4 Ways to Protect Yourself From a Biotech Meltdown

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Biotech stocks tend to scare most investors away, as many stocks in this sectors can make huge moves based on data releases that can cause gut-wrenching volatility. If a key compound fails to meet an endpoint during its clinical trial, it's certainly possible for its developer's stock to drop 50% or more in a single day. A disappointment like that can tempt even the most risk-tolerant investor to swear off the entire sector. Meanwhile, since much of the sector is made up of clinical-stage companies that have yet to turn a profit, valuations are often based on speculation on the potential of developing drugs. With so much riding on little more than hope, biotechs are often the hardest hit during market-wide sell-offs.

So what can you do to protect the biotech portion of your portfolio from experiencing a biotech meltdown? We asked our team of Motley Fool contributors to share their top ideas for how you can keep your biotech stocks safe.

Todd Campbell: Bursting biotech is reminding investors that the industry is among the market's riskiest, but there are some tactics that investors can employ to help keep that risk from imploding their portfolios.

For example, focusing the biotech portion of portfolios on proven sector giants like Gilead Sciences (GILD -0.65%) and Celgene (CELG) can give you market-beating returns without the pipeline risk associated with clinical-stage companies. Both Gilead Sciences and Celgene already market billion dollar blockbuster drugs that are swelling their cash stockpiles, and each has a long list of needle-moving prospects in their pipeline that could offset the risk of a clinical trial failure -- something that is common in the biotech industry.

Of course, concentrating your portfolio on biotech industry Goliaths like Gilead Sciences and Celgene means likely giving up the jaw-dropping potential returns associated with small companies trying to shoot for the moon, but long-haul investors can take solace in knowing that they're investing in companies that can allow them to sleep more soundly.

Selena Maranjian: A classic way to protect your investments is through diversification, and it's no different when it comes to biotech companies. Spreading your assets over a range of companies in different industries with different market capitalizations and different geographical focuses can lower your risk of getting whacked if a certain industry or other group of companies falls on hard times.

It's arguably even more important to diversify when it comes to biotechnology holdings, as many of these companies are somewhat speculative, pinning a lot of expectations on new drugs that take many years and much money to develop, and which may not ultimately win FDA approval. Biotech stocks can be quite volatile. For example, Xoma, which develops treatments for metabolic, inflammatory, and infectious diseases, plunged 37% in December alone, and was recently down more than 80% year over year. Yikes. Xoma and other biotechs that crater are not always doomed, but they are not for the faint of heart and can lose many investors' dollars. 

Those with strong biology expertise are better suited than others to invest in the field, as they can better understand the science involved in various companies' projects and can make more informed investment decisions. Still, the rest of us are not out of luck. We can still invest in individual biotech companies if we want, but we can also opt for exchange-traded funds or mutual funds that focus on biotech, spreading assets over many companies in the field. With these funds, if a particular biotech company implodes, it will only represent a portion of investor assets. 

A well-regarded ETF to consider is the iShares Nasdaq Biotechnology ETF, which holds around 144 different companies. Its top three holdings are Celgene, Amgen, and Gilead Sciences, with, respectively, 9%, 8%, and 8% of assets. 

Brian Feroldi: Biotech heartbreaks tend to occur in companies that have a substantial amount of their value derived from a single compound. If data is released that shows that the compound is not safe and the company has to abandon its development, investors head for the exits together, causing shares to crater.

The easiest way to sidestep this issue is to only invest in companies that derive their value from many, many different drugs, so that way your risk isn't as concentrated in only one place. If you want to protect yourself even further, simply insist that you won't invest in any biotechs until they have a handful of different drugs on the market driving revenue growth.

For example, biotech giant Biogen (BIIB -0.84%) currently boasts nine different drugs on the market that are currently producing revenue. If news were to break that one of those drugs was going to be pulled from the market, the stock would most certainly take a hit, but the company wouldn't be permanently impaired -- the company derives a lot of its value through many other products as well.

Biogen also derives a good amount of its value through its pipeline, as it currently boasts five drugs that are in phase 3 clinical trials or already pending FDA approval. By having a good mix of already approved products and a deep pipeline, the company has provided its investors with greater insulation from a biotech meltdown. 

George Budwell: Biotech meltdowns can be painful from both a financial and an emotional perspective. So learning how to avoid them altogether is certainly advisable. 

In my experience, a common theme among biotechs that crash and burn is an over-reliance on a single "make or break" product, frequently in the experimental stage of its life-cycle. As such, I tend to avoid biotechs with weak clinical pipelines or companies that put all their eggs in a single basket, so to speak. 

So when playing the high risk, high reward clinical-stage or early commercialization-stage biotech game, I tend to stick to companies with well-diversified clinical pipelines that offer multiple shots on goal. For example, I think Exelixis (EXEL 0.53%) is a prime example of how a well-rounded clinical pipeline can protect investors from complete disaster over the long-run. 

While Exelixis' share price did plunge last year after its flagship cancer drug Cometriq failed late-stage testing for advanced prostate cancer, it has since rebounded in a big way after this drug met its primary endpoint in another pivotal trial for kidney cancer earlier this year. The company also is co-developing an advanced melanoma drug, cobimetinib, with cancer drug giant Roche that's currently under regulatory review in both the U.S. and EU.

Put plainly, Exelixis' multi-pronged approach to drug development has been the main reason why the company didn't completely fold after Cometriq proved ineffective in the prostate cancer setting, and it's also been the saving grace for shareholders that took the long view. The same simply can't be said for the dozens of other biotechs that have seen their potential blockbuster product flame out in late-stage testing.