There are two kinds of risks in the stock market. The first is execution risk, which is the probability that the company whose stock you are buying will survive and thrive. And the second one is valuation risk. This is the risk that you are paying too much for your shares.

Many biotech companies have neither profits nor revenues, which makes this sector highly risky. When you buy a biotech stock, you are taking a risk that your company will fail to execute and the biotech's drugs will not receive approval from the U.S. Food and Drug Administration (FDA), or otherwise fail to make any money. 

Lab researcher mixes chemicals in a test tube.

Image source: Getty Images.

One way you can stay on the safer side in the biotech world is by reducing your risk on the valuation front. It might be worth your time to research small-caps and micro-caps in the biotech space, and look for companies with impressive science and a cheap stock price. That's why I'm pretty excited about Pieris Pharmaceuticals (NASDAQ:PIRS).

The potential upside is mind-boggling

What's got me excited about Pieris is that it's a platform company. So it's not just one or two drugs that might make this stock a winner. If the upcoming clinical trials validate Pieris' science, then the value of the company's intellectual property is astronomical.

What Pieris is attempting to do is introduce a whole new class of drugs to the market -- artificial proteins called Anticalins. The company derives these molecules from human lipocalins, proteins that transport molecules throughout the human body. Pieris invented Anticalin proteins, so the biotech has strong intellectual property in this area, and it's built up a massive library of over 100 billion Anticalin proteins.

If you have any interest in biotech stocks at all, you've probably heard of monoclonal antibodies (mAbs). The market for these treatments will be worth an estimated $145 billion this year. Pieris believes its technology is superior to mAbs. Specifically, Anticalin proteins are eight times smaller than antibodies. So, for instance, a drug company trying to treat a patient with asthma might want to use Anticalin tech, because Pieris' small molecules offer direct delivery to the lungs (something mAbs can't do).

Not surprisingly, successful biotech companies are interested in this technology, and are willing to spend a little money in clinical trials to see how it works. So Pieris has collaboration agreements with AstraZeneca, Seagen, and Roche. These pharmaceutical companies have licensed the Anticalin technology and are testing the drugs now in clinical trials.

The valuation risk is minimal

When we're at the level of a micro-cap, it's all about the execution risk. Most micro-caps stay in obscurity and quietly disappear. That's why I'm very happy to see all those collaboration agreements, because for me it validates the science of this micro-cap. The researchers at those large companies know way more about drug development than I do.

So far, Pieris has received $175 million in upfront and milestone payments from its biotech partners. This doesn't mean that its drugs will succeed, of course. But you don't pay $175 million to access a drug library from a micro-cap unless you perceive that library to hold value.

Right now, Wall Street is valuing Pieris stock at $220 million. That's roughly twice their cash on hand ($120 million). Pieris has no debt. This is a dirt cheap stock right now in the biotech world. There are lots of unprofitable biotech stocks that have market caps of $2 billion or more. In other words, Pieris shareholders might enjoy a 10-bagger if market sentiment changes (or awareness increases). So, in my opinion, there's not much in the way of valuation risk for Pieris, vis-à-vis the biotech market as a whole.

The execution risk is substantial

What makes Pieris risky is what makes many biotech stocks risky investments -- execution risk. We simply don't know yet if Pieris is right on the science. Will more and more drug companies take an interest in Anticalin proteins? I hope so. The company is expecting phase 2 readouts next year, so we will have a much better idea sooner rather than later.

For me, the risk/reward ratio is fantastic. For instance, under its existing collaboration agreements, Pieris might make up to $9 billion if its drugs meet all the milestone targets under contract. And that number doesn't include future royalties. And it doesn't include future collaborations with other pharmaceutical companies if this tech actually works.

In other words, good news from the phase 2 trial isn't just good news for a particular drug. It's a validation of the whole Anticalin platform. And the value of this stock will increase geometrically, as other biotech companies start paying to access the Pieris library and use Anticalin tech to design drugs.

My initial investment here is tiny, almost ridiculously so. I bought 200 shares at a price of $3.50 each. I hope to add to my shares over the next several months. But if I don't, it's not a big deal. That's the nice thing about micro-caps -- all you need is a small investment in a successful company to make money. And if the company fails, a small investment is all you want anyway.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.