Picking Biotech's Winners

As the biotech analyst for Motley Fool Rule Breakers, I get tons of email, and two questions show up in my inbox far more frequently than any others. The first is "Why do you spell your name so funny?" Since you've now hurt my mother's feelings, it's best to move on to the next one.

The second question I get frequently is about how I go about picking biotech stocks. There are a couple hundred publicly traded biotech companies to choose from, and obviously we want to invest in only the winners. Screening for the high-quality selections out of this universe can be a daunting task. While there are promising up-and-comers to invest in, there are also tons of duds that need to be avoided. All they will cause is pain and misery, and we don't want that.

There are two routes to travel to find investment-worthy ideas. The first is to get a monkey to throw darts at a board covered with companies, then buy what the monkey hits. By random chance, some of the darts are bound to strike gold.

The problem with using the monkey is that monkeys aren't the easiest animals to live with. Between the screeching and the throwing of bodily waste, you probably don't want to have a monkey roaming around your house. There is also the minor matter that the monkey will be successful only through random luck, but don't tell him that or he'll get testy. But we know that it is not a good idea to just pick companies at random and hope for the best. Doing so is a recipe for disaster, and I know we can do better than that. As tough as it is to pass on using a helper monkey, let's skip the simian sage and explore option No. 2.

When I'm looking at my spreadsheet of companies, I have a short list of criteria I use to screen out the losers to get to the champs. This screen is designed to find quality companies by filtering out the fundamentally weak operations. I'd like to share this process with you today to help you become a successful biotech investor. Here are the traits I look for:

A strong management team
To make a great investment in a quality company, we must start at the top with good leadership. Bad management can quickly run good drug programs into the ground, eroding shareholder value. You can find bad management by listening to company conference calls over a period of time. Some of the most common signs of poor management are repeatedly missed drug development timelines and financial guidance.

Good management will present a viable business plan in a clear manner. In this way, it communicates with investors the road map for the future of the company. It tells us where the company is going and then takes us there.

Fill a unique niche
All else being equal, it is far better to be the first entrant in an underserved market than to be the latecomer to a crowded field. Many of biotech's success stories attained superstar status by creating a drug that met an unmet medical need. Biotech top dogs Genzyme (Nasdaq: GENZ  ) and MedImmune (Nasdaq: MEDI  ) are two great examples. Both of these companies developed drugs for markets that needed an effective product, becoming 10-baggers for their shareholders in the process.

Catalysts
The company has to have a clear timeline for increasing its value. There are plenty of biotech companies that have been around for more than 10 years and have yet to do anything that creates shareholder value. We do not want to invest in stagnant companies that are on the fast track to nowhere.

Drug development takes a long time, but we can make a chart of upcoming events that are potential value drivers. Typically for small biotechs with early-stage drug programs, this will be the release of clinical trial data or the signing of key partnerships. Of course, the best catalysts are drug approvals, as these events, hopefully, signal the transition to profitability.

Catalysts are crucial because they ensure there is a light at the end of the tunnel, where the patience of the investor is rewarded. Or maybe, more appropriately, the pot of gold at the end of the rainbow.

Financially capable
We can't kid ourselves here: 99% of biotech companies do not have the treasure chest of an Amgen (Nasdaq: AMGN  ) or a Genentech (NYSE: DNA  ) . And what meager resources they do have are dwindling by the day as the company invests in research and development.

But that doesn't mean that shoddy balance sheets are acceptable either. One measure is to not invest in companies that have less than a year or two of cash on hand. An alternative approach that I tend to prefer is to look for companies that have enough cash to fund R&D until a catalyst can be reached. This doesn't necessarily mean having funds that last until drug approval. It can mean having the cash to last until key clinical data can be generated that can then be leveraged to gain access to additional funds. This can come through partnering a drug and getting upfront payments, or even becoming an acquisition target.

Proven technology
I tend to stick with the tried and true unless there is a very compelling reason to make an exception. And by "compelling reason," I mean at least phase 2 efficacy data. Preclinical data in animal models when the drug is based on a new (i.e., unproven) technology carries very little weight with me.

Investing in experimental drug programs is risky enough that we don't need to add to our risk by investing in technologies we can't even be sure work. In general, I recommend sticking with companies that are developing small molecule or protein drugs, such as monoclonal antibodies. In contrast, antisense, cancer vaccines, gene therapy, and stem cells carry a lot of additional risk because these technologies have not been proven to be able to generate a commercially viable drug.

Valuation
It's not the easiest thing in the world to calculate the value of a small biotech company, but it's very much worth doing. For a quick tutorial on one approach, see my commentary What's a Drug Worth?

It's one thing to make the right call about whether or not a drug works. But success as an investor also requires buying the company's stock when the drugs are not priced in. Biotech investing requires being right in both areas.

Final thoughts
Doing well as a biotech investor comes as much from avoiding the losers as picking the winners. If you can deftly dodge the disasters that will cause 50% losses, you will be on the right track. Applying the above criteria is how I avoid the vast majority of land mines while finding the stars.

The quest to find tomorrow's industry leaders is the focus on my monthly Biotech Beat in Motley Fool Rule Breakers. In the latest issue, I offered up some small-cap biotechs that are on the move. If you'd like to join the discussion and see a few companies that could be the next Amgen, take a free 30-day trial. There is no obligation to subscribe. Together, we can uncover biotech's 50-baggers.

For additional articles on the drug industry, see:

Fool contributor Charly Travers does not own shares of any company mentioned in this article.


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