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?

Sequenom (Nasdaq: SQNM)

(75.7%) -- Apr. 30, 2009

Fetal Down syndrome test data was revealed to be unreliable.

Human Genome Sciences (Nasdaq: HGSI)

276.8% -- July 20, 2009

Lupus drug Benlysta shown to work in phase 3 trials.

Source: Company press releases.

Just so you know, a failed trial doesn't always mean a destroyed company. Sequenom fired the people responsible, picked itself up, dusted itself off, and is currently running a new set of tests using proper techniques this time. And, of course, Benlysta has been submitted to the Food and Drug Administration for approval, with a potential "hear by" date of Dec. 9, 2010.

While we all hope to grab big winners like Human Genome Sciences, 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 when (I mean, "if") 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 while developing a promising drug. Plus, the scientists from big pharma have vetted the potential drug, giving a measure of safety to investors. But even they can be caught by surprise, so this is 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, neither the patients nor the doctors know who is getting what (that's the "blind" part), and neither does the company. This means thattrial 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 ideas
With that introduction over, here are three companies to consider:

Name

No. of Pipeline Drugs

Most Advanced

Partnerships?

Cerus (Nasdaq: CERS)

2*

Intercept Blood System

No

Arena Pharmaceuticals (Nasdaq: ARNA)

5

Lorcaserin

Yes

Ariad Pharmaceuticals (Nasdaq: ARIA)

3

Ridaforolimus

Yes

Source: Company websites, releases. *Same product, two different chemical cross-linking agents.

Cerus has its blood pathogen killing product, the Intercept Blood System, approved for use in the EU since 2002. But it has not been able to convince the FDA that it should be approved. The product is designed to ensure the safety of blood and plasma before transfusion. New hope was given to the company yesterday, when it reported that its product was able to completely remove copies of XMRV, a virus suspected of being involved in chronic fatigue syndrome and a previously-unidentified pathogen in blood. The company is still losing money, but if it can get the product approved by the FDA and expand its use both in the U.S. and EU, it could end up doing quite well.

Arena is waiting to hear back from the FDA on its obesity drug, lorcaserin. The advisory committee meets later this month with the final decision due in late October. However, with VIVUS' (Nasdaq: VVUS) drug Qnexa having failed to get a recommendation for approval from its advisory panel meeting in July , your guess is as good as mine about what the panel will do with lorcaserin. It has milder side effects, yes, but not as much weight loss as Qnexa. Remember what I said about binary events? A big one is coming up for Arena.

Ariad modified its deal with Merck (NYSE: MRK) on cancer drug ridaforolimus in order to generate some cash. The company is waiting for phase 3 data on this drug, with the possibility of an interim look at the data any time. That look is certainly an upcoming binary event, and the stock could either jump or plunge depending on the results. If they're good, then the company could submit the drug to the FDA for marketing approval.

Final thoughts
The medical science that biotech companies are involved in 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 which can be turned into revenue will go a long ways to 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.

True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.

Fool analyst Jim Mueller owns shares of Sequenom, but holds no financial position in any other company mentioned above. He works with the Fool's Stock Advisor newsletter service. The Motley Fool has a disclosure policy.