In last week's article, I articulated my thoughts for a reader who had sent me an e-mail stating that he had invested 100% of his IRA in what he called "a penny stock biotech company" that he fervently believes could be the investment of a lifetime. I argued that most people shouldn't ever put more than 25% of their portfolio in any one stock, and in fact, only very aggressive investors should even consider such concentration.

This is particularly true for risky biotech companies. In my own investing, I rarely invest more than 3% of my total portfolio in any early stage biotech company, no matter how promising it might look. The chance of a catastrophic loss is just way too high.

Today, I'll cover small-cap biotech investing in more detail, using the same stock, Peregrine Pharmaceuticals (Nasdaq: PPHM) as a case study. At the outset, I'd like to note that, despite the fact that the company trades at less than $5 per share, it does have a market cap of almost $400 million. I don't think of a $400 million company as a "penny stock." Nevertheless, it is a very risky investment, which I will attempt to demonstrate in my analysis. I also want to note that this article isn't about Peregrine Pharmaceuticals per s. Rather, my purpose is to demonstrate how you can evaluate development stage biotech companies.

How to evaluate small-cap biotechs

Here's the checklist that I use when evaluating a development-stage biotech, which is covered in more detail, along with my favorite small-cap biotech stocks, in this year's Industry Focus. I look for:

  • Drugs on the market
  • Deep product pipeline
  • Late-stage drug candidates with strong sales potential
  • Partnerships and alliances with leading drug companies
  • Good management and a sound business strategy
  • Enough cash to survive until the company achieves profitability

Let's use the list to see how Peregrine stacks up. 

Peregrine is focused on the development of what it calls Collateral Targeting Agent technology, which use antibodies that bind to specific structures found in cancer tumors.

Peregrine's lead product candidate is called Cotara, which has completed Phase 2 clinical trials in brain cancer, and is also in early Phase 1 trials in a number of other cancers that exhibit solid tumors. In addition to Cotara, the company has a product candidate called Oncolym in Phase 2 trials for the treatment of Non-Hodgkins Lymphoma. Oncolym is an antibody that is bound to a radioactive agent. Both of these products have been designated by the FDA as Orphan Drugs, meaning that they will receive priority review from the agency, among other benefits.

Peregrine also has a couple of other projects that aren't yet in the clinic. I don't assign any weight to these, since even if successful, they are at least seven years away from the market. Remember, only one in five products that enters Phase 1 clinical trials makes it to the market, and only one in three marketed products ever recovers its development costs.  These are brutal odds, and small-cap biotech investors need to keep them in mind at all times.

So, reviewing our first three items on our checklist, Peregrine has no marketed products, only two drugs in the pipeline, and the most advanced drug candidate is only now beginning Phase 3 trials. As far as sales potential, if Cotara does prove to be effective in breaking up solid tumors in the brain and other organs, then clearly it will be a commercial success. But it's way too early to tell whether the drug is effective in a large patient population, so we'll need to wait and see how the Phase 3 trials go.

That brings us to partnerships and alliances. We like to see emerging biotechs attract strong partners to validate the potential of the science. We prefer to see the big names in pharma or the top tier biotechs as corporate partners. Peregrine does not score strongly on this point.

The company has an agreement with a Chinese drug company called Brilliance Pharmaceuticals, which owns the product rights to Cotara in China. This deal was done through a third company called Cancer Therapeutics, to which Peregrine granted an exclusive right to sublicense in China for ten years. But investors should note that this is a related party transaction. According to last year's 10-K filing, Dr. Clive Taylor, who is an officer, director, and 26% owner of Cancer Therapeutics, is also a member of the board of directors of Peregrine Pharmaceuticals. This doesn't necessarily mean it's not a good deal, but I am somewhat skeptical that it will lead to material revenues for Peregrine.

The other partnership for Cotara is with Merck KgaA, an established German drug company, for a specific use of the company's technology. Unfortunately, the deal is only worth about $400,000, which is very tiny compared to some of the megabuck alliance agreements that the biotech industry has witnessed in the last year.

In reading last year's 10-K filing, it appears that Oncolym was licensed at one time to another German drugmaker, Schering AG, which designed and funded early stage clinical trials for the drug. In June of 2001, the partnership was apparently ended, and Peregrine is currently looking for a new partner for Oncolym. Schering isn't the only company that has chosen to discontinue development pacts with Peregrine; Cambridge Antibody Technologies (Nasdaq: CATG) terminated an agreement with the company in May of 1998, and another corporate partnership, with Scotia Pharmaceuticals, ended in 2001 when that company announced its bankruptcy.

The biggest partnership the company has landed so far is with OXiGENE (Nasdaq: OXGN), a micro-cap biotech that has pledged $20 million in development costs as part of a joint venture agreement to jointly commercialize some of Peregrine's technology. This sounds impressive until you note that OXiGENE has a market cap of only $38 million -- clearly not on the "A" list of drug partners. Peregrine did land another modest deal, struck with biotech Supergen (Nasdaq: SUPG) in early 2001. But Supergen, with a market cap of around $470 million, isn't much larger than Peregrine.

I don't know enough about management to make a judgment about the company's score on that item, so I'll skip that criterion for now. That brings us to cash: Peregrine has, at various points in its history, nearly run out of cash a couple of times. It's most recent financing, in which it issued 5.75 million shares at an average price of about a buck apiece, was completed in November and brought the company's cash hoard to just over $11 million as of November 30.

Peregrine has burned an average of about $8 million per year over the past three years, and will likely be accelerating the burn as they move Cotara into pivotal Phase 3 clinical trials. That being the case, I expect that Peregrine will have to go back to the well to get more money soon. This presents real risk for Peregrine, and at the very least will likely result in substantial dilution to current shareholders.

In conclusion, Peregrine is simply at a very precarious point in its development as a company, and as such makes for a very risky investment. It does not score particularly well on any of our checklist points -- and there are many companies in the same market cap area that score better. While I hope Peregrine does succeed in its efforts to develop the next big cancer drug, I'm passing on the stock for now. 

Zeke Ashton does not own stocks of any company mentioned in this article. The Motley Fool is investors writing for investors.