Biotech stocks are risky, but they're also a great way to pack your portfolio with a bit more growth potential than it might have otherwise. Unlike big pharma companies, biotechs rarely have significant sales revenue from products, so they can be hard to value. Still, one of the best -- and worst -- things about these stocks is that the right headlines can drive them to grow -- or drop -- by 50% or more overnight.
Figuring out which company is going to have which outcome isn't easy, though it can be possible if you're willing to devote time to it. So if you're going to dabble in the world of biotech stocks, you'll need to be on your A-game -- and that means avoiding these three common mistakes.
Image source: Getty Images.
1. Assuming that success in the lab or the clinic is a matter of time
Per the American Council on Science and Health, only 13.8% of drugs and vaccines make it through the entire clinical trials process to reach regulatory approval for sale. The BIO trade association, which includes biotechnology companies, has an even more pessimistic take, finding that on average, only 9.6% of medicines make it from phase 1 trials through approval. The point here isn't to discourage you from investing in biotech companies, but rather to make it crystal clear that the drug development process is extremely difficult. No matter what anyone says, success in a given project is not guaranteed, and you shouldn't invest in a company with the idea that it is.
Even the best companies have clinical failures. A lot of the time, failure occurs during phase 2 clinical trials, where there's roughly a 30.7% chance of moving forward to the next phase. It's no coincidence that phase 2 trials are where biotechs need to show that their drugs are actually helpful for patients.
2. Discounting the impacts of collaborations
Before they have medicines of their own on the market, many biotechs bring in revenue by collaborating with larger companies. Typically, the smaller companies will agree to license technologies, sell drug development leads, or work in tandem with their benefactors to develop a new product. Frequently, the revenue from these collaborations is not very significant in comparison to the biotech's research and development (R&D) expenses, nor can investors count on the revenue to be recurring for longer than the term defined by the collaborators. Thus, that income might not seem relevant to a stock's valuation.
Nonetheless, there's a lot more to a collaboration than revenue alone. In fact, biotechs can gain a tremendous amount from having a larger player to guide them through the drug development process -- or vice versa. In some cases, as Pfizer's management has keenly pointed out about working with BioNTech to develop their coronavirus vaccine, the larger business can gain so much technical know-how from a collaboration that its relationship with the smaller biotech is made superfluous.
Plus, the terms of collaborations can sometimes change, giving investors an inside look at how the two parties expect their shared project to develop. As an example, consider the implications of a major company like Vertex Pharmaceuticals (VRTX -1.02%) choosing to increase its level of ownership of a joint therapy development project with CRISPR Therapeutics (CRSP -1.35%), as it did last month. In buying the majority control of the CTX001 gene therapy, whereas before it only had 50% ownership, Vertex signaled its high degree of confidence in the project. At the same time, CRISPR's willingness to give up its equal share of the program shows that its management thinks that it can get a higher rate of return elsewhere, especially given Vertex's payment of $900 million for majority control. In short, with collaborations, the fine print matters, so don't ignore it.
3. Putting all your eggs in one basket
Perhaps the most dangerous mistake that investors make when buying biotech stocks is inadequate diversification. Especially when investing in early stage biotechs, it's critical to hedge your bets by distributing your funds across multiple companies. Spreading out your investment ensures that if one of the companies hits a rough patch as a result of setbacks in the clinic or a worse-than-expected earnings report, your entire portfolio won't get taken out. For instance, if your account wasn't diversified, Inovio Pharmaceuticals' massive bad-news-driven drop last month would have been a gut punch, potentially a drop of 25%.
On the other hand, diversification also means that your winners won't swing your portfolio's overall value as much if they spike. So that gives you the opportunity to partially cash out your profits to keep your stocks weighted proportionally, thereby reducing the impact of daily price movements.
Diversification doesn't need to be too fancy: Just invest in a group of three or four different biotechs, instead of just one. It's true that you'll need to do a bit of extra research to find those additional companies, but your portfolio will be much more resilient in the long term.
