Over the last four years the biotech sector has been nothing short of unstoppable, with the SPDR S&P Biotech ETF rising 211% while the broad-based S&P 500 rose only 57%.
A rebound in the U.S. economy has certainly played its role, increasing investors' appetites for growth stocks, but we've also witnessed our fair share of clinical advances among both blue chip biotech stocks and select small- and mid-cap biotech stocks, which has extended the rally. The end result has been a clear outperformance for biotech stocks.
3 types of risks facing biotech stocks
However, even in a bull market biotech stocks aren't without risk. There are three broad types of risks facing biotech stocks that all investors should be aware of.
1. Binary risks
The biotech sector is unique in the fact that traditional fundamental analysis has minimal relevance. Whereas all investors look to the future when evaluating the relative "cheapness" of a stock, biotech investors have to approach their analysis from a completely different angle. Instead of P/E and PEG ratios, biotech investors focus on the peak annual sales potential of a company's pipeline and/or how many patients a product portfolio could eventually treat.
The easiest way to gauge the success of a pipeline is through preclinical and clinical stage data releases, which are also known as binary events. In its simplest form, a binary event has one of two outcomes: positive or negative. Rarely are investors left in a middle ground wondering whether the results a company has generated are good or bad.
As you might imagine, positive binary events confirm the safety, efficacy, or both of a developing preclinical or clinical drug, and give credence to the thesis that the drug in question may one day make it to market. A negative binary event, on the other hand, can be devastating depending on the depth of a company's pipeline or how advanced the drug in question was relative to the remainder of a company's pipeline.
Look around the biotech sector and you'll find no shortage of examples of what can happen when a binary event doesn't go shareholders' way. Just a few weeks ago Aerie Pharmaceuticals' (NASDAQ:AERI) shareholders witnessed their stock lose 64% during a single session after the company announced that its lead drug, Rhopressa, a treatment designed to lower eye pressure in patients with glaucoma or ocular hypertension, failed to meet its primary endpoint of non-inferiority to twice-daily timolol.
Aerie CEO Vicente Anido Jr. noted that if the high-end of the baseline range for non-inferiority had been a tad lower, Rhopressa would have met its primary endpoint. Although more data is expected later this year on Rhopressa, investors have essentially written off Aerie's lead compound.
2. Financing risk
Nearly 90% of all biotech companies are currently losing money -- that's a fact. It can take years, or even longer than a decade in some instances, to develop a drug or get an experimental product moved from the lab to approval by the Food and Drug Administration. During this time it's not uncommon for clinical-stage biotech companies to burn through their cash on hand. This leaves them with a tough dilemma: how to raise cash?
On one hand, biotech companies that choose to let their cash run dangerously low run the risk of needing to seek bankruptcy protection. It's extremely rare that biotech stocks run out of ways to finance their ongoing operations, but cancer drug developer Dendreon experienced just this when it sought bankruptcy protection in November. Its FDA-approved advanced prostate cancer product Provenge never came close to meeting Wall Street's lofty sales expectations, and despite two restructurings Dendreon's debt levels ultimately pulled the company into bankruptcy protection.
A considerably more common risk for investors is financing-based dilution. With the exception of blue chip biotech stocks that have established product portfolios, and the lucky few biotech stocks that land enormous partnerships with big pharmaceutical or biotech companies netting them handsome upfront payments, the most common cash-raising method is a stock offering.
For example, cancer immunotherapy and vaccine developer Inovio Pharmaceuticals (NASDAQ:INO) announced that it was pricing 9.5 million shares of its common stock at $8 per share before the markets opened on April 30. Its $8 price tag was 19% below where Inovio stock had closed the previous day. Shares wound up finishing the day lower by 17%.
In the end, Inovio wound up selling all 9.5 million shares of common stock as well as the 1.425 million share over-allotment to its underwriters, netting it an estimated $82.1 million after discounts and commissions were factored in. The move solidified Inovio's cash position and gives the company a cash runway that'll take it safely through 2018; however, it lopped significant value off of its shares in the meantime.
3. Obsolescence risk
The third type of risk that biotech stocks face is the risk of product obsolescence. As established above, it can take a long time to get a drug from the discovery stage to pharmacy shelves, so when a drug is approved biotech companies have to hope that it has staying power so it can generate substantial profits over time to cover research and development costs. Unfortunately, not all approved drugs will have long shelf lives due to ongoing discoveries at rival companies.
Four years ago the standard of care for hepatitis C patients was a combination of IV interferon and ribavirin. This combo resulted in the elimination of detectable levels of HCV in about half of all patients, but it also came with nasty side effects that included flu-like symptoms and rashes, to name a few.
In 2011, though, Vertex Pharmaceuticals (NASDAQ:VRTX) landed the approval of oral HCV product Incivek. Incivek still required HCV patients to use IV interferon and ribavirin, but it pumped up the effective cure rate from around 50% to 79% for those patients who were treatment-naïve. Following Incivek's launch, it became the quickest drug in history to reach $1 billion in cumulative sales, taking just a hair over six months to do so.
However, Incivek's fame would be short-lived due to Gilead Sciences (NASDAQ:GILD) and a clinical compound called sofosbuvir (which you probably know best as Sovaldi). Sovaldi is a once-daily pill that removed the need for IV interferon, greatly improving patients' quality of life during their treatment. It also reduced treatment times in some instances, while providing a cure rate that often surpassed 90% in a number of clinical trials.
Gilead's next-generation product, Harvoni, which is nothing more than a combination of Sovaldi and ledipasvir, can treat genotype 1 HCV patients, the most common form of the disease, without IV interferon or ribavirin. In its first full quarter on pharmacy shelves it racked up $3.58 billion in sales and is now the quickest growing drug in history.
Thankfully for Vertex it had a winning card in its back pocket known as Kalydeco for cystic fibrosis. Yet it would be crazy to think that the loss of $1 billion-plus in annual revenue didn't hurt Vertex at all.
Beyond Vertex there are a number of obsolescence struggles ongoing within the biotech sector.
Although each biotech stock has its own set of risks -- and you'll need to dig deeply into each company you're considering buying in order to discover these risks -- the above three risks are universal to all biotech stocks. If you take anything away from this, it should be that you have to keep an eagle's eye on the rough binary event timeline, cash position, and competition of all the biotech stocks you own or plan to buy.