For a host of reasons, it's not uncommon to see a biotechnology company's share price double virtually overnight. A report about the favorable performance of a cutting-edge technology, a green light from regulators, or positive signs from a clinical trial can -- and do -- light outsized fires under such stocks.
And an unfortunate fact of life (for me, at least) is that when biotech stocks head to the moon, it's hard not to be jealous of people who invested in them before liftoff.
It's wisest to keep that jealousy at bay, though. If there's one thing I've learned about investing in this industry, it's that trying to jump on board a biotech stock when it's already shooting skyward can be a costly mistake.
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No matter how good the news, it's expensive to buy at the top
Assuming you aren't already a shareholder, when you see a biotech stock skyrocketing, your options are to either jump in and buy its shares, or, to do nothing (perhaps only temporarily). If you don't buy the stock, you're sure to miss out on whatever is left of the price-surge, and that might even leave a bad feeling. But it's usually the better choice.
Consider Humanigen (HGEN +0.00%) as an example. In early April 2020, it announced that the Food and Drug Administration (FDA) had approved its petition for emergency compassionate use of its antibody therapy lenzilumab in patients at high risk of experiencing acute respiratory distress syndrome (ARDS) caused by COVID-19. The company's stock soared from around $4.35 to above $24 within two months.
Data by YCharts.
If you bought the stock during this run up, you'd probably have been quite satisfied with your snap decision for a while. The more aggressive you had been with your purchase relative to the announcement, the better your near-term returns would have been.
But by November, data from ongoing clinical trials had soured the market's appetite for the stock. and its price had fallen to less than $10. It hasn't even approached its former highs since then. In other words, if you had bought the stock at almost any point after the lenzilumab-related surge became clear, you'd be sitting on some gnarly losses right now, even after more than a year of patiently holding onto your shares.
And therein lies the rub.
It doesn't require a floundering clinical trial or failed regulatory filing to send a biotech stock down significantly, and time definitely does not heal all wounds in this space. At least until a couple of weeks ago, when the FDA denied its Emergency Use Authorization request, Humanigen hadn't hit any major roadblocks. In fact, its ongoing phase 3 clinical trial for lenzilumab was reporting decent results as late as August.
Avoid the hype tax
So, what's the best way to avoid buying a rising biotech only to see it plummet? There's no magic bullet, but there is a tactic that can help.
If you invest in a company right after it announces great news, you're opting to pay what I call the hype tax. The market has a habit of being a bit too enthusiastic about good news (that's the hype tax), and a bit too turned-off by bad news. It doesn't necessarily make use of any additional information to weigh the impact of the original news, something that's needed for a balanced and realistic view of the event. However, getting a balanced view takes some time -- so you, too, should take some time to evaluate the event.
How do we do that?
Start by self-mandating a significant delay between when you notice a biotech stock exploding, and when you will allow yourself to log into your brokerage account and buy it. A biotechnology company that's actually worth buying today should still be worth buying after conducting due diligence, provided there's no new information to the contrary. In fact, you might be able to buy it at a significantly lower price too as most of the hype may have already died down.
Due diligence holds key
How long those waiting periods should be will depend on a plethora of factors, such as when the company expects to report its next batch of clinical trial results, or when the next updates are due from its meetings with regulators.
Generally, assuming that you aren't waiting for more information to form your opinion about whether the stock is worth buying, you'll want to invest before those anticipatable events occur. If you aren't sure about when the next catalysts will arrive, try waiting a few weeks or a month to start with, then check the price again to see if the hype tax has fallen.
Delaying your purchase in this fashion wouldn't have completely saved you from taking a bath on Humanigen, given its ultimate difficulties with getting its drug approved for emergency use. But, it could have significantly reduced the damage. Instead of your investment being down 70% or so now, it would be down by something like 20%.
When it comes to the boom-or-bust world of biotech stocks, doing what you can to make your losses tolerable is just as important as investing early in companies that have the potential to blast off in the future. That's why conducting due diligence is of utmost importance.
