3 Drugmakers for the Risk-Averse Investor

When looking for development-stage drugmakers to invest in, you've basically got three groups to choose from:

• Sub-$100 million market cap companies; some have potential, but wading through the wreckage can be painful.
• Companies with market caps between $100 million and $1 billion. These offer the best chance at a 10-bagger on positive clinical trial data, but the chance of major loss is still high.
• Companies with market caps above $1 billion, where the risk has been somewhat removed, but there's still no drug on the market.

I think investors who don't have the stomach for drug development should consider investing in that last group, because a lot of the risk has been removed.

Source: Capital IQ, a division of Standard & Poor's.

Second time's the charm?
Dendreon will hear from the Food and Drug Administration on or about May 1, but this won't be the first time the biotech has faced the scientific jury -- the FDA turned down Provenge's marketing application in 2007. Investors have higher hopes this time after additional phase 3 data came back positive. The FDA signed off on the trial design, so Dendreon seems out of the woods on the efficacy front.

The only place I could see Dendreon running into trouble is with manufacturing.

The FDA is likely to look long and hard at Provenge's manufacturing because the procedure involves collecting patients' immune cells, activating them, and then inserting them back into the body. That's considerably more complex than making a drug like Lipitor, which is synthesized through a chemical reaction.

Two shots on goal
Human Genome has two shots at getting drugs approved this year, but one of them matters a heck of a lot more than the other.

The company's hepatitis C drug, Zalbin, which is partnered with Novartis (NYSE: NVS), passed its phase 3 trial, but its efficacy wasn't that spectacular compared to current treatments offered by Merck (NYSE: MRK) and Roche. Zalbin may get past the FDA in October, but the market opportunity seems somewhat weak.

Benlysta, on the other hand, should have free range in the lupus market; there hasn't been a drug developed specifically for the disease in 50 years. Many people were skeptical of the drug's chances (present company included), but after two positive phase 3 trials, a thumbs-up from the FDA later this year seems pretty likely.

You want how much for that phase 3 drug?
Vertex sticks out like a sore thumb in the table above. It's is the only one that doesn't have phase 3 data out yet, but it's also the most expensive. What gives?

There are a couple of things working in Vertex's favor. First, hepatitis C is a fairly large market, and current treatments from Merck and Roche fail to cure about 50% of patients. Vertex licensed out most of the non-North American rights to Johnson & Johnson (NYSE: JNJ), but it still has the complete U.S. rights, from which a majority of the profits will come.

The other reason that investors are willing to pay so much for a drug that hasn't completed phase 3 trials is that antiviral drugs tend to have high correlation between phase 2 and phase 3 studies. Considering the outstanding results for telaprevir up to this point, the activity could be lower than previously seen and still be sufficient to pass phase 3 trials.

Vertex is up nearly 300% since it was first recommended by the Motley Fool Rule Breakers newsletter in 2005. It'll take a while to quadruple again -- that would put it in the same range as Gilead Sciences (Nasdaq: GILD) -- but there's also a lot less risk than there was back in 2005.

The bigger they are, the smaller they fall?
None of these companies are completely risk-free, because the FDA could still find problems with their applications; just look at Mannkind, which was in the $1-billion-market-cap club until the FDA sent the company a complete response letter asking for clarification of data.

But the chance of a major failure at this point is much lower than it is for their smaller brethren that haven't proven themselves in the clinic yet. Stock drops because of delays like the one that Mannkind is experiencing still pale in comparison to those caused by drug failures, like Medivation's 67% drop earlier this month.