Whenever a small drugmaker fails to earn approval for a new product, its shares are likely to drop. But these regulatory headwinds can sometimes create excellent buying opportunities in the volatile biotech industry, provided the company in question can address regulators' concerns and eventually receive the green light for its product.

Many companies find themselves in this very situation as we speak. Two in particular look promising: Axsome Therapeutics (AXSM 1.28%) and Provention Bio (PRVB). These aren't the most prominent biotechs, and their shares look somewhat risky. But there are good reasons to consider initiating positions in both. 

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1. Axsome Therapeutics

A series of regulatory setbacks led to Axsome Therapeutics' slump over the past year, but the biotech is on the rebound. That's because it may be on the verge of earning approval for a key candidate. Axsome's AXS-05, a potential therapy for major depressive disorder, failed to make it past its last regulatory hurdle in August 2021 -- that is, marketing approval from the U.S. Food and Drug Administration (FDA). 

The agency flagged deficiencies in Axsome's application which, at the time, precluded labeling discussions for the drug. But recently the biotech received proposed labeling from the FDA, which could signal that approval is somewhat imminent. The drugmaker expects the health regulatory body to make a decision by Sept. 30.

In May, the FDA also rejected Axsome's investigational therapy for acute migraines, AXS-07. The agency cited manufacturing issues as the reason behind the unfavorable decision. Axsome expects a "type A" meeting with the agency during the third quarter. Type A meetings are often necessary to gain input from the FDA to determine the best path forward for a drugmaker whose application for a new therapy was rejected. There do not seem to be problems associated with AXS-07's safety or efficacy, which means the medicine's chances still look good.

Axsome's portfolio also includes Sunosi, a treatment for excessive daytime sleepiness associated with narcolepsy that it recently acquired, as well as a few other pipeline programs. It would be unfortunate if the company failed to earn approval for AXS-05 by the end of the year and the FDA required additional studies before it can grant AXS-07 the green light. That's why Axsome Therapeutics remains a bit risky.

But the company's upside could be huge if things go according to plan. AXS-05 has a massive addressable market, especially given that the prevalence of depression increased during the pandemic. Axsome estimates a potential market of 19 million patients for AXS-05 and an additional 37 million for AXS-07. With these opportunities ahead and potential catalysts on the way, Axsome Therapeutics is a great stock to consider for biotech investors

2. Provention Bio

Provention Bio's situation somewhat resembles that of Axsome Therapeutics. In July 2021, Provention failed to gain FDA approval for its leading pipeline candidate, teplizumab, as a potential therapy for patients at risk of developing type 1 diabetes (T1D); the rejection was due to manufacturing issues. Provention Bio's focus is the delay or prevention of autoimmune diseases.

Teplizumab performed well in clinical studies, delaying the onset of T1D by almost three years (at the median) in one trial. But this regulatory headwind delayed the launch of teplizumab although it now seems close to approval. In February, Provention Bio announced that it had resubmitted an application for its leading candidate to the FDA following feedback from the agency. It expects an answer by Nov. 17.

Obtaining marketing approval for teplizumab would be a big deal for Provention Bio, which is still only a clinical-stage biotech. First, it would allow the company to generate some revenue, thereby helping it fund its programs. Second, and just as important, it would help validate the company's project to help prevent or delay autoimmune diseases. Provention Bio is also developing teplizumab as a potential treatment for newly diagnosed T1D patients, and it is running a phase 3 study to that effect.

The company is targeting several other illnesses, including systemic lupus, an autoimmune disease whereby a patient's immune system attacks its own tissue, and celiac disease, a condition that causes damage to the small intestine.

Provention Bio isn't without its risks either; unforeseen clinical and regulatory headwinds could sink shares of this small-cap stock. The company's market cap is only $313 million as of this writing. Failure to obtain approval for teplizumab in November would likely push its shares into micro-cap territory.

On the other hand, teplizumab may be an asset worth more than the company's current market cap. Provention Bio estimates that up to 2.3 million people are at risk of developing T1D globally. However, it plans to focus the launch of teplizumab on the 30,000 patients in the U.S. who are direct relatives of the existing T1D population in the country. Still, teplizumab was the first medicine to show the ability to delay this chronic disease by two or more years in studies, so even with a modest target market, it could become highly successful.

There is certainly potential upside for investors here, although only those comfortable with heightened risk and volatility should initiate a position.