A Blueprint to Biotech Profits

I'm a biotech investor. And I know what you're thinking: too risky. While it's true that some folks treat biotech investing like gambling -- blindly placing their hard-earned dollars on the 50/50 outcome of one clinical trial or regulatory decision -- that would be more risk than I can stomach. There are ways to identify better biotech opportunities -- such as the ones that have made Amgen (Nasdaq: AMGN  ) and Genentech (NYSE: DNA  ) some of the best-performing investments of the past decade.

I know because I'm a member of the Motley Fool Rule Breakers team, where we have recommended eight biotech companies to subscribers since inception nearly two years ago. Despite a brutal environment for biotech stocks in 2006, the average return of our biotech portfolio is up 10.5% -- versus 3.5% for the S&P 500 over the same period. Not every pick is in the black, but we've been able to find some stellar performers that have made the risk worthwhile.

I'm not trying to hog any glory here, but I think there's a reason our team has been so successful. We share a common goal of finding companies for subscribers that won't just pop for a day, but rise for years to come. Here are three of the critical factors we seek when looking for long-term biotech winners:

1. Management, management, management
A lot of amateur biotech investors think that a company will succeed or fail based on the quality of its drugs. That's only partly true. More important than great science is great management.

Why? Because getting a drug to market isn't simply a matter of putting it through the "right" clinical trial for the "right" indication, and then waiting out the results. Compounds don't come out of a test tube with a little tag that says "potential blockbuster for disease X." Choosing the best indication, establishing the optimum dosage, and determining how much to dedicate to phase 2 refinement calls for a balancing act of financial resources, market evaluation, personnel allocation, and scientific analysis that only great management can make happen.

Take thalidomide, which was tragically miscast as a safe treatment for morning sickness when it was first introduced in 1957. The drug found new life when Celgene (Nasdaq: CELG  ) licensed new rights to the product and began developing it for AIDS-related wasting syndrome in 1992. That market all but disappeared when new HIV protease inhibitors were developed, but Celgene completed a 1999 study showing that thalidomide effectively treats multiple myeloma. Celgene's management turned a decades-old horror story into a newly proprietary product that racked up about $388 million in 2005 sales. In 50 years, the biology of thalidomide didn't change. Savvy entrepreneurs just perceived new opportunity.

2. Focus on phase 2
Casual biotech investors know the basic steps a drug takes along the path of development -- from lead compound to preclinical testing (in the lab and later in animals), then through phase 1, 2, and 3 clinical testing, and finally to an approval decision.

Most investors also know that a phase 3 study can make or break an investment. The fortunes of a product typically rest on two -- or sometimes even just one -- of these large, expensive studies. Phase 3 is truly where headlines are made. At the other end of the clinical spectrum, phase 1 trials are designed to weed out drugs that have noxious side effects, poor pharmacokinetics, and the like.

But what about phase 2 -- the Jan Brady of the drug development process? Phase 2 is widely misunderstood by most investors, which is why a well-informed Fool can earn great returns by identifying opportunities during this clinical mid-stage. While there is no set number of phase 2 studies a company must conduct before moving on to pivotal trials, nor a set amount of time a drug will spend in phase 2, this stage is the most critical and most informative of the entire drug-development process. A company that takes its time and gets phase 2 right greatly increases its chances of positive phase 3 results. At Rule Breakers, we pay special attention to phase 2 tests in order to identify drugs that have better-than-average chances of making it big on the market.

But don't be lulled into a false sense of security by all phase 2 "successes." Many aggressive, cash-strapped biotechs will take shortcuts in phase 2, conducting one or two quick studies before moving into phase 3. Without complete and sound data, these products are more likely to fail at the most expensive stage of the process.

ICOS (Nasdaq: ICOS  ) , for example, made a big deal out of the "spectacular" phase 2 results it got with Pafase, an anti-inflammatory drug it was developing in partnership with Daiichi Suntory to treat sepsis. ICOS took results from a single phase 2 trial (and another small exploratory study done a couple years earlier) and rushed into a phase 3 program, where the drug flamed out.

Could investors have somehow known in advance that Pafase was doomed? Not at all. But they should have been extremely cautious about the program, and discounted its chances for success significantly. ICOS lacked complete phase 2 data, and sepsis is a complicated illness that has proved to be an incredibly difficult nut to crack. (The only approved drug for severe sepsis, Eli Lilly's (NYSE: LLY  ) Xigris, is only modestly effective, has significant risks, and has not been a big seller.) There's no way to know, but more early phase 2 work might have prevented ICOS from making the larger phase 3 investment, might have changed the phase 3 design in such a way that the drug could have succeeded, or might have led the partners to a different inflammatory indication that would have met with better success.

3. Access to new drugs
"Platform technology" was a buzz phrase during the genomics bubble of 2000, but it's since become unfashionable. Companies don't want to talk about their discovery capabilities because they think Wall Street doesn't care. They're probably right -- all it seems the Wall Street pros care about these days are products, regardless of how the company came by them.

But the truth is, drugs fail. A short-term focus on quick revenue can make for real investment disaster. The formerly high-flying (and research-light) Pharmion (Nasdaq: PHRM  ) and Tercica (Nasdaq: TRCA  ) , among others, rely heavily on in-licensing. That strategy has the makings of disaster -- and when that happens, investors are far better off with a company that has a discovery and research engine that can produce new drug candidates. (In fact, I first warned about Tercica's and Pharmion's business models last August. Since then, they have dropped 31% and 45%, respectively). That's why, at Rule Breakers, we put particular importance on credible discovery platforms.

Don't stop there
Of course, the three criteria for great biotech investments I've outlined here are not the only points that matter. If you'd like to learn more, and read about the eight biotech companies we've already identified, I invite you to join us for a 30-day free trial of Rule Breakers. We discuss biotech investment strategy on a daily basis and pick the best and brightest for our portfolio. There is no obligation to subscribe. Click here to get started.

This article was originally published on Aug. 30, 2005. It has been updated.

Karl Thiel does not own stock in any of the companies mentioned in this article. He is a member of the Motley Fool Rule Breakers team, which seeks tomorrow's next great growth stocks today. Eli Lilly is an Income Investor recommendation. The Fool has adisclosure policy.

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