Investors often find that turning a blind eye to risks lurking in their investments is far from a profit-friendly strategy. Identifying long-term stocks to hold in portfolios means understanding both a company's puts and takes.
That balanced investment approach applies to even the hottest companies, including GW Pharmaceuticals (NASDAQ:GWPH), one of biotechnology's best performers this past year thanks to excitement surrounding its marijuana-based medicines.
Although no one can predict with certainty whether shares in GW Pharma will rise or fall, let's consider three challenges facing the company that may weigh on the stock.
1. Buy the rumor, sell the news
Biotechnology investors tend to be most bullish ahead of pharmaceutical trial results or commercial launches. That's because there's a significant need for new therapies, particularly for life-threatening diseases, and because drug spending is climbing thanks to longer-living populations and eye-popping price tags for next-generation medicines.
Investors in emerging biotechnology companies like GW Pharma may want to take that kind of enthusiasm with a grain of salt.
According to a McKinsey study, pre-launch excitement often misses the mark. For example, analysts' peak sales projections are wrong 60% of the time for 260 drugs launched between 2002 and 2011, and overly optimistic outlooks overstated the potential market by as much as 160%.
That's not to say that GW Pharma won't be the exception, but it does cast some doubt on whether the valuation being given to the company's shares is justified.
After all, GW Pharma's current market cap of $1 billion is about 20 times its annualized trailing-quarter sales. For comparison, when Amgen paid 17 times sales to buy highly coveted Onyx Pharmaceuticals and get its hands on Onyx's promising cancer pipeline. Similarly, deals to acquire ViroPharma and Forest Laboratories have valued those companies at less than 10 and seven times sales, respectively.
Even if we assume that new approvals will move the sales needle for cannibinoid-based drugs like GW Pharma's Sativex, which is currently approved to treat multiple sclerosis spasticity in Europe, sales would need to at least double to bring the company's valuation more in check.
2. Crossing the moat in cancer pain
Much of the interest in GW Pharma stems from its potential to win FDA approval of Sativex as a treatment for breakthrough pain in cancer patients.
Sativex has shown solid efficacy during cancer patient trials, and an FDA decision could come within the year. Although spending on breakthrough pain totals in the billions annually, investors may want to temper predictions.
That's because doctors have significant experience prescribing opiates for the condition, and other companies such as Mallinckrodt are already innovating longer-lasting, abuse-resistant, formulations.
In addition to challenges in winning over doctors, investors should also recognize that Sativex's potential approval in this indication is for second-line use. That means that Sativex will only be approved for use in patients whose pain is inadequately controlled by first-line opiates like Teva Pharmaceutical's Actiq, Mallinckrodt's Xartemis, or Insys Therapeutics' Subsys.
3. Tempering enthusiasm over use in epilepsy
Investors are also staking a lot of GW Pharma's success on Epidiolex, a promising drug for the treatment of epilepsy.
There's no question that epilepsy is an indication in need of new treatment options. And a positive showing in a 27-patient phase 2 trial landed GW Pharma fast-track status for Epidiolex, which is being studied specifically for Dravet Syndrome. However, even if the drug eventually wins an FDA nod, the total market here might be small: just 5,400 patients are diagnosed with the condition in the United States.
Fool-worthy final thoughts
GW Pharma has been studying the potential of medical marijuana for more than a decade, but it's not alone in its attempts to develop treatments based on the drug. Insys Therapeutics has a host of promising marijuana-based medicines in development, including a new formulation of Marinol, a drug that formerly had sales north of $100 million annually.
Whether investors will continue to price perfection in GW Pharma is anyone's guess, as is whether the company's drugs will win approval and become market share leaders. Given where share prices are now, it would seem investors will need GW Pharma to enjoy a best-case outcome to justify its valuation.
Todd Campbell has no position in any stocks mentioned. Todd owns E.B. Capital Markets, LLC. E.B. Capital's clients may or may not have positions in the companies mentioned. Todd owns Gundalow Advisors, LLC. Gundalow's clients do not have positions in the companies mentioned. The Motley Fool recommends shares of Teva Pharmaceuticals. 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.