Buffett Would Hate These Highfliers

Warren Buffett doesn't invest in biotech. The closest he comes to drugs is large pharmaceutical companies likes GlaxoSmithKline, Johnson & Johnson (NYSE:JNJ), and Sanofi-Aventis. And he freely admits to not following their pipelines.

I think he's an inferior investor because of it.

Did you really just say that?
Yes, I did. But let's keep this in perspective. Buffett is still a great investor. He'd just be a better one if he would open up his eyes to the possibility of swinging for the fences once in a while.

Biotech is, after all, a sector that has seen its fair share of multi-baggers -- Celgene (NASDAQ:CELG) is up over 350% over the last five years, and Amgen (NASDAQ:AMGN) had an even more astonishing 700% run over five years in the late 1990s.

But it appears that biotechs fall in Buffett's "too hard" box and get thrown out as investment ideas without any further exploration.

I'll bet he's not the only one
You need to look no further than The Motley Fool's own CAPS to see that many people put biotech in their "too hard" box.

And when you look at a smaller drug maker whose products are all still in development, like Vertex Pharmaceuticals, the discrepancy gets even greater.

Seriously? Ten times as many people think they know which way Ford is headed or Garmin will steer itself?

Sure, more people drive cars than have backgrounds in science, but you don't need a Ph.D. to figure out biotechs -- or to make a bundle investing in them. In fact, one of our own Motley Fool Rule Breakers analysts is living proof. Before coming to The Fool, he managed a small biotech mutual fund -- but his degree is in English.

The fear of the unknown
Peter Lynch's maxim, "buy what you know" seems reasonable, but I've always thought the corollary "know what you buy" was much better.

Every industry has its quirks: health insurers are valued based on their medical cost ratio, banks until recently were valued based on book value, and oil companies have their proven reserves. Learn the system and it's not that hard to find the winners.

For biotech, the key is simple: find companies who are poised to have positive clinical trials and marketing approvals by government agencies like the Food and Drug Administration. It's those binary events -- approval versus denial -- that result in the monster returns seen by biotechs in the past.

By understanding how much a company will be worth after the binary event occurs, investors can make wise choices even if they still involve risk. Figuring out what the company is likely to be worth is relatively easy: just find a company with an already-approved drug in a similarly sized market. It's a rough approximation, but when we're talking about doubling or quadrupling in value, that's good enough.

Deciding how likely it is that the drug will be approved is a little more difficult, but there's no shortage of analysis on pipeline drugs. Understanding how the drug performed in clinical trials and how well its potential competition works will go a long way toward helping you predict the odds of a successful application.

Then it's just a matter of figuring out whether the returns justify the risk. For instance, if a company will be worth four times its current value after an approval, and there's a 30% chance of approval, that's a pretty good investment. You won't hit a home run every time (there's only a one-in-three chance in our hypothetical example), but when you do, it'll more than make up for the other losers.

Need a little help?
Highfliers are highfliers because they're transforming the landscape of their industries. Don't be intimidated if those industries are unfamiliar -- some time and attention can remedy that, and diving in to industries with high-flyer potential can make a big difference to your bottom line.

If you're convinced that you should part ways with Buffett and take a few swings at the fences with a portion of your portfolio, consider grabbing a free trial to The Motley Fool's high-growth Rule Breakers newsletter.

Fool co-founder David Gardner and his team of analysts focus on finding companies with high-growth potential -- both in the drug industry and out of it. In the January issue, they recommended a biotech whose stock is so beaten down the investors are getting the pipeline for free. If you'd like to see what it is -- and to see all of their other high-flying recommendations -- just click here for a 30-day free trial of the newsletter. There's no obligation to subscribe.

Fool contributor Brian Orelli has a Ph.D. in cancer biology, but he doesn't let it go to his head. He doesn't own shares of any company mentioned in this article. Garmin is a Motley Fool Global Gains recommendation. Johnson & Johnson and Glaxo are Income Investor picks. Dell is an Inside Value recommendation. Vertex is a Rule Breakers selection. The Fool's disclosure policy would be happy if Buffett used it as a placemat.