Buying when everyone else is scared may sound like a fantastic way to buy great companies at bargain-basement prices, but it can be tricky to figure out when there's enough fear to justify buying, especially in hit-and-miss industries like biotechnology.

Since so many promising drug candidates end up in the clinical trial waste bin, biotech's pop-and-drop nature makes them suitable for only the most risk-tolerant investors. But for investors willing to take some risk and own companies in the industry, short interest may be a good way to measure fear. After all, short interest tends to peak when markets are at their rockiest.

With that in mind, I crunched the numbers to see whether there were any  heavily shorted biotechnology companies that may be worthy of portfolios. Read on to see which three heavily shorted biotech stocks I found intriguing.

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Source: Emergent BioSolutions.

1. Emergent BioSolutions (NYSE:EBS) is one of those kinds of companies we kind of hope never sees a surge in demand. Why? Because Emergent specializes in making vaccines that can be used to defend populations against biological warfare. The company manufacturers BioThrax, an FDA-approved vaccine for the prevention of anthrax and various other treatments that can be used to treat or prevent diseases such as smallpox.

BioThrax accounted for $67.5 million of Emergent's $110 million in Q2 sales, which was up slightly from $65.6 million a year ago. But Emergent's revenue really improved thanks to government contracts to develop botulism and an inhaleable anthrax vaccine. Those contracts resulted in revenue of $22.9 million, up 36% year over year. Overall, the company's second quarter prompted the company to boost its sales guidance for the full year to between $425 million and $450 million, up from a prior forecast of between $415 million and $445 million.

Importantly, unlike many biotechs, Emergent is already profitable. Analysts expect Emergent to earn $1.17 per share this year and $1.70 next year, which gives it a very reasonable forward P/E ratio of 12.7. Although most of Emergent's sales come from the government, and despite its sales growth and profitability, short sellers are sitting on 3.77 million shares, equal to nearly 18 days' worth of average daily trading volume.

2. NewLink Genetics (NASDAQ:NLNK) may have fewer short sellers in its shares next week, given news out this week that giant drugmaker Roche (NASDAQOTH:RHHBY) is teaming up with the company.

Roche's Genentech is handing over $150 million upfront to partner up with NewLink on its immunology drugs for the treatment of cancer. If that partnership works out, NewLink could earn more than $1 billion in milestones.

In September, NewLink also launched a phase 1 trial that's studying its Ebola vaccine in healthy volunteers. The vaccine, which the Public Health Agency of Canada initially developed, has shown promise in primate studies, and the phase 1 trial will be conducted with help from the Department of Defense. 

Despite the deal with Roche and the Ebola vaccine trial, NewLink is still a risky bet since it doesn't have any products on the market. But Roche's cash infusion should give NewLink plenty of dry powder to advance these drugs through clinic, as well as others including drug candidates for pancreatic cancer and melanoma.

Regardless, with sellers short 35% of the company's shares available for trading, representing nearly 18 days of average trading volume, there may be an opportunity for upside.

3. Albany Molecular (NASDAQ:AMRI) isn't your typical biotech. Instead of developing new drugs, it helps others discover and manufacture them. 

Albany operates a large manufacturing business that manufactures 50 different drugs and drug ingredients, or APIs, for other companies, and rising demand for contact manufacturing over the past few years is more than offsetting falling revenue at its contract research business.

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Source: Albany Molecular.

Importantly, rising sales are becoming increasingly more profitable. The company thinks it will deliver an estimated EBITDA margin of 20% this year, up from a low of 2.8% in 2011.That has industry watchers expecting EPS to grow from $0.88 this year to $1.12 next year.

Albany thinks its contract research revenue will rebound, growing from about $80 million today to between $200 million and $300 million by 2018. Albany is even more bullish on its API business, projecting that it could grow from $126 million last year to $700 million in 2018 as more companies, including generic-drug makers, outsource production. And Albany believes its drug manufacturing business will expand from about $40 million today to between $200 million and $300 million in 2018. If Albany comes through on those forecasts, it would have combined total revenue of at least $1.1 billion a year.

That's a rosy forecast, and short sellers appear unconvinced. Sellers are sitting on 23 days' worth of average daily trading volume short, but they may discover it's not worth betting against Albany CEO Bill Marth. After serving on Albany's board since 2012, Marth took over the reins as CEO earlier this year. Previously, Marth spent a decade running Teva Pharmaceuticals' (NYSE:TEVA) U.S. operations, orchestrating 10 acquisitions along the way. If Marth can duplicate the success he had at Teva, shorts may be forced to cover. Since Marth bought 30,000 shares of Albany in May at $15.40, it would seem he's pretty confident that he can pull it off. 

Looking ahead
Short interest suggests that pessimism is too high tor these three stocks given that each has catalysts that could allow for future growth. Emergent and Albany are expected to see earnings grow, rather than shrink, in the coming year and Roche's vote of confidence in NewLink may give sellers reason to pause. 
However, all three of these biotech companies are small cap stocks, which means that they can be particularly volatile and risky and that means that only the most risk tolerant of investors may want to consider them.

 

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 Emergent BioSolutions and Teva Pharmaceutical Industries. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.