I believe it goes without saying that the biotechnology sector is one of the most unique sectors in the stock market. Whereas most industries (and the companies within those industries) are valued based on their profitability, sales, and other financial metrics, investors in biotech stocks often don't have the luxury of relying on those numbers.
Biotech: in a world of its own
You see, most biotech stocks are losing money and are still predominantly clinical in nature, meaning they're diligently trying to develop new drugs that could one day help thousands, or maybe millions of people. Because of this unique aspect of biotech stocks, they're typically valued not for where they've been, but instead by how large their patient pool and sales potential could possibly be.
For example, a company like Intercept Pharmaceuticals, which is developing a drug known as obeticholic acid to treat nonalcoholic steatohepatitis, or NASH, a disease affecting an estimated 3% of the U.S. population, is currently sporting a hefty valuation based on its large patient pool and previously strong clinical data.
In contrast, my personal holding Exelixis has just one approved drug, Cometriq, for metastatic medullary thyroid cancer, which can treat in the neighborhood of 1,500 people worldwide. This much smaller patient pool and potential corresponds to a minimal effect on Exelixis' valuation thus far.
Three catalysts that drive biotech value
Before you can invest money in biotech, you first have to understand the three main catalysts that can push biotech stock prices up or down. Yes, these will be a bit simplified, and you can certainly expand the list out a bit, but these are the primary catalysts that will move the share prices of biotech stocks.
First, we have binary events. In layman's terms, a binary event is where you either have a positive outcome or a negative outcome from reported clinical trial data. Nothing is more important to the valuation of a biotech stock than the results from its clinical trials. The safety and efficacy of a drug, or series of drugs, in a product pipeline will usually determine the bulk of the valuation of a biotech stock.
Clinical trials are most commonly run as phase 1, phase 2, and phase 3, in that order. Phase 1 studies often involve just a few dozen healthy subjects and are targeted strictly at safety. Phase 2 trials expand into subjects with a targeted disease, can involve 100 or more patients, and still focus largely on safety, although efficacy may begin to creep into the data. Phase 3, or late-stage studies, are broad (think hundreds or thousands of people) and focus on both efficacy and safety. Phase 3 is the meat and potatoes of where stock valuations are made.
Secondly, capital on hand and access to capital matters. As mentioned above, biotech stocks tend to lose money for years, or even decades, as they research new products and attempt to build a successful portfolio of therapeutic drugs. Unfortunately, that means burning through a lot of money in the process. Therefore, investors need to pay close attention to a biotech company's cash burn rate, capital on hand, and ability to raise additional capital if need be.
Lastly, drug launches are important. It's no longer sufficient to just get a drug approved by the Food and Drug Administration these days and assume everything will go perfectly. New drugs need to be priced appropriately, marketed at the correct audience, and picked up by a large percentage of insurers if they're to have a shot at long-term success.
Three paths to being a successful biotech investor
Now that you have a better idea of what drives biotech stocks up or down, let's take a look at how to invest in biotech successfully!
The first pathway to success is to focus on established product pipelines. Here, we're talking about the Gilead Sciences (NASDAQ:GILD) and Celgenes (NASDAQ:CELG) of the world that already have established products and a deep experimental product pipeline.
Gilead Sciences, for instance, has its dynamic hepatitis C duo of Sovaldi and Harvoni, which brought in $12.4 billion in sales last year. Both drugs dramatically improved the HCV cure rate over the prior standard of care and, in some cases, even removed the need for the use of interferon or ribavirin, which come with nasty side effects. Following its recent purchase of Phenex Pharmaceuticals' liver disorder pipeline -- which contains NASH-targeted compounds -- Gilead looks to have a long list of future product candidates waiting in the wings.
Celgene doesn't have as extensive a current product portfolio as Gilead and is instead relying heavily on blood cancer drug Revlimid, but it does have the ability to extend the life of its three key products -- Revlimid, Abraxane, and Otezla -- by expanding their label indications. Revlimid alone is being studied in eight additional indications. The great thing about expanding the label of an already-approved drug is that the FDA isn't likely to be too concerned with safety, removing one of the major uncertainties associated with drug development.
The second pathway you can take is to focus solely on deep pipelines, regardless of profitability. One idea to consider here is predominantly clinical-stage biotech company Isis Pharmaceuticals (NASDAQ:IONS).
Isis is currently losing money, and will likely still be losing money two or three years from now. So, what's the attraction? Isis has a drug development pipeline about three dozen products deep, covering multiple therapeutic fields and encompassing about a dozen different partnerships. Isis has about one dozen drugs in development that are still unpartnered, leaving an opportunity to further monetize its pipeline and platform. This type of diversity allows Isis to literally swing for the fences. It would only take a few home runs to potentially justify a very healthy valuation for the company.
Also, Isis Pharmaceuticals' drug development platform is incredibly unique. Its antisense platform is able to use predictive results from previous studies to rapidly discover new compounds at a faster and cheaper rate than traditional drug development processes. Whether it remains a stand-alone company or gets purchased by a larger pharmaceutical company, it's certainly a deep pipeline biotech investors are going to want to consider.
Finally, if the prospect of hunting down individual biotech names scares you, or if you don't have the time to do the necessary research, you can consider investing in ETFs, or electronic baskets of stocks such as the SPDR S&P Biotech ETF (NYSEMKT:XBI).
At the moment, the SPDR S&P Biotech ETF has exactly 100 holdings with a weighted average market cap of $8.6 billion. In other words, your investment isn't going to evaporate overnight. Its gross expense ratio (i.e., the fee to manage the fund) is also a very reasonable 0.35%.
Buying into an ETF allows you to spread your risk around, especially if you're a biotech sector novice, and own a little bit of everything, including Gilead, Celgene, and Isis. ETFs are by no means risk-free, and if anything, it should be noted that biotech tends to be one of the most volatile sectors around. An ETF likely reduces your volatility compared to buying individual biotech stocks, but it still allows you to take advantage of their potentially exponential growth rates.
Sean Williams owns shares of Exelixis, but has no material interest in any other companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
The Motley Fool owns shares of, and recommends Gilead Sciences. It also recommends Celgene, Exelixis, and Isis Pharmaceuticals. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.