Biotech is a notoriously risky sector. What seems like a sure success one day can easily result in debilitating failure, and companies are constantly making headlines for nosediving in price when expectations fall through. But if you're an investor with any interest in the space, don't worry -- understanding risk is one of the best ways to mitigate it.

In this week's Industry Focus: Healthcare, Kristine Harjes and Todd Campbell go over the three main points of risk in biotech (trail failure, commercial failure, and patent expiration), and explain how investors can best manage their risk in the space.

A full transcript follows the video.

This podcast was recorded on March 9, 2016. 

Kristine Harjes: Getting risky with it, on this healthcare edition of Industry Focus.

It is Wednesday, March 9, 2016. Welcome to the show! I'm your host, Kristine Harjes, and I've got Todd Campbell, The Motley Fool's fantastic healthcare contributor, on the line calling in from New Hampshire. It is absolutely beautiful out at Fool HQ in Alexandria, Va., today. Is the sun shining out by you as well?

Todd Campbell: It is an astonishing 70 degrees in New Hampshire. That is unheard of!

Harjes: Unprecedented for March, yeah. I definitely did my morning prep for this episode sitting outside.

Campbell: Yeah, it's supposed to be mud season here. [laughs] Not that I miss it.

Harjes: There you go. So, today's topic is something near and dear to all biotech investors' hearts: risk. It's one of the riskiest industries out there, and I would argue that the best way to mitigate this risk is by simply understanding it. So, with that in mind, let's lay out some categories of risks that biotechs face.

Campbell: Like most things in life, education is the key to overcoming adversity. So, the more we can learn about risk and the risks we face as investors in biotech and pharmaceuticals, the better prepared we are to deal with them and position our portfolios for success. I tend to think of risk as falling into three categories in biopharma. You've got trial failure risk, commercial failure risk, and patent expiration risk. Those are the biggies.

Harjes: OK. So, let's start from the very top there. So, risk of trial failure. How big of a risk is that? How should investors be thinking about it?

Campbell: Well, we've got, unfortunately, a really good example in Celldex (NASDAQ:CLDX), a company that was working on therapy for brain cancer, glioblastoma. It, at one point, was very promising, but unfortunately, just recently, the company announced that it's going to have to discontinue its study because, sure enough, a late-stage trial will not out-perform placebo.

Harjes: Yeah, that was a huge disappointment when we saw it in the news. And the stock tanked, what, 50% or so just on that one news item?

Campbell: Right. This stock is down below $4 now, and this is probably a touchy, painful subject for investors who own the stock, given that it was trading around $30 last summer. As recently as the fourth-quarter conference call, management seemed encouraged, they were offering up encouraging words. The CEO said that he believes that fundamentally, they have a drug that's approvable in this drug, Rintega. The chief medical officer said that there was a chance that maybe the trial could get stopped early for success, and it could get to the market sooner rather than later. So, I think what this does is it reminds investors that you can take a drug that looks really, really good at mid-stage trials, for a very important indication, like brain cancer, where so many people, thousands of people get it, unfortunately, thousands of people are still dying from it. And that can make you think, "Wow, they're going to revolutionize this indication! And this is going to be a fantastic investment for me to get involved in." Until the drug clears the phase 3 trials, which is the third stage, you just can't assume anything.

Harjes: Yeah, especially with cancer medicines. We know that 90% of medicines fail at some point during clinical trials. That number goes up to 93% when we're talking about cancer.

Campbell: Cancer is very, very hard to treat and to attack, and medicines they're developing now are incredibly complex, so we don't fully understand them, especially when they get rolled out into much larger patient populations in phase 3. This trial had 745 participants in it. Anything can and sometimes does happen. In this case, it wasn't necessarily a failure for Rintega, it was a better-than-expected outcome for the people who were taking the control, the placebo group. In past trials, the placebo group didn't perform nearly as well as they did in this phase 3 trial. So, it's hard to say that Rintega is a complete failure. But, that being said, the company has halted development of the drug, and that basically leaves investors saying, "OK, what could happen next for the company?"

Harjes: So, it seems like there might still be a little bit of promise in this company. Do you think that falls into Rintega? Or do they have any other assets to fall back on?

Campbell: I think you have to consider Rintega as basically gone for now. Unless they can do some retroactive analysis that allows them to figure out how to run another trial, I don't see any more development of that drug. They do have two other drugs, though, that are interesting. I'll shorten the names, because as we all know, the names are hard to pronounce in biotech, the generic names. But, one is Glemba and the other is Varli, and these are both monoclonal antibodies that are under development, mid- and late-stage trials, for cancer. Results from both trials could start rolling out to investors either later this year or 2017. So, there are some catalysts that could re-energize the stock price. However, as we saw with Rintega, there's still a lot of risk here. If neither of these trials pan out, then you have to look at other trials in development. That being said, the market cap is far lower today than it was a month ago. They do have a pretty good amount of cash on hand that should get them through 2017.

Harjes: So, moving a little bit farther down the approval pathway, once you have a drug that has gone through trials and it didn't fail -- in fact, it performed great -- and it goes through approval, gets the green light from the FDA, the next risk you're looking at there is commercial failure. How does that one work?

Campbell: Well, probably the best recent example of a commercial failure is MannKind's (NASDAQ:MNKD) Afrezza. You and I have talked a lot about it on the show, when it won approval from the FDA, people thought that it could really change the burden that's on diabetics in how they dose themselves with insulin. Afrezza is an inhalable version of insulin that theoretically would reduce the need for them to inject themselves with insulin at mealtime. People thought that was a big advantage. However, commercially, it just didn't stick. And as a result, sales ended up in the couple million dollars per quarter range, and that's just not enough to keep the lights on.

