Understanding and researching biotech stocks can be one of the most complex tasks for any type of investor. There are numerous considerations that need to be taken into account, and forgetting any one of them can be disastrous for your portfolio's health if you are invested in biotech companies.
Last month, I described some of these important rules to keep in mind when wading into the land of biopharmaceutical stocks. Thanks to some great reader responses, we're offering some more commandments that should never be forgotten for anyone investing in this sector. The first six commandments can be found here.
Biotech Commandment VII
When looking at clinical trials of a drug and evaluating its prospects for approval, don't focus on just the benefits or efficacy of the drug candidate. Be sure to study the seriousness and prevalence of the adverse events that occur in a drug's trials, as well.
A drug which has the possibility of terrible side effects oftentimes won't gain approval. Even if it does get approved, it may not have a high level of sales due to its risk-reward profile. According to a journal article in Modern Drug Discovery, 31% of drugs fail in clinical trials because of lack of efficacy, but almost as many, 22%, fail because of excess toxicity.
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So a drug's benefits need to be weighed against its side effects, because sometimes a drug with lots of benefits might not be as highly prescribed (or likely to gain approval) as a drug with fewer benefits but also fewer side effects.
Biotech Commandment VIII
Investing in companies with earlier-stage pipelines provides opportunity for larger rewards but comes with larger risks than investing in biopharmaceutical companies with late-stage or marketed drugs.
One oft-cited journal article found that only 20% of drug candidates reaching phase 1 clinical trials will eventually make it to market. Thus, investors taking a chance on companies with earlier-stage pipelines are often at a much greater risk of large share-price declines than those who invest in biopharmaceutical companies with compounds in phase 3 trials or newly approved and marketed drugs.
Another point worth adding here is that the average cost of bringing a drug through the whole clinical trial process and to market (assuming it can get that far) is more than $800 million. Thus, a revenue-less development-stage biotech won't have the resources to overcome multiple drug failures, whereas a large pharmaceutical company like Eli Lilly
Biotech Commandment IX
With the one constant of all biopharmaceutical stocks being their volatility, investors can take certain actions to mitigate the risks of investing in this field.
If your investment is going to change dramatically due to a binary result like a Food and Drug Administration approval decision or upon the release of a clinical trial, it sometimes can be prudent to hedge the risk of a negative outcome by using options.
Another good point -- made by Motley Fool member PuddinHead on the Fool's biotech message board -- is that investors need to be aware of the risks of drug stocks and be careful not to overweight themselves in shares of any one company. All potential biotech investors should remember this point, because nothing is certain in the land of biotech. The value of a biotech stock can drop by more than 50% overnight on the revelation of a new negative drug interaction, a forced FDA label change, or the pulling of a drug off the market (which occurs at the rate of almost two a year).
Biotech Commandment X
The success of a biotech investment is based not only upon a biotech company successfully bringing new drugs to market, but also on a host of other factors outside the company's control.
There are very few drugs in development that will be used in indications with no already approved treatments. Many diseases such as heart ailments, cancer, and diabetes have numerous drugs already approved to treat them. Thus, for a newly approved drug to achieve a high rate of sales, the new treatment must have superior efficacy, a better side-effect profile, or more convenient dosing (or a combination of those). Therefore, it is important to research not only the drugs in the clinic of the biotechs you own, but competing drugs as well.
The other big outside considerations that deserve attention are the regulatory agencies that give the thumbs-up or thumbs-down to all drugs. Getting a sense of how certain drugs are faring at the FDA or EMEA usually provides hints about similar drugs' chances of garnering approval.
A more nebulous variable exogenous to the biotech stocks you may own, but still potentially just as vital, is the political climate and potential laws that are always swirling around in Congress. Potential laws that could pave the way for bio-generic drugs, mandatory government-sponsored health insurance, or rigid price caps on drugs would all dramatically change the biopharmaceutical sector. Even the perception of the level of conservatism among the politically appointed leaders of the FDA matters when it comes to biopharmaceutical investing.
Concluding remarks
There are other essential things to look out for, like being sure to assess the quality of a biopharmaceutical company's management team and checking to see that its members have strong financial and scientific backgrounds. The more in-depth your research of a potential biotech investment, and the more you remember to follow these commandments, the better your potential for success will be when investing in this fascinating field.
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Fool contributor Brian Lawler does not own shares of any company mentioned in this article. Eli Lilly is an Income Investor pick. The Fool has adisclosure policy.
