This might surprise my regular readers, who probably think of me as a crusty, Graham and Dodd-style value investor, but I love biotechnology stocks. In fact, if I had to pick a single favorite industry, I'd choose biotech. The appeal to me is profound -- it's science, it's commerce, it's the possibility of making a whole lotta money if you pick right (and losing a big chunk if you don't).
Yet biotech may be the trickiest sector for individual investors to evaluate. Even highfalutin' PhDs and MDs routinely make the wrong choices here, and the sheer weight of the science-speak can chase away those who diligently avoided the science building back in college. But the prospect of gains between 100% and 5,000% continues to draw people back to the space, no matter how many times their fingers get burned.
There's no fail-safe approach to buying individual biotech stocks. Anybody who tries to sell you one is pushing a load of fertilizer. What I hope to do is simply highlight some of the red flags in the sector, in hopes that I can help steer you away from some potential disasters and toward companies with a more promising risk/reward profile.
It's a given that most biotechnology drugs will fail. The average drug enters phase 1 clinical studies with less than a 10% chance of being approved. For reasons that are still not fully understood, though, there are certain diseases that have demonstrated even worse success rates in the past -- and it's not for a lack of trying.
First on the list is Alzheimer's disease -- the horrible memory-robbing ailment that strikes people in their later years. Failures here include recent, high-profile cases like Axonyx, Forest Labs, and Myriad Genetics
As somebody who sweated through immunology classes, I can tell you that calling the human immune system complex is like saying Bill Gates has a few bucks. Unfortunately, when the immune system goes haywire, it can pretty much ruin your life -- diseases like multiple sclerosis, Crohn's disease, rheumatoid arthritis, and even some types of heart disease are all caused by the immune system going bonkers.
While there are a handful of successful approved drugs for the MS/Crohn's/RA trimuverate, this is another subcategory where the failure rates for new drugs far exceed the norm. Companies like ICOS, BiogenIdec
The granddaddy of biotech nightmares, sepsis is a terrible condition that has proven exceptionally difficult to treat. Despite recurrent hope and enthusiasm, biotechs like ICOS, Xoma, and Chiron
Sooner or later, somebody will figure out how to crack these coconuts, and the benefits (to patients, the health-care system, and shareholders) will be astounding. Nevertheless, treatments for these diseases have proven profoundly complicated. As a result, investors would do well to steer clear of biotech ideas that hinge on one or more of these markets.
Thin pipelines = fat risks
I've previously made the case for steering the bulk of your biotech investment dollars toward companies with more robust pipelines, but some of the highlights bear repeating.
The more drugs in the pipeline, the more swings at bat a company has, and the better its chances for eventual success. ICOS saw three of its four main drugs in 1997 ultimately fail, but the success of Cialis has meant that long-term investors still have some profits to show for their patience. On the flip side, stocks like Axonyx, Genta, and Pharmos have been crushed when their drugs failed important studies, leaving little or nothing on which to fall back.
There's a reason that companies like ICOS, Biogen Idec, Neurocrine, and Chiron are all still alive and kicking despite some failures-- their pipelines were stocked with multiple independent drug candidates, and the failure of one or two didn't bring the roof down on their heads. Single-product companies may seem more potentially rewarding, but successful investors always make sure they live to fight another day. Leave the single-product rockets to investors who don't mind losing between 70% and 100% of their money.
The flavor of the month usually tastes bad
Like most other sectors, biotechnology has its fads. Recombinant DNA, monoclonal antibodies, oncogenes, antisense, genomics, stem-cell therapies -- all of them were at once the next cure-all panacea. Like most fads, they largely went up in a puff of smoke from burned-up investor dollars.
That's not to say that there weren't success stories amidst the carnage -- Amgen
As soon as a fad takes hold in the investing public's consciousness, a stream of cruddy biotech IPOs emerge, as investment bankers and venture capitalists rush to ring the cash register. The best defense is to never lose your head over "missing" the next wave; it generally takes between 7 to 10 years to get a drug to market, and that's plenty of time to soberly and patiently evaluate a company's prospects, pipeline, and technology. Don't rush to get in at the absolute beginning; it's just not worth the risk.
Whistle past the graveyard
The odds against any given upstart biotech are daunting, as are the odds against any individual investor picking biotech stocks. Luckily, there are ways to improve your chances.
Sticking to companies with broad portfolios and deep pipelines is a good place to begin. Keeping a level head and selling into manias while looking for the underappreciated is another strategy that has helped me greatly. Last but not least, readers can take into account the advice in this and other Foolish columns on the biotech industry, and consider subscribing to our Motley Fool Rule Breakers newsletter.
While Rule Breakers isn't devoted entirely to biotechnology, about one-quarter of the newsletter's picks have focused on the biotech industry. Not only has the team found big winners like Vertex
Give our newsletter staff the chance to impress you and lend their assistance in finding the next great biotech stocks. It's a field fraught with risk and disappointment, but one that I deeply love.
Fool contributor Stephen Simpson has no financial interest in any stocks mentioned (that means he's neither long nor short the shares). Myriad Genetics is a Rule Breakers recommendation. Biogen Idec is a Stock Advisor pick. The Motley Fool is investors writing for investors.