One biotech stock making recent headlines is Karuna Therapeutics (NASDAQ:KRTX). This company, now with a market capitalization of $2.9 billion, has seen its shares skyrocket by over 700% since announcing impressive results for its schizophrenia drug candidate.

It's definitely a big win for both the company and its shareholders, but investors thinking about making Karuna a part of their portfolio in light of this news shouldn't be too hasty. There are a few things worth mentioning before you consider buying shares in this hot stock.

A person arranging a series of wooden squares that make a picture of increasing, upward arrows.

Image source: Getty Images.

Could this be an overreaction?

It's pretty common for a biotech stock to jump 20%, 30%, 50%, or more on strong news, such as receiving U.S. Food and Drug Administration (FDA) approval for a breakthrough drug. However, investors should ask themselves whether a 700% surge in stock price -- based on just one set of phase 2 results -- is justified in the grand scheme of things.

For one, Karuna has a number of competitors in the antipsychotic drug market. Several major drugs in the market for treating schizophrenia include AstraZeneca's Seroquel and Pfizer's Geodon, although they tend to have a number of adverse side effects like weight gain and drowsiness. In comparison, Karuna's schizophrenia drug, KarXT, seems to have less severe adverse effects on patients while demonstrating a significant reduction in psychosis symptoms compared to the placebo. 

The study demonstrated that patients taking KarXT had an average 11.6 point reduction in the Positive and Negative Syndrome Scale (PANSS), a medical scale used to measure the severity of psychosis symptoms in patients. Additionally, 91% of patients involved in this trial were able to successfully graduate to higher doses of KarXT without having any severe adverse reactions, something which bodes well for the tolerability of the drug. KarXT's worst side effects in the study were feelings of constipation and nausea, with 54% of patients reporting at least one of these symptoms while 46% of patients remained symptom free for the entirety of the trial.

No one's denying that should receive FDA approval in the upcoming years, its lack of side effects would definitely give it an edge over its competition. The problem lies in reaching that point. Tons of companies had encouraging phase 2 trial data only to see diverging results appear in the following phase 3 trial.

The uncertain nature of phase 3 trials

In 2017, the FDA published a collection of 22 case studies documenting drugs that had strong phase 2 results yet ended up failing at the phase 3 level. Investors should pay special attention to the very first case study, which featured another promising schizophrenia drug developed by Roche called Bitopertin. Despite the fact that Bitopertin's phase 2 results saw significant symptom reductions in schizophrenia patients, the drug failed to see the same results in its phase 3 trial, with the FDA going so far as to say that it found "no evidence of a statistically significant improvement" in patients. 

Each stage in the clinical trial process becomes more rigorous than the last, with phase 3 trials requiring a larger sample size and a longer time frame than phase 2 trials, as well as often being tested against the current generation of treatments instead of a placebo. Only 58% of drugs that begin a phase 3 trial end up being put forward for FDA approval, according to biotech trade group Biotechnology Innovation Organization. 

Now, not every phase 3 failure is due to a problem in the drug itself. The trial can be a failure due to some error in the experiment. However, even if this is the case, having to redo a phase 3 trial can set a company back for years, further pushing back the release of an otherwise acceptable drug.

The point is that even with a successful stage 2 trial, there's still plenty of risk for Karuna's KarXT at this stage. With only a fraction of phase 3 trials leading to a petition for FDA approval coupled with the fact that the FDA rejects drugs for myriad reasons, there's still plenty of uncertainty around KarXT's chances.

That's not to take anything away from Karuna's recent results; They're excellent. The question is why investors should buy shares in a stock that has shot up by 700% when there's still this much uncertainty. At the same time, Karuna estimates that it won't be starting its phase 3 trial until the end of 2020, which means that investors have to wait until 2021 at the earliest to find out how KarXT's crucial phase 3 trial is doing. While it would be fantastic for schizophrenia patients and Karuna shareholders alike if it does well, it wouldn't be the first promising schizophrenia drug to fail to show results at this stage of clinical testing, and investors need to be prepared for this possibility.

Wait for a correction

Even before this announcement, most experts on Wall Street were quite optimistic about Karuna Therapeutics. Analysts at Goldman Sachs, Wells Fargo, and Wedbush all issued buy ratings for the stock earlier this year. The problem, however, comes down to Karuna's new price tag. 

Considering that many promising drugs have failed in phase 3 trials, including others targeting schizophrenia, investors need to consider this risk and whether Karuna's lofty valuation is worth it. Investing isn't just about buying a promising stock. It's about buying a promising stock at the right price. Even with these impressive results, it's hard to justify a 700% increase in share price for a drug that's only just past the phase 2 trial milestone.

In fact, I wouldn't be surprised if there's a major correction in the stock in the upcoming weeks as the speculative fervor surrounding Karuna dies down. Consider waiting for prices to settle before you think about buying this biotech stock.