3 Simple Rules for Investing in Health Care Stocks

This year has seen another monumental rise in health-care stocks, with sector indices like the SPDR S&P Biotech ETF (NYSEMKT: XBI  ) climbing 33% year to date. And I'm on record stating that 2014 could be another banner year in health care, thanks to a plethora of catalysts already on the schedule. With that in mind, I think it's important to consider three simple rules to keep your money safe in this particularly volatile sector.

1. Don't follow the crowd.
Health care stocks with large social media followings like Arena Pharmaceuticals  (NASDAQ: ARNA  )  make it difficult to separate the wheat from the chaff, so to speak. Not to say these are bad stocks, but it's important to understand that anything even remotely negative is quickly refuted by their dedicated followers. In Arena's case, there's considerable debate over Belviq's commercial prospects as a treatment for chronic obesity. Consequently, it's difficult to understand what's real, and what's not. And that can lead you down the wrong path in terms of investing decisions. To avoid this problem, I look for health care companies flying under the radar, making it much easier to separate fact from fiction. 

2. Go with companies with an approved drug.
It's no secret that health care companies with prior regulatory  experience with the U.S. Food and Drug Administration are more likely to be successful in getting their other clinical candidates approved. Betting on developmental stage companies is a risky endeavor. Specifically, you face the monstrous risks of clinical or regulatory failures without the company having anything to fall back on.

To avoid this pitfall, you should look into the diversity of health care companies with one or two FDA approved drugs that are working on expanding their commercial portfolio. Such companies give you a protective moat in case the worst comes to pass, as well as the potential for continued growth.

Sarepta Therapeutics' (NASDAQ: SRPT  ) dramatic fall in November is a prime example. As a refresher, Sarepta shares fell more than 60% in a single day after its lead experimental drug for Duchenne muscular dystrophy experienced a regulatory setback. Because Sarepta has no commercially available drugs, its stock price is very much tied to the potential of its experimental pipeline -- and all of its inherent risks.

In my view, developmental-stage health care stocks like Sarpeta are all-or-nothing plays. For investors with a long-term outlook, I think there are plenty of health care stocks that have evolved into the commercial stage of their life cycle that still offer decent levels of growth with much lower levels of risk. 

3. Use market cap to find bargains.
One of the biggest misconceptions among health care investors is the notion that a stock is cheap based on its share price. Professionals never look at a stock's price to assess whether it's cheap or not. Instead, they tend to look at metrics like earnings, cash on hand, etc. I personally believe market cap is a good guide in terms of assessing a stock's potential value, especially in the health care sector.

For example, MannKind's (NASDAQ: MNKD  ) market cap tops $1 billion, and the company hasn't sold a single product yet. In fact, its solitary commercial candidate, an inhaled insulin product known as Afrezza, is still under regulatory review. So although MannKind's stock price may seem cheap in absolute terms, its market cap tells a different story.

On the other hand, there are several health care companies with market caps below $500 million whose share prices appear anything but cheap at first glance. As a result, it's important to look past share price when assessing value in this sector. At the end of the day, what matters most is how much you expect the company to continue growing. In my experience, market cap is a much better indicator of potential growth than share price.  

Foolish takeaways
Health care stocks are infamous for their chaotic ways. While they can be excellent vehicles to stellar single-year returns, they can also make you wish you never opened a brokerage account. By following a handful of simple rules, you should be able to make this sector work to your advantage, and avoid some of the major pitfalls that dot the health care landscape. As always, your number one goal should be to avoid losing money. And these three simple rules should go a long way toward achieving that goal.

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