I've written a lot about biotech investing in my time as a contributor here at The Motley Fool. Although I haven't written a lot on the topic recently, I still get e-mails from readers asking me about their favorite biotech stocks. Often, their inquiry comes a day or two after their favorite stock is down some whopping percentage after reporting disappointing clinical trial news.

These readers want me to tell them that, despite the latest setback, things are eventually going to be all right. They want to hear that the market is being irrational to push their stock down 50% because of one little clinical trial setback. I'd like to tell them that, but unfortunately I can't, because I generally don't think that's true. If my several years of researching the drug sector have taught me anything, it's that investing in development-stage biotech really can be a loser's game.

Let me explain what I mean by that, using Regeneron Pharmaceuticals (NASDAQ:REGN) as a recent example.

The Perfect Storm
A couple of years ago, I developed a checklist designed to help aspiring biotech investors sift the good from the bad in the biotech sector. Based on that list, Regeneron Pharmaceuticals entered 2003 with virtually every quality that an investor could reasonably ask for in a development-stage biotech.

With five drug candidates in clinical trials, including a late-stage drug for obesity, there is a deep pipeline with drugs targeting large, underserved markets. There are partnerships with some of the drug industry's heavy hitters like Amgen (NASDAQ:AMGN), Novartis (NYSE:NVS), and Proctor &Gamble (NYSE:PG).

As for management quality, Regeneron's chairman is Roy Vagelos, the former chairman and CEO of Merck (NYSE:MRK), and there isn't any better pedigree in the drug business than Merck. Regeneron's stock had been trading in the $20 range in late March, giving the company a market cap of over $800 million. But on Monday, March 31, the stock plunged 56% after the company released news that the Phase 3 clinical trial data for its obesity drug candidate wasn't as positive as investors had hoped. Yesterday, the stock closed at $6.66, giving the company a market cap of $296 million.

That's pretty disappointing for Regeneron investors considering that in just the past five years the company has invested over $350 million in research and development. Unfortunately, given that the company's most advanced drug now appears unlikely to be approved, and that the next drug candidate is several years from the market, the stock market's nasty reaction isn't all that irrational.

This is the problem with development-stage biotechs -- it isn't like it took a perfect storm to knock Regeneron from $20 to $6. One clinical trial was enough to blow the ship over. And while a 50% one-day stock market meltdown should be a pretty rare event, it happens to biotech stocks with annoying regularity. I can give you literally dozens of examples of biotech companies that were fine one day and imploded the next. This isn't the exception for biotech companies, but the rule.

Why does this happen? Well, if a biotech company doesn't have a successful commercial drug, then its only asset is technology. And the technology is only valuable if it has a good chance of becoming a commercial drug. If the data disappoints, there's no telling how far the stock can fall. The sad truth is that there is no margin of safety for unprofitable biotech stocks.

A Basket Full of Holes
Assume you take a basket of 10 stocks. Assume further that these stocks have three things in common: they are the stocks of good, profitable companies, the management teams of those companies are ethical and shareholder-oriented, and the stocks of those companies are purchased at a price that is within hailing distance of fair value. I would argue that the most likely outcome for such a basket for all but the worst five-year holding periods would be positive. That's a winning basket, a portfolio of an investor playing a winner's game.

Now take 10 development-stage biotech stocks, companies without an approved successful commercial product on the market. Again, assume that each of the 10 companies is run by ethical and competent management, and also assume that each stock in the basket was purchased at a reasonable price. I would argue that the five-year expected return for this basket would be poor.

After all, you've got 10 stocks that are burning away cash every quarter, year after year until either they run out of money or get a drug approved or get a big royalty deal or do something that brings some cash in the door. Most of them won't make it.

I used to think that there would be at least one or two runaway winners in such a basket that would make up for the losers, but I don't believe that anymore. There have only been about a dozen big-time stock winners in the history of biotech, and this is an industry that is now going on 30 years old. The odds in this business are just truly terrible, which is a reality that you should consider the next time you hear somebody griping about high drug costs. For every Amgen or Merck, there are probably ten drug companies that went bust looking for the next blockbuster drug.

Playing the Loser's Game
I have invested in quite a few biotech stocks over the years, and my overall experience has been reasonably good. Now I realize that my experience has probably been better than I had a right to expect, and I have probably benefited from more than my share of lucky bounces. I don't own a single biotech stock today. I do own a few big pharmaceutical companies, and I own a couple of generic and specialty drug makers.

I suppose I will own the odd biotech in the future, but the value proposition will have to be pretty compelling. Any biotech stock I buy will be a company with products on the market, cash in the bank, and either positive cash flow or reasonable prospects of such in the very near future. I still keep my longtime favorites Millennium Pharmaceuticals (NASDAQ:MLNM) and Ligand Pharmaceuticals (NASDAQ:LGND) on my radar for possible buys at a certain price. That's the most important thing I've learned -- when investing in development-stage biotechs you really do need that margin of safety.

Zeke Ashton has been a longtime contributor to The Motley Fool, and is the managing partner of Centaur Capital Partners, LP, a money management firm in Dallas, Texas. At the time of publication, Zeke owned shares of MRK in some managed accounts. Please send your feedback to zashton@centaurcapital.com.