical trials.
During the first quarter of 2013, Keryx showed a burn rate of around $9 million. At the end of March, Keryx showed cash and cash equivalents of more than $87 million thanks largely to a secondary stock offering earlier this year. This means that the company is in solid shape from a cash standpoint. That's not always the case with biotechs.
2. Regulatory roulette
Another key investing concept for beginners to understand is that biotechs live or die on regulatory decisions. The road to approval for a drug is a long and winding one.
Dynavax (NASDAQ: DVAX ) is a good case in point. The company's Heplisav hepatitis B vaccine looked good in clinical trials when compared to the leading vaccine on the market. Dynavax thought that the safety profile for Heplisav also compared favorably. The Food and Drug Administration even told the company that it could expand its Biologic License Application, or BLA, to include a wider age range of adults than originally planned.
All of that meant nothing, though, when an FDA advisory committee voted not to recommend Heplisav for approval because of safety concerns. It meant even less several months later when the FDA heeded that recommendation and didn't approve the vaccine. Dynavax shares plunged more than 60% from previous highs.
Sometimes, even the hint of an unfavorable regulatory decision can impact a biotech stock. Sarepta Therapeutics (NASDAQ: SRPT ) shares lost more than 25% of their value in April. There wasn't an outright adverse FDA decision in this case. Instead, the FDA requested additional information related to a potential accelerated approval for Duchenne muscular dystrophy drug eteplirsen.
3. Vicious volatility
Investing in any stock can be something of a roller coaster ride. However, few sectors display the vicious volatility of biotech. Beginners to biotech investing need to be prepared for a wild ride.
Keryx shot up 164% in a matter of a few days in January. By early February, the stock was down almost 30% from those highs. Dynavax still hasn't come back from the stock's wipeout. As mentioned, Sarepta dropped more than 25% in April. However, shares are now up 28% from the low point.
Unfortunately, gaining FDA approval and commercializing a product don't necessarily end a biotech's volatility. Dendreon (NASDAQOTH: DNDNQ ) received approval for prostate cancer drug Provenge in April 2010. JPMorgan estimated that peak annual sales for the drug could reach $3 to $4 billion. Those estimates failed to materialize. Disappointing sales for the drug have contributed to a stock collapse of more than 90% since the FDA approval.
Basics still apply
While some parts of conventional investing don't fit well with clinical-stage biotech, many of the basic principles still apply. In fact, some are perhaps even more important.
Diversification, for one, is critical to handle the risks inherently associated with biotech. Buying for the long term potential of a biotech and its products makes sense with the wild swings commonly experienced with these stocks. And the old mantra of "bet on the jockey" applies to biotech like any other industry.
Biotech investing for beginners presents big challenges. The points I mentioned only scratch the surface of what you need to know. However, every person that has done well in biotech was once a beginner also. There's no better time to begin than now.
Editor's note: In a previous version of this article, a milestone payment of $7 million was not considered when calculating Keryx's burn rate. The Fool regrets the error.
While you can certainly make huge gains in biotech stocks, you don't want to put all of your eggs in that basket. The best overall investing approach is to choose great companies and stick with them for the long term. The Motley Fool's free report "3 Stocks That Will Help You Retire Rich" names stocks that could help you build long-term wealth and retire well, along with some winning wealth-building strategies that every investor should be aware of. Click here now to keep reading.