Trap

Source: Flickr via user Botheredbybees

I've been working and investing in biotechnology since the 1990s, well before it was fashionable to do so. As such, I've seen enough of the industry to realize that it's quite unique in ways that can be extremely counter-intuitive to the average investor.

Perhaps the oddest part is that even though patterns in the sector repeat themselves over and over again, the vast majority of investors fail to grasp them, causing them to pick stocks that simply aren't great investing vehicles for long-term gains. Or worse yet, they ignore stocks that are gearing up to become top dogs in the industry.

So let's take a deeper look at three common pitfalls that plague biotech investors.

1. What management says is often meaningless
I think all investors hope and pray that they can trust what management says on their quarterly conference calls. But in the biotech industry, you should take nearly everything they say with a huge grain of salt.  

For instance, the management teams of top-tier biotechs like Celgene Corp. (NASDAQ: CELG) and Gilead Sciences (NASDAQ: GILD) have become infamous for their conservative annual guidance. And that's led to some painful days and weeks for investors following these announcements.

But true to form as a counter-indicator, Celgene and Gilead have both repeatedly crushed their annual projections, triggering major rallies in their shares. The bottom line is that the dips in their shares after guidance was released in 2014 and 2015 turned out to be excellent buying opportunities for investors who realized that management was setting the bar low on purpose. 

On the flip side, it's commonplace for smaller, struggling biotechs with new products to overestimate their annual guidance, even grossly so in some cases. Aegerion Pharmaceuticals (NASDAQ: AEGR), for instance, has had to continually slash its quarterly and annual sales guidance for its novel cholesterol-lowering drug Juxtapid since the drug's launch, which has caused its share price to crater:

AEGR Chart

2. Market size is often meaningless
One of the biggest "tricks" the biotech industry plays on investors is hyping up the enormous market size of an experimental drug. The logic is simple: big market, big money. But nothing could be further from the truth. 

As Arena Pharmaceuticals (NASDAQ: ARNA), Orexigen Therapeutics (NASDAQ: OREX), and VIVUS have clearly demonstrated with their FDA-approved fat-fighting pills, market size is meaningless if doctors aren't willing to prescribe the drugs. Prior to their commercial launches, this next generation of FDA-approved weight loss pills were predicted, by some, to garner staggering sales numbers in the billions. More than two years since the first wave of these drugs hit the market, however, it's unlikely that their combined sales will reach $170 million this year, meaning that there probably won't be a single blockbuster among them. 

Rare disease drugmakers drive this point home even further. The leaders in the rare disease space, like BioMarin (NASDAQ: BMRN), have barely been noticed by the average retail investor, as demonstrated by its staggering 99% institutional ownership. Yet the company's laser-like focus on treatments for diseases with tiny target markets has catapulted its revenues and share price higher over the last few years:

BMRN Chart

3. The past is totally meaningless
In biotech, you have to forget about the past completely or it'll burn you. I think the biggest pitfall for investors is their reliance on past events to guide their investing decisions. But if I've learned anything from watching biotech for more than a decade, it's that success -- or failure, for that matter -- in one clinical trial in no way predicts the future clinical progress of an experimental drug or medical device.

As a brief example, Acadia Pharmaceuticals (NASDAQ: ACAD) was a beaten down biotech stock at one point because its experimental Parkinson's disease psychosis drug, Nuplazid, failed to meet its primary endpoint in a pivotal late-stage trial in 2009. Fast-forward a few years and factor in a couple of tweaks to the clinical trial design and Nuplazid ended up crushing its primary endpoint in another trial, causing Acadia's share price to do this:

ACAD Chart

Key takeaways
A few years back, I missed the boat on Acadia because of Nuplazid's prior clinical history. And since then, I've bought a couple stocks that looked promising based on early stage clinical results but ultimately flopped.

That said, I've been able to stay in the biotech game -- and even beaten the broader markets on a consistent basis -- by holding a diversified portfolio of stocks for the long haul. Gilead, for instance, has been a monstrous stock for me, and along the way I've largely ignored what management was saying about annual sales guidance. And I've made a habit of owning a rare disease drugmaker. Not only do these stocks garner huge premiums, they also tend to be snapped up by larger pharmas. 

At the end of the day, biotechnology is perhaps one of the most challenging industries to invest in because it requires a working knowledge of business, biology, and general scientific principles. Biotech can fool even the best of us due to its numerous contrarian indicators, which range from how management talks about their business outlook to the clinical history of key product candidates.

The trick is to try and avoid these three common pitfalls and stay invested for the long-term in top-notch companies like BioMarin, Celgene, and of course, Gilead. 

 

George Budwell owns shares of Gilead Sciences. The Motley Fool recommends BioMarin Pharmaceutical, 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.