Investing in stocks of emerging biotech companies is a tough way to make money. The biggest risk, of course, is the arduous and expensive process of getting a drug through the FDA clinical trial process -- a gauntlet that only a small percentage of drug candidates survive. A nasty setback for a late-stage drug can often cause a biotech stock to lose half its value in a heartbeat. But even for those companies that succeed and get multiple drugs to market, a decent return for shareholders willing to shoulder the risk isn't a foregone conclusion. I've learned this lesson from personal experience, and I'm going to share it with you today.

The hunt for the next Amgen
My interest in biotech investing began in 1998, when I began developing a framework for the sector that I thought would help me find the next Amgen (NASDAQ:AMGN), which had ridden two blockbuster drugs to billions in profits and turned the stock into a 100-bagger in 10 years. Find one Amgen, I thought, and you are set for life. My research eventually drew me to a little company called Ligand Pharmaceuticals (NASDAQ:LGND), a company with some newly approved products and a great R&D pipeline. The stock was then about $13 per share.

Yesterday, Ligand closed at $7.86 per share, or about the going price of the stock way back in August 1998. The lesson here isn't that Ligand has been a failure as a company; rather, that the stock has gone nowhere in six years despite considerable commercial success. Consider this: In 1998, Ligand had no marketed products, had net debt of about $60 million, and reported a loss of $117 million on revenues of just $17.7 million for the full year. Today, Ligand has five products on the market, and revenues have jumped more than eightfold to $141 million in 2003. Yet the stock is right where it was six years ago.

Broken promises
There have been highs and lows, to be sure. An investor wise or lucky enough to sell before Ligand's latest disappointment might have gotten upwards of $20 a share -- a level the stock also touched briefly in early 2002. Of course, the stock has also fallen to abysmal depths, once dropping below $4 in January 2003. The latest stock drop is but a natural reaction by investors to a management team's refusal to learn to temper expectations.

CEO David Robinson aggressively set expectations in his 1998 annual letter to shareholders when he promised that growing revenue from two newly approved products, in combination with cost controls, "will facilitate reaching early profits in 1999 and significant profitability in 2000." In the same letter, Robinson noted that the company's cash hoard of $72.5 million would be "adequate to finance our operational cash needs to profitability." Upon the approval of Panretin, Ligand's first product to market, Robinson informed investors at the BancBoston Robertson Stephens Medical Conference in December that "the company expects Panretin to have sales of $35 million to $70 million annually in the US" according to an article at that time.

The stock rose to more than $13 around the time that annual report hit shareholder mailboxes. By August, when it was clear that profitability was nowhere in sight, shares were back under $7. As I write this article, Ligand still is not profitable, and annual revenues of Panretin have never exceeded $4 million.

In the 1999 shareholder letter, Robinson reported that "while we would like to be able to report that we met our original goal of achieving profitability in 1999, we fell short of that goal. The approval and launch of Targretin capsules and the doubling of our sales force and marketing force, however, should greatly facilitate achieving profitability in 2000." The company went on to lose another $59 million the next year. By the 2000 annual letter, Robinson's stated goals were reduced to "revenue growth and quarterly operating break-even in 2001." That didn't happen, either; the 2001 letter reported that "we cut annual operating losses in half, to $23.1 million, and expect to show a profit on an operating basis in 2002." Uh-uh -- Ligand's operating loss actually increased in 2002. More disappointment followed in 2003, and earlier this week Ligand missed its Q2 earnings forecast -- and reported the resignation of its independent auditors. Not a good sign, that last one.

Dilution destruction
Ligand's failure to sustain any shareholder wealth creation has been caused by more than just its consistent inability to hit its own profitability targets, as annoying as that has been. Savvy investors see beyond that. The problem is that Ligand has had to keep going back to the financing well for more capital to fund its ongoing losses -- since 1998, shares outstanding have almost doubled, from 40 million to 73 million. This dilution means that a 1998 shareholder owns 42% less of the company in 2004 than in 1998. Not all of this dilution has come from capital raising, either. Ligand, like most biotech companies, is a liberal issuer of stock options to executives and employees. Option grants have averaged well above 2% of outstanding shares each year since 1998. This adds up over time.

The tragedy about all this is that Ligand has been great at doing what biotech companies are supposed to do -- getting new drugs to market. The company has introduced five new drugs in the last five years, a truly outstanding achievement. Unfortunately, the company has contributed to the nasty volatility of the stock by its foolish attempt to play the Wall Street earnings game -- a no-win affair in any case, but particularly nasty if you have a habit of overpromising and underdelivering.

Deja vu all over again
Let me summarize what I've learned from this biotech odyssey. First, drug development takes far longer than you think it will. Second, dilution kills. Third, if you are going to buy, buy when the bad news is out -- you get a far better price. Ligand looks pretty cheap at under $8, but there's a fourth lesson -- make sure the bad news is really out. The auditors have resigned -- that's one good reason for caution. The other is that the company's guidance for full-year revenues of $235 million to $255 million is still way too high. The company managed only $77 million in the first half of the year, and making those numbers will require $158 million in second-half sales. Based on the company's track record, I wouldn't be surprised if Ligand disappoints yet again.

Guest columnist Zeke Ashton is the managing partner of Centaur Capital Partners LP, a money management firm based in Dallas. At the time of publication, Centaur had no investment positions in the companies appearing in this article. Please send your feedback to The Fool is investors writing for investors.