Biotech is the quintessential growth sector. Companies that can successfully bring a new drug to market can see their share price soar, providing early investors with huge returns in a short period of time.
However, investing in biotech stocks can be intimidating for beginners. It's no surprise that many investors consider the word "biotech" to be synonymous with "risk," as it often takes millions of dollars and several years to navigate a new drug through the regulatory approval process. Even if a drug gains FDA approval, success is far from guaranteed. Add in the feeling that you need a science degree just to understand the medical jargon used in press releases and presentations, and it's no surprise many investors simply write off the entire sector.
However, biotech doesn't have to be intimidating if you learn a few basics about the industry, and there are ways to help reduce the risk. We asked some of our top biotech analysts to share some advice about how a beginner can start investing in biotech stocks. Here is what they said.
Todd Campbell: If you're new to investing in biotechnology, strap in, because biotech stocks are among the market's riskiest investments. These companies can pop or drop significantly based on the latest news from their research pipeline; for that reason, one of the first things I do before buying any biotech stock is consider whether the company's pipeline opportunity outweighs the risk of a drug failing during clinical trials.
Roughly 90% of all drugs that enter clinical trials end up in the waste bin, so small biotech stocks that don't have any revenue and are only developing one drug are often too dangerous for most investors to own. A better approach could be to focus on proven companies, such as Celgene Corp. (NASDAQ:CELG) or Gilead Sciences (NASDAQ:GILD), that have strong existing revenue sources and pipelines that cut across many drugs and different diseases.
However, if you're intent on investing in small-cap businesses and are willing to accept a pipeline failure, try to stick at least with companies that have late-stage research trials under way that are addressing either a big patient population, where demand for new therapies can be significant, or rare indications, where pricing power is likely to be best.
For a beginning investor, a great way to own these entrenched biotechs and also gain exposure to small caps with major upside potential is to buy shares of the iShares Nasdaq Biotech ETF (NASDAQ:IBB). The top three IBB holdings are Gilead at No. 1, Amgen at No. 2, and Biogen Inc. (NASDAQ:BIIB) at No 3. But IBB also holds plenty of smaller players that have the potential to break out. Those include bluebird bio (NASDAQ:BLUE), a stock I recommended in December that has soared 85% year to date. Overall, the fund gives investors exposure to this high-growth sector without having to take on the risk of choosing individual stocks.
However, if you want to dip your toes in buying individual small caps, the most important thing to remember is that these stocks generally trade based on clinical trial failure or success. That's why I advise focusing on companies with strong collaborative partners that can provide cash to help them weather setbacks. Otherwise, if a drug misses its expected endpoint, your holding can lose most of its value in one day.
Brian Feroldi: Biotech investing, I'll mention once again, is risky by nature, so my advice to new investors is to build your knowledge in the space by starting on the lower-risk end of the spectrum by eliminating from consideration any company that is not free cash flow positive. To make this determination, simply look at the company's most recent annual cash flow statement, find "Total Cash Flow From Operating Activities," and subtract "Capital Expenditures." If the number is positive, the company has proven its ability to generate cash from its operations and is more likely to be in control of its financial future. Sticking with these more established companies is a great way to reduce risk.
Consider Amgen, a relatively safe company that Cheryl also mentioned. In 2014, the company generated about $7.8 billion in free cash flow, which gives it plenty of firepower to invest in new drugs, make acquisitions, buy back stock, and even pay a strong dividend. With Amgen creating that much free cash flow, there are plenty of ways for a long-term investor to win, even while taking on much less risk compared to other biotech investments.
Brian Feroldi has no position in any stocks mentioned. Cheryl Swanson owns shares of Amgen, and Biogen Idec. Todd Campbell owns shares of Gilead Sciences. The Motley Fool recommends Bluebird Bio, Celgene, and Gilead Sciences. The Motley Fool owns shares of Gilead Sciences. 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.