Biotechnology is still the Wild West of the investment world: dangerous, largely misunderstood, and holding an unending allure for those seeking to make a quick fortune. Legendary gold strikes such as Amgen (Nasdaq: AMGN ) , Biogen-Idec (Nasdaq: BIIB ) , and Chiron (Nasdaq: CHIR ) have an unending allure for those looking to seek their fortune in riskier stocks. Just as it was back in the untamed West, speculators who prepare themselves beforehand have a better chance of finding their way and staying unharmed. In particular, carefully examining a company's research-and-development pipeline is a sound method for avoiding quite a few pitfalls.
Examine the pipeline
The first, and easiest, step is simply to assess how many compounds the company has in its pipeline. A single promising drug is great. Two promising drugs are better. Three or more promising drugs are... well, you get the idea.
But "promising" is a matter of degree, and every company has only so many resources. Shouldn't a company select its best one or two compounds and devote all its attention to just those? Isn't it better to have one really great drug than five lousy drugs?
In theory, yes. In reality, though, separating the great from the lousy before it's too late is pretty hard to do. Other than the fact that the FDA requires them to do so, companies conduct clinical trials for a very simple reason: People don't know what's going to work until they have the data in their hands. Spreading the risk around makes a great deal of sense.
Those risks can be truly breathtaking: Only 11% of drugs that enter Phase 1 studies ever make it to approval. This number gets even worse when you consider that many drug approvals are follow-ons to already-approved drugs (like pediatric formulations) and thus are double-counted in that number. Stripping these out of the equation reduces the odds of approval to something on the order of 6% -- not very good.
Consequently, you have to know where in the development process those pipeline drugs are, and what that means in terms of risks. Clinical trials for drugs are divided into three phases, with each phase designed to learn more about the safety and efficacy of the drug. Roughly speaking -- and including follow-ons -- only 18% of drugs in Phase 2 get eventual approval, but almost 46% of Phase 3 drugs meet that goal. That's a considerable difference that highlights the relative risks involved.
ICOS (Nasdaq: ICOS ) provides a good lesson in the benefits of pipeline diversification. In 1997, ICOS had four drugs in clinical trials, and all but one of them ultimately failed. ICOS shares took a short-term hit with each drug failure, but nevertheless, the stock is now much higher now than it was in early 1997. Why? Because the one drug that made it just happened to be Cialis.
Many analysts at the time thought that head-trauma treatment Hu23F2G, one of the four drugs in the 1997 trials in 1997, was the most promising compound of the four. What if ICOS had decided to put Cialis on the back burner or sell it to someone else in favor of Hu23F2G?
Looking elsewhere, you can see how companies like CV Therapeutics (Nasdaq: CVTX ) and DOV Pharmaceuticals (Nasdaq: DOVP ) have numerous late-stage clinical options, whereas companies like Arena (Nasdaq: ARNA ) and Axonyx (Nasdaq: AXYX ) each have only a single drug in development beyond Phase 1.
Axonyx has a very interesting Alzheimer's drug in late Phase 3 studies, but what happens if the study fails? If DOV Pharmaceuticals or CV Therapeutics runs into trouble with a single drug, they have other late-stage drugs in the pipeline to fall back on. But for Axonyx, it's either the penthouse or the outhouse. Such was the case recently with Pharmos (Nasdaq: PARS ) , a company that had looked to have a promising drug for head trauma, until a Phase 3 trial failed to show meaningful efficacy. The company's stock lost almost 80% in one day, and it's anyone's guess whether the company will find new compounds to put into trials.
When checking a pipeline, you also need to separate multiple drug candidates from multiple trials of a single drug candidate. Companies commonly launch multiple trials of one drug, particularly when it's an autoimmune-disorder or cancer drug. And bear in mind that multiple trials for a single drug offer only a very modest improvement in an investor's margin of safety. If a drug fails in one indication, it's statistically even more likely to fail in additional studies.
That said, companies have a clear, though seldom openly discussed, motivation for trying a drug across a range of diseases. All that a company truly needs is approval. Once a drug is approved, physicians can generally prescribe it for anything they see fit. This process -- called off-label usage -- is more common than most people realize and can make up a sizable chunk of drug companies' revenue. Consequently, if a company can get a drug approved even for an obscure and uncommon disease, good marketing can deliver sales well in excess of what was anticipated.
Dig a little deeper
Simply looking at the breadth of the pipeline is only the first step, though. A little due diligence into the drugs themselves can often reap rewards. Don't worry about not having a Ph.D. in molecular biology. Drug companies employ thousands of these people, and even they don't consistently know what's going to work. But the more you can understand about the disease and the currently available options, the more you can separate the winners from the losers.
Take Vivus (Nasdaq: VVUS ) , for instance. Vivus developed a treatment that once was thought to have the potential to compete with Pfizer's (NYSE: PFE ) Viagra and the other erectile-dysfunction drugs. But the treatment, called Muse, involves a process akin to loading an old black-powder rifle, in which a bullet was placed in the end of the gun and rammed down the barrel. Not surprisingly, this method has proved unpopular. As a result, sales for the first nine months of 2004 for all of Vivus's products, including Muse, amounted to less than $10 million.
NPS Pharmaceutical's (Nasdaq: NPSP ) Phase 3 osteoporosis drug Preos is another example. At first blush, the drug would appear to be a blockbuster -- more than 10 million people have osteoporosis, and the market is estimated to be worth at least $4 billion worldwide. Dig deeper, though, and you learn that only a fraction of osteoporosis patients are likely to be given Preos. That changes a blockbuster drug into just a very good drug.
The lesson here is that good old common sense can take you a long way. Don't be afraid to use your own experience and judgment. One upside of biotech's uncertainty is that your guess is probably just as valid as that of an average Wall Street analyst. Roll up your sleeves and learn about the drugs' side effects, since bad side effects can make approval difficult and may mean that patients won't take the medicine. Also ask how the drug is administered. Is it something easy, like a pill, or something unpleasant, like a daily injection? Finally, try to take a dispassionate look at who might actually use the drug. Will it be available to a broad range of people, as Viagra is, or will it be a specialty niche drug? Both are OK, but you need to know before you invest.
You can do a lot of this work from the comfort of your computer. You'll find a wide range of medical and scientific journals online. And many agencies, like the FDA, post a wealth of information on the Web, if you look for it. And don't overlook the websites assembled by disease advocacy groups, such as the American Diabetes Association or the American Cancer Society. The more you can learn about the company, its drugs, and the diseases they intend to treat, the better your decision-making can be.
Putting it together
Of course, just examining the pipeline isn't the end of the line. Management quality, cash burn, and valuation all matter a great deal and are worthy subjects for another day. When it's all said and done, biotech stock selection can appear to be equal parts science, art, and voodoo. But checking out a biotech's pipeline is the first step in separating the pretenders from the contenders.
Stephen Simpson is a Fool contributor and holds a CFA. He is also an avid biotech investor/speculator but has no financial interest in any stocks mentioned in this report.