Exciting. Scary. Lucrative. Risky. 

All of these adjectives apply to investing in biotech stocks. The excitement and the prospects for generating huge profits make biotech stocks appealing to many investors. On the other hand, the fear of big losses that stem from the high risk levels associated with many biotech stocks causes other investors to stay away.

How should you go about investing in biotech stocks? There are seven key steps to follow that should improve your chances of success:

  1. Know which stocks are biotech stocks -- and which aren't.
  2. Determine your risk tolerance.
  3. Understand the risks specific to biotech stocks.
  4. Know what to look for in a biotech stock.
  5. Evaluate the top biotech stocks and biotech exchange-traded funds (ETFs).
  6. Invest cautiously.
  7. Monitor changing dynamics.

Here's what you need to know about each of these seven steps for investing in biotech stocks.

Five test tubes with increasingly higher levels of green fluid in each tube and a green line with an arrow at the end curving upward behind the test tubes

Image source: Getty Images.

1. Know which stocks are biotech stocks -- and which aren't

First, you'll want to know which stocks actually are biotechs and which aren't. It's not as easy as you might think.

Biotech is short for biotechnology, a term that references any technology that incorporates biological organisms. Companies that make genetically modified foods fall into this category, as do drugmakers that develop biologic drugs -- large, complicated molecules that are manufactured within a living organism. 

But while many big pharmaceutical companies develop biologic drugs now, they aren't usually viewed as biotechs. That's primarily because these companies make most of their revenue from sources other than biologic drugs. 

Also, some drugmakers are typically classified as biotechs even though they don't make most of their money from biologic drugs. Why? A lot of people call any small drugmaker a "biotech" regardless of whether the drugs it develops use living organisms. Even when these small companies grow to be large, they're still called biotechs.

If you're looking to invest in biotech stocks, there is one quick way to determine which stocks are biotechs and which aren't. You can check out the industry designation for the company on investing sites. On Fool.com, for example, enter the ticker symbol for a given stock and then click on the "Profile" link. If the industry in the company info section is "Med-Biomed/Genetics," it's a biotech stock. 

2. Determine your risk tolerance

Perhaps the most important step of all with investing in biotech stocks is to determine your risk tolerance. Some investors are aggressive and can tolerate higher levels of risk. Others are more conservative and seek to minimize their risk levels. There's a big reason you'll want to know your risk tolerance: It will help you determine which biotech