What Is That Stock Price Telling You?

Biotech is one of the few sectors that regularly seems to prove bulls and bears wrong.

Case in point is Dendreon (NASDAQ:DNDN), which skyrocketed back in March after an FDA advisory panel voted in favor of approving Provenge, a controversial prostate cancer vaccine. Then, a few weeks later, the FDA went against its custom of following the recommendations of its panels and asked for more data on the drug. I won't hash through all the details -- that's been done in numerous Dendreon postmortems. Suffice it to say, the shorts were right after all -- even though a lot of them probably lost money.

I fall in the opposite camp. I've owned Dendreon shares since 2005. That's a long-term position, so whether I'm right or wrong about the company may depend on timescale, but this was certainly a losing round. Yet I still made money.

There are a lot of raw feelings about this stock, so I want to be clear that I'm not claiming to have had any special read on the data or any prescient prediction of how things would play out. I was on pins and needles before the advisory panel, and I was taken aback when the FDA went against its panel.

But I followed one piece of advice I learned from Michael Mauboussin, the chief investment strategist at Legg Mason. I closed my ears to all the hubbub and just looked at what the stock price was telling me. At less than $4 prior to the meeting, it was clear that investors expected failure -- viewed it as a near certainty, even. After all, now that the worst one might reasonably have expected has actually come to pass, the stock is still trading higher than it was before the meeting (though it may well drift lower). That was some serious pessimism.

After the meeting, when shares shot up to above $20 and Dendreon had a market cap of nearly $2 billion, investors were saying that approval was a slam-dunk.

I never felt entirely confident about either position. I did feel confident that the rewards heavily outweighed the risks before the meeting and that after the jump in price, the risks began to outweigh the additional upside that would come from an approval. I sold most of my stake between the two events (though I continue to hold a small position).

It quite simply pays to be uncertain when it comes to biotech investing. Looking at traditional measures of value -- like future cash flows -- can actually lead you astray with early-stage companies because there are so many binary events that mean huge differences in stock price. I've learned from experience that investors tend to be too sunny about the future and too focused on clinical and regulatory events. Take a look at the chart below:

In each of these cases, product sales, which are what we should care about, did not match the expectations baked into earlier stock prices (though I'll admit a soft spot for CV Therapeutics, which I recommended to Motley Fool Rule Breakers subscribers and I still believe is undervalued).

I'm not suggesting you throw up your hands. Uncertainty can be your friend, because you can weigh it against the market's expectations. There was and is money to be made in every one of the stocks above, long or short, if you can figure out which events other investors have become too certain about.

I sure didn't expect the FDA to go against its panel. I don't think Dendreon President and CEO Mitch Gold did, either. But that didn't stop him from dumping $2.7 million worth of his own company's stock after the panel meeting. He's been around long enough to know from uncertainty.

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Rule Breakers analyst Karl Thiel still owns some shares of Dendreon. Legg Mason is a Motley Fool Inside Value pick. The Motley Fool has a disclosure policy.