Anyone investing in the biotech sector can tell you it takes only one mistake or overlooked aspect of a company for you to instantly lose 40% or more on your investment.
The first step to avoiding these types of losses is to understand the patterns that emerge over time in the biopharmaceutical companies that suffer such drops. I'll call these patterns my Biotech Commandments.
As with anything in biotech, these rules don't hold for all companies. There will always be exceptions to these commandments, but in general, if you pay attention to them, you can avoid, or at least be prepared for, any biotech landmines that may be lurking ahead.
Biotech Commandment I
Drugs that fail their primary endpoints in clinical trials yet still get submitted to the Food and Drug Administration, in their creators' hopes of gaining approval based on some data mining or retrospective statistical analysis, usually do not get approved.
Back in 2004, longtime Fool biotech guru Charly Travers wrote about the problems associated with data-mining clinical trials when drug companies shoot for drug approval. A more recent example occurred last year, when Abbott Labs
Officials at the FDA advisory board meeting for Xinlay were not impressed with Abbott's data mining and unanimously voted to reject the drug for approval. It was no surprise: Very rarely do drugs failing all of their primary endpoints gain approval. So be wary if a company's management says that it's going to file for approval when the drug in question has failed its primary endpoints.
Biotech Commandment II
Biotech companies located on the Pink Sheets, over-the-counter exchanges, or even the American Stock Exchange often make for lousy investments.
The development-stage biotech stocks that populate these exchanges often have to raise funds via share offerings, and they generally just aren't large enough, don't attract enough investor attention, and lack the type of liquidity to avoid raising capital at prohibitively expensive rates.
Biotech Commandment III
Expect volatility in the share price of biotech stocks whose companies don't have revenues or approved drugs.
Biotech companies without any revenues often experience dramatic swings in their stock prices -- swings based largely on the whims of the market, or changes in the prospects of the larger biopharmaceutical companies, like Genentech
Examples of this phenomenon abound. One good example is Rule Breakers selection Exelixis
Biotech Commandment IV
Drugs formulated to treat certain types of diseases have a much harder time gaining regulatory approval than do other drugs.
Drug candidates in the areas of pain management, Alzheimer's disease, or several of the autoimmune diseases such as Crohn's disease, or drugs for patients not responding well to a standard of care, tend to have larger hurdles to overcome in successfully showing efficacy and ultimately gaining regulatory approval.
The history of biotech is littered with the failure of drugs in these areas. The lack of success getting drugs approved in these indications is due to many instances of the placebo effect, high patient dropout rates, or lack of knowledge of how the disease works.
Take Alzheimer's disease, for instance. There are still numerous theories on how the disease works, and multiple drugs are being developed based on these theories. It may be discovered that Alzheimer's attacks the brain in multiple ways, yet some drugs will undoubtedly have been developed based on incorrect theories and will ultimately fail.
Even if a drug to treat Alzheimer's does show efficacy in early non-randomized clinical trials, it could still fail when taken in randomized late-stage trials in which the placebo effect is reduced. Without knowing much about how Alzheimer's disease works, though, handicapping which drugs will succeed and which will fail is next to impossible.
Biotech Commandment V
As a clinical trial's size and length increase, so do the complexity and probability that something may go wrong.
Drugs-in-testing intended to treat chronic disorders, such as diabetes or multiple sclerosis, or more common ailments affecting a large group of the population, such as high blood pressure or other cardiovascular-related problems, require large and lengthy clinical trials. Thus, clinical trials in these therapeutic areas are much more prone to cost overruns and trial delays.
The upside, though, is that it becomes much easier to show a drug's benefit when it's being tested in a large clinical trial. The larger a clinical trial is, the smaller a drug's benefit can be and still show "statistical significance" -- the probability that the results seen in patients who received a drug is due to the drug and not to chance.
Biotech Commandment VI
Charly Travers proposed this one on the Rule Breaker biotech discussion board: Stay away from unproven technologies. You have no idea whether the tech even works in people, let alone the specific drug you're investing in.
Antisense and cancer vaccines are good examples of drug technologies that are still very early in their scientific lives, despite many years of research and development. Numerous companies, among them Cell Genesys
Today, the current hot class of drugs is monoclonal antibodies, or mAbs. Lots of companies have profitable mAbs, including Biogen IDEC
In no way is this a complete list of Biotech Commandments, and while a company possessing any of the bad characteristics we've mentioned here isn't necessarily an investment time bomb waiting to explode, it might be riskier than the average biotech.
Since long-term successful biotech investing requires accurate risk assessment, you must be aware of the risk you're taking on. Just as with any prospective investment, if you diversify your biotech holdings, you can somewhat mitigate these various risks. Fool analysts Karl Thiel and Charly Travers do just that with their biotech picks in the Rule Breakers newsletter. You should, too.