The secret to successful biotech investing is to understand how the industry works better than the next guy. Following the crowd is no way to make money.
For instance, it's hard to make money on shoo-in Food and Drug Administration approvals. The approval is already reflected in the price. On numerous occasions, we've seen shares dip after expected FDA approvals.
Years of experience can help identify when the crowd has things wrong. So can reading many different opinions.
Except when things change
It used to be that the FDA was pretty conservative. It wanted well-documented data that proved a drug was safe and effective. If the company didn't have it, the drug wasn't approved.
While that wasn't good for drug developers, the consistency helped investors know what could get past the FDA and what would get shot down. There are drugs that fall in the grey area in between obvious approval and obvious rejection, but they were easy to identify as such even if it was harder to know which way they were headed.
But now the grey area seems to be moving. All signs point to the FDA becoming less stringent. The agency approved 39 drugs in 2012, compared to the 23 per year it averaged in the previous 15-year period. Bloomberg reports that Janet Woodcock, director of the FDA's Center for Drug Evaluation and Research, said that a large phase 1 trial might be good enough to gain approval for drugs that have gained the new "breakthrough" therapy designation.
Vertex Pharmaceuticals (NASDAQ:VRTX) was the first to announce that it had gained the designation for its cystic fibrosis drugs. This week, Pharmacyclics (NASDAQ:PCYC) and Johnson & Johnson got the designation for their blood cancer drug ibrutinib.
Most drugs require data from multiple phase 3 trials. Accelerated approvals are possible with phase 2 data for diseases with no treatment options. But phase 1 data? Wow, talk about bringing in the goalpost.
Unprecedented -- until it isn't
I've argued that Sarepta Therapeutics is unlikely to gain approval of its Duchenne muscular dystrophy drug, eteplirsen, because the most recent trial only treated eight patients with the drug. And two of the patients weren't included in the clinical efficacy calculations because they had deteriorated too far.
I know of no drug that has been approved with data from less than 10 patients. Twenty or 30 patients? Sure, the FDA will accept that few if the drug treats an orphan disease where there aren't that many patients. There's no precedence for approving a drug with eight patients that I know of.
Except, now it sounds like this data could be enough for an approval. Maybe. Possibly. Perhaps.
Dealing with uncertainty
While the FDA becoming less stringent is obviously good for the industry, it makes it tricky for investors until there's been enough decisions that it's clear exactly where the line is for the new standard for approval.
Investors and industry pundits have gotten caught in this shift already. Last year, when VIVUS (NASDAQ:VVUS) and Arena Pharmaceuticals (NASDAQ:ARNA) were trying to gain FDA approval for their respective obesity drugs, it seemed likely to me and a lot of other biotech veterans that the drugs would be rejected. The FDA had already turned down the drugs once. VIVUS' Qsymia had birth-defect side effects; Arena's Belviq had a laundry list of issues that kept it from getting approved the first time. The third player, Orexigen (NASDAQ:OREX), was required to run a large trial to prove that its drug, Contrave, didn't cause heart problems before the drug could be approved.
Except the safety-first FDA did an about face and approved Qsymia and Belviq. It's even signaled to Orexigen that its pathway to approval could be sped up.
If you sat on the sidelines, you missed out on a spike after the FDA advisory committees and the approvals, but at least you didn't lose any money.
Unless you shorted the stocks, of course. Getting back to how I opened this article: The easiest way to make money in this sector has been to bet against the uniformed crowd. Cult investors are more likely to be optimistic about a drug's chances than overly pessimistic. Shorting was always risky, but with the uncertainty, it's even more so now.
Investors can limit the risk by buying put options, which allow you force the seller of the put to buy shares at a predefined price. If the shares fall below that level, you can buy shares and collect the difference between the two. The most you can lose is the cost to buy the put.
More risk-adverse investors would be best off sitting out these questionable approvals altogether until it becomes clear exactly how the new regulations will affect FDA approvals.
Fool contributor Brian Orelli has no position in any stocks mentioned. The Motley Fool recommends Johnson & Johnson and Vertex Pharmaceuticals. The Motley Fool owns shares of Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.