The Wrong Way to Invest in the Right Stocks

Persuading you to invest in biotechs should be easy. Persuading you not to use what seems like a less-risky strategy might be harder.

But I'm willing to give it a shot.

Explosive growth
Here's the easy part -- sometimes numbers speak louder than words:

Sure, I cherry-picked some of the best five-year periods, but that's exactly the point: To get the triple-digit annual percentage gains, you've got to find drug companies before they launch a new product or two. You need to find the companies before they become the next Celgene or Amgen.

Biotechs, by their very nature, are risky, because they depend on binary events like clinical trials and Food and Drug Administration approvals. But even the most conservative of portfolios can afford to take a swing at the fences for gains like those.

One way to invest in biotech
If you're convinced that returns like those would be great, but the riskiness of biotech scares the living daylights out of you -- don't worry, you're not alone.

From the very beginning of our investing careers, we all learn that the way to mitigate risk is to increase the number of companies we're invested in. A concentrated portfolio has little defense, should things go wrong. So maybe investing in the entire biotech sector through an exchange-traded fund (ETF) is the answer.

Wrong!

Unfortunately, the set-it-and-forget-it ETF strategy doesn't work as well for investing in biotech companies as it does for other industries.

Like many ETFs that follow industries, the iShares Nasdaq Biotechnology Index Fund is dominated by a handful of large companies.

Source: Morningstar.

But in biotech, even more than in other industries, the small up-and-coming companies will drive returns. And in an all-industry ETF, their power is muted by companies that long ago had their day in the sun.

A shining example
Don't get me wrong; industry-focused ETFs are fine for some sectors. Investing in an ETF guarantees that you'll get the average return of many of the companies in the industry. If you don't have the time or knowledge to figure out which ones will outshine, taking the average is a good alternative.

But the average return in biotech isn't all that special, because the skyrocketing returns that make investing in that industry worthwhile get lost in the crowd. In this field, regression to the mean isn't all that impressive.

Consider the results from the top performers of the current holdings of these two SPDR ETFs in 2007, the last year they had positive returns:

Source: Capital IQ.

The utilities sector fund, for example, is dominated by larger companies such as Exelon (NYSE:EXC), FPL Group (NYSE:FPL), and Southern Company (NYSE:SO). Investing in the ETF, instead of in rising-star companies, would have reduced your returns somewhat -- but look at the difference between the biotech industry performance and its highfliers.

A better way
Rather than trying to diffuse risk by buying the whole industry, you can do so by tracking a small, hand-selected group of drug developers and watching their pipeline developments closely. That way you can find the next Amgen or Celgene -- before they're five-or-more baggers.

A biotech with a strong pipeline mitigates some of the risk inherent in biotechs, because if one of the drugs fails in clinical trials, there's another to replace it. And during bear markets, when secondary offerings are a bad idea, the pipeline can provide some much-needed cash through licensing deals with pharmaceutical companies.

While it's ideal for a company to have multiple compounds in the pipeline, it's also possible for a biotech to see one compound grow into multiple treatment areas. For instance, Onyx Pharmaceuticals was able to post those stellar returns in 2007 by expanding the use of its cancer drug Nexavar from kidney cancer into liver cancer.

Positive clinical trials and FDA approvals bring big rewards for investors -- which is why it's worth your time to track the up-and-comers.

Build your own ETF
Rather than buying shares of an ETF, build your own by investing in a basket of biotech stocks. You'll be more interested in following the companies, and you'll have control over selling should the risk-reward ratio start tipping in the wrong direction.

If you need some ideas to get started, take a look at our Motley Fool Rule Breakers investment service. A free trial will get you access to all the back issues of the newsletter -- including the recommendations of a drugmaker with a whopping 14 drugs in the pipeline and another that the analyst estimated was so beaten down that investors were getting the pipeline for free.

If you'd like to see what they are -- and the team's most recent 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, Ph.D., doesn't own shares of any company mentioned in this article.

Southern Company is a Motley Fool Income Investor recommendation. The Fool has a disclosure policy.