Harjes: Yeah. And this, mind you, was a drug that, before it was actually commercialized, was forecast to be a billion-dollar blockbuster. And the disappointment that came with it really just hammered the stock. But, interestingly, I was looking at it, last time we talked about this company on the podcast was Jan. 6 of this year. And MannKind is up almost 60% since then. Would you take that as some sort of sign of encouragement, that maybe there is something to this whole Afrezza drug?

Campbell: Well, it's now a $1-$2 stock. I don't know, I don't put too much credence in the share price movement at this point. They've got a tremendous amount of debt, their balance sheet isn't very healthy. I feel like, you're grasping at straws in thinking that Sanofi, its commercialization partner, that they failed -- where they were able to build Lantus into a multi-billion dollar long-lasting insulin drug, they failed with Afrezza, and MannKind thinks that on their own, they can do better? I don't know. I think the proof has to be in the pudding there. I think, at this point, you have to say this is a commercial failure. And until they prove you otherwise, better to stay on the sidelines and just not risk an up 20% or down 20% day with your money.

Harjes: Yeah, that's the impression I've always had from this stock, that it's extremely volatile, extremely risky, and recently, the bump that it's had, to me, seems like speculation more than anything, over a possible buyout. But, again, it remains to be seen. So, our third and final risk is patent risk. So, this is even farther along in a drug's life, when it actually hits, maybe, the end of its commercial useful life.

Campbell: Right, and I think a great example of this, we actually had one of our listeners write in about questions on this stock, so I'm glad that we're talking about it today, is PDL (NASDAQ:PDLI), symbol PDLI. PDL gets the vast majority of their revenue in royalties on patents that they own on monoclonal antibodies for some of the best-selling drugs in the world, drugs like Avastin. Highly complex, expensive drugs that are multi-billion dollar blockbusters, and they're just sitting back, raking in cash. And as a result, they pay one of the highest dividend yields out there. However, the patents have all expired on most drugs, and now, as a result, PDL doesn't expect to get any meaningful revenue from those patents after this quarter.

Harjes: Yeah, thank you to Aaron in Oklahoma City, who wrote in asking about PDLI. He says that it popped up on a screener for him with these really impressive financials, and was just kind of wondering what else there was to this story. And, I think, this is a really good way to paint the picture of what happens when patents expire. You could have a really awesome revenue generator, and then it just dries up when generic competition comes in. 

Campbell: Yeah, in this case, you're right, Kristine -- we're talking about over 80% of PDL's revenue. And it's just going to disappear.

Harjes: Yeah, exactly. One question I do want to address with patent risk is, whether or not you can trust what the company itself says? Maybe not so much for PDLI, but any sort of drugmaker that says, "Oh, don't worry about it, we've got all these additional patents covering us through 2020," or whatever year.

Campbell: Yeah, we've seen that a lot more with biotechnologies. Biologics are complex to manufacture, and a lot of people are arguing, "Hey, we've got method of use patents, we've got all these other things that could protect them, and plus, it's complex, and generic drugmakers aren't going to be able to craft identical versions of it." Take everything with a grain of salt. Don't ever underestimate generic drugmakers' ability to overcome some of these hurdles and obstacles. So, I think what you have to do is, you have to look at it and say, "Okay, what do I think after reading through the SEC filings, after looking at these companies' drugs and who's challenging whom, what is my risk in this regard?"

Harjes: And, I'll also throw it out there that, you could have it go the opposite way, too, where the branded drug actually does way better than you'd expect when generics enter the market. The best example I can think of this is Copaxone from Teva.

Campbell: Yeah, that was a really interesting story. Part of that was because they had created a longer-lasting formulation that required fewer doses than the generic that was approved. So, theoretically, if a new dose gets approved by the FDA by the generics, then maybe you see Teva's sales slip off in that.

Harjes: Yeah. It's almost starting to seem like, the more different aspects of risk you think about, the more complicated it gets. And some of these are really, really difficult to actually put an expected value on. I know Gaby, on her show, the Monday Financials edition of the show, talked a little bit about forecasting and how frequently analysts miss estimates hugely, and this is definitely something that occurs in biotech and healthcare as well, where it's pretty difficult to measure exactly what the level of risk is in all three of these things we've talked about: the trial failure, the commercial failure, and the patent risk. So, Todd, ultimately, what's the best way to mitigate all of these risks?

Campbell: Diversification. I mean, you need to make sure you're not betting the farm on any one particular biotech company. You can also reduce your risk by focusing on companies that have been there and done that. You look at large-cap companies like Celgene and Gilead that rake in billions of dollars in sales and have tremendous amounts of money and financial flexibility that they're plowing back into their R&D budgets. That's a way to mitigate your risk, too. Then maybe sprinkle in some of these more clinical-stage companies that pose more risk. But don't expose yourself too broadly to them, because we've seen with Celldex and Mannkind and PDL, potentially, share prices can drop.

Harjes: Yeah, and that's also a really good way of learning the industry first, getting your feet wet before you start to go smaller-cap, more niche-y players. So, yeah, I think that's really good advice. Thanks, Todd, for being on the show, as always.

And I'll remind everyone that people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. Thank you for listening, and Fool on!

Kristine Harjes owns shares of Gilead Sciences. Todd Campbell owns shares of Celgene, Celldex Therapeutics, and Gilead Sciences. The Motley Fool owns shares of and recommends Celgene and Gilead Sciences. The Motley Fool recommends Celldex Therapeutics and Teva Pharmaceutical Industries. 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.