If a stock is undervalued, you should buy it. If it's overvalued you should short it or, at the very least, consider selling if you own shares. If you determine it's fairly valued, throw it on your watchlist until it hits one of the two extremes.
Seems simple enough. That's Stock Investing 101.
But there's a fourth class that investors should be keenly aware of. In fact, I'd argue that a vast majority of the stock universe falls into this category.
For many different reasons, a lot of stocks are very difficult to value. Smart investors recognize those situations and choose not to go long or short because it's too difficult to figure out which way to go.
Know your weakness
I know a lot of people stay away from the sector I usually write about: biotech. You certainly don't need a Ph.D. to figure it out -- although it doesn't hurt -- but investing in biotech does require digging deep both into the process of drug development as well as the individual company you're interested in. Don't have that kind of dedication? Stay away.
By the same token, I have no inclination to invest in banks. I have neither the time nor the patience to understand how the assets that they hold affect the valuations.
You can always take a passive approach for exposure by buying a sector-specific ETF. Or for health care, you can take Warren Buffett's approach, buying big pharmas including GlaxoSmithKline (NYSE: GSK ) , Johnson & Johnson (NYSE: JNJ ) , and Sanofi (NYSE: SNY ) , and figure the pipelines aren't nearly as important as how the businesses are run.
But even if you're an expert in a specific sector, that doesn't mean you can successfully gauge the value of every company in that sector.
Judging patent lawsuits is pretty difficult even if you're a patent attorney. For the average everyday Fool, it can be nearly impossible to assign a risk-adjusted value to a drug that has intellectual-property issues even if you know everything there is to know about the drug.
And when it comes to clinical trials, it can be very difficult to predict which way they're going to go, especially for phase 2 proof-of-concept trials. The failure of Aeterna Zentaris and Keryx Biopharmaceuticals' (Nasdaq: KERX ) cancer drug perifosine is a prime example. There's just no way to know whether some trials will succeed, and it's OK to take a pass.
Same goes for some FDA decisions. Sometimes it's easy to know which way the FDA is leaning, but other times there are minor issues where it's unclear if the FDA will make a big deal about them. For example, an FDA advisory committee recommended approving Chelsea Therapeutics' (Nasdaq: CHTP ) Northera, but not by an overwhelming majority, making it difficult to predict what the FDA would do. I guessed correctly that the FDA would go against the panel and reject the drug, but I wasn't confident enough to recommend a short, either.
Sometimes it's best to just stay away.
The downside of sitting out
If you can't figure out the valuation of a company, there's a good chance others can't as well. If no one wants to buy the stock, its price is going to fall. And that, of course, can create a potential buying opportunity. Again, Stock Investing 101.
You just need to make sure the margin of safety is so ridiculously high that the potential overwhelms the uncertainty. For instance, Human Genome Sciences rose 6,300% from its low point before the phase 3 trials for Benlysta were announced until it was approved two years later. Before the data release, it seemed the drug had little change of approval, but to justify that potential return, you need the drug to succeed less than a 2% of the time. Even the most pessimistic person would have a hard time justifying that the likelihood of success was that low.
Of course, if Benlysta had flopped, Human Genome Sciences would probably have been out of business and the investment would be worthless. Investing smaller amounts on these high-risk, high-reward names is often a good move to counteract the risk. Options can also help in these types of situations to limit the downside.
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