Is There Life After 600% Returns?

Did you miss the more than 970% run that Dendreon (NASDAQ:DNDN) has made off its March lows since announcing positive results for its prostate cancer treatment, Provenge? Or what about the 626% overnight gain that Vanda Pharmaceuticals (NASDAQ:VNDA) pulled off earlier this month after the Food and Drug Administration approved its antipsychotic, Fanapt?

Yeah, me too. But that doesn't mean that there's not still multi-bagger potential left in the drug companies. Maybe.

Some historical examples
Just because a drug company gets a massive increase in the stock price after a positive clinical trial or an FDA approval, that doesn't mean all the growth is completely factored into the stock price.

Source: Capital IQ.

But a large run-up isn't necessarily a signal to buy, either. Even after large run-ups, companies often have additional risks associated with their stocks.

Source: Capital IQ.

You'd think that the decline from United Therapeutics' former highs could be attributed to the bear market, and that accounts for some, but not all of it. A little over a year after releasing Viveta's positive data (last November in fact), another one of United Therapeutics' late-stage drugs failed a phase 3 trial, sending shares down 35% in one day. Prices have recovered slightly since then.

With potential reward comes real risk
Today, both Dendreon's and Vanda's stock have potential for future growth, but because investors are uncertain about the companies' futures, they require extra compensation to take on that risk. Let me explain what I see going on.

For Dendreon, the next major event will be a potential FDA approval of Provenge, which is likely to come down this time next year. The company believes the new study is enough to satisfy the FDA, which gave it an approvable letter in 2007. But investors aren't privy to the private conversations between the agency and the company. Dendreon does have a Special Protocol Assessment (SPA) agreement with the FDA, which increases the likelihood that the most recent trial will be enough, but it's not a guarantee for an approval. Investors are likely to discount for the risk of non-approval until the FDA actually gives Provenge the green light.

Vanda has already gotten past the FDA approval risk, but the growth risk is still present because sales of Fanapt are far from a sure thing. The drug performed better than placebo, but apparently no better than other schizophrenia treatments such as Johnson & Johnson's (NYSE:JNJ) Risperdal and Pfizer's (NYSE:PFE) Geodon, putting potential sales growth in danger.

It's easy to imagine that most doctors won't prescribe the drug, favoring well established drugs like those that Fanapt failed to beat, as well as AstraZeneca's (NYSE:AZN) Seroquel and Eli Lilly's (NYSE:LLY) Zyprexa. Some doctors may be willing to try it out on mild patients or those who have failed other drugs, but figuring out how many doctors that might be is next to impossible. It seems wise for most investors to stay away until the potential market is a little more defined.

Taking it all in
With so many small drug developers out there, many don't hit investors' radar screens until they make the "today's top performers" list. The huge run-ups should be neither a signal to buy nor a signal to ignore them. Instead, take your time, find out why everyone else is excited, and then proceed with caution. There's often plenty of time to get in and still catch a nice wave of growth.