Biotech. The sports cars of the investing world where fortunes can be made or lost, literally overnight. These stocks, probably more than any other, rely on binary events that can send a stock soaring or plunging.

Company

One-Day Move

Why

Dendreon (Nasdaq: DNDN)

(64.3%) -- May 9, 2007

Provenge turned down by FDA.

Onyx Pharmaceuticals (Nasdaq: ONXX)

97% -- Feb 12, 2007

Nexavar shown to work in liver cancer, trial stopped early.

Source: Company press releases.

Just so you know, a failed trial doesn't always mean a destroyed company. Dendreon was able to pick itself up, run another Phase 3 trial, and get Provenge approved earlier this year. And, of course, Nexavar has been a huge hit for Onyx.

While we all hope to grab big winners like Onyx, investors in biotech must be aware of the chance of ending up with one of the big losers. The landscape is littered with once-promising drugs that either didn't make it out of clinical trials or were turned down by the Food and Drug Administration.

The keys to success
The important things to understand and follow when investing in biotech are:

  • Number of drugs in the pipeline and position in the pathway to approval -- A successful phase 1 study is not nearly as big a deal as passing phase 2 and entering phase 3. Getting in after a lead candidate begins phase 3 is the sweet spot, because if it succeeds, the stock price will likely jump and then could jump again if and when the FDA approves it.
  • Presence of marketing or development partnerships with big pharma -- Marketing might is needed to successfully sell the drug, and big pharma's deeper pockets can certainly help a struggling biotech. Additionally, the scientists from big pharma have typically vetted the potential drug, giving a measure of safety to investors. But even they can be caught by surprise, so this is still no guarantee.
  • A basic understanding of some clinical-trial and statistical terms -- Double-blind, randomized trials are best, especially in phase 3. Patients have been randomly assigned to receive placebo (or an alternate drug) or the drug under investigation and neither the patients nor the doctors know who is getting what (that's the "blind" part), and neither does the company. This means that trial results should be due just to the action of the drug and not "massaged" by researchers. Showing that a drug is "non-inferior" means it's "at least as good as," but for judging potential sales, "superior" can be better. Finally, in order to be successful, the results have to be "statistically significant." That is, the probability that the results are due to chance has to be really small. Smaller is better, so a "p ≤ 0.005" (0.5% probability the result is a fluke) is better than "p ≤ 0.01" (1% probability the result is a fluke).

Three to ponder
With that introduction over, here are three companies to consider:

Company

Number of Pipeline Drugs

Most Advanced

Partnerships?

Geron (Nasdaq: GERN)

5

GRNVAC1

Yes

Isis Pharmaceuticals (Nasdaq: ISIS)

22

Mipomersen

Yes

InterMune (Nasdaq: ITMN)

4

Pirfenidone

Yes

Source: Company websites, releases.

Geron saw a recent jump in price when it announced a bit over a week ago that the FDA had lifted its hold of a phase 1 clinical trial on embryonic stem cell treatment of spinal cord injuries. Personally, I think Geron might have missed the stem-cell boat by focusing on the controversial embryonic stem cells. Several other promising reports using adult stem cells -- including creating beating heart muscle cells and repairing damaged heart tissue in animals -- indicate to me that embryonic stem cell research is not going to be as important as once thought. However, the company's most advanced products are exploring the creation of cancer vaccines.

Isis has a very deep pipeline of nearly two dozen drugs in various stages of clinical and pre-clinical workup in several disease areas. Its most advanced one, mipomersen, partnered with Genzyme (Nasdaq: GENZ), reduces cholesterol levels quite handily, but it has some potentially pretty severe side effects. While that probably won't prevent it from getting approved, the FDA is likely to limit the approved use to just those patients who have a genetic defect and cannot lower their cholesterol in other ways. And that's going to restrict sales. However, getting the drug to market will boost revenue and cash flow at the biotech. And that will let the company continue to work on the rest of its pipeline.

InterMune got pounded earlier this year when Pirfenidone was turned down by the FDA, which asked for further study. The company has begun meeting with the FDA to work out how to proceed from here and whether it could present results of a Japanese trial moving forward. Idopathic pulmonary fibrosis (IPF) is a very severe disease, so it is expected that the drug will be approved ... eventually. Just like with the Dendreon and Provenge story, however, investors today will have to be patient.

Final thoughts
The medical science that biotech companies are involved with scares away many investors. But a science background isn't really required to successfully invest here. Instead, an appreciation for the binary events, the partnerships, and the size of the pipeline that can be turned into revenue will go a long way toward putting you onto the road to success. The above companies are three likely candidates that may help get you there.

So do some reading, review the articles linked above, and come back to Fool.com, where we regularly cover biotech.

And if you want more, you could also take a free 30-day trial to Motley Fool Rule Breakers where biotechs are often chosen, including recent winner Momenta Pharmaceuticals.

Fool analyst Jim Mueller does not own shares of any company mentioned. He works with the Fool's Stock Advisor newsletter service. The Motley Fool has a disclosure policy.