Is Your Dream Stock Really a Nightmare?

The Human Genome Project literally changed my life. A decade ago I was a lowly graduate student (aka indentured servant) studying the molecular mechanisms of how cancer cells work. My goal was to get my Ph.D. and work at a drug company as a research scientist. I'm a creative problem-solver by nature who likes science, and that career path seemed like a natural fit.

As it happened, I found out midstream that I just didn't have the passion for designing and conducting experiments. That's kind of a problem in that line of work. While I was figuring out what else I should be doing with the rest of my life, the Human Genome Project was all over the news. Cracking our genetic code was going to lead to all sorts of new advances in treatment for notoriously tough-to-treat diseases like Alzheimer's, cancer, and HIV.

Which companies were going to be the big winners from these medical breakthroughs? Apparently all of them.

The Nasdaq Biotech Index (NBI) skyrocketed 230% from March 1999 to March 2000, setting all-time highs. From my stool by the lab bench, the stock market was exciting, fun, and apparently you could make a lot of money quickly. This was the catalyst for me to make a career change, and for years after I was obsessed with biotech companies and figuring out competitive advantages across products and how to value their drug pipelines. I ultimately ended up at The Motley Fool, using my science background to cover biotech stocks for Rule Breakers.

The fallout
The party was fun for a while, but the hangover was brutal. From its closing high at 1,596 in March 2000, the NBI plummeted 75%, bottoming at 404 in July 2002. Many biotech investors' favorite stocks were crushed, turning dreams into nightmares for those who had hopes of sports cars, yachts, and early retirement:

Company

Fall, Peak to Trough

Affymetrix (Nasdaq: AFFX  )

90%

Amgen (Nasdaq: AMGN  )

50%

Celgene (Nasdaq: CELG  )

81%

Geron (Nasdaq: GERN  )

93%

Human Genome Sciences (Nasdaq: HGSI  )

90%

Vertex Pharmaceuticals (Nasdaq: VRTX  )

71%

ZymoGenetics (Nasdaq: ZGEN  )

48%

Data from Yahoo! Finance.

Investors chasing stocks when they didn't know anything about the businesses or how to value them got burnt very badly as the sector went into a multiyear decline that wiped out all prior gains and more. In many cases, those all-time highs haven't been touched even a decade later.

Growth investing done right
We all want to find the next five-bagger, but we can't let greed compromise our investing principles. A sexy story is not enough -- just ask anyone who invested in one of the many now-defunct gene therapy companies. I'm all in favor of investigating a new drug technology, but I always need to know that the approach is viable and that one day a profitable product will come from the company's R&D efforts.

One of my colleagues recently said that value investing is the only true investing. While I appreciate a good deep value play, I don't agree at all that growth stocks should be ignored. Disciplined, diversified, and patient. That is the recipe for success as a growth investor.

Growth investing is at its best when you can pay a reasonable price in the context of the company's market opportunity and the risk the business faces. Keep your position sizes small and own a sizable number of stocks so that a single disappointment, which will happen, doesn't devastate your portfolio.

So here are the key lessons we can learn from the bursting of the biotech bubble a decade ago:

  1. Keep your emotions in check.
  2. Pay a reasonable price.
  3. Be patient.
  4. Don't put all your eggs in one basket.
  5. Make sure the company has a legitimate technology or product.

Always remember: The best growth companies are able to build a wide economic moat and reinvest their profits into projects that generate high returns on capital. These companies can increase in value many times over for the patient investor.

In fact, three of the top five stocks in the history of the Rule Breakers service -- each is up more than 200% -- have come from the health-care sector. If you want to see what our newest stock ideas are, you can join us with a 30-day free guest pass. Simply click here.

Charly Travers owns shares of Vertex Pharmaceuticals, a Rule Breakers selection. The Fool has a disclosure policy.


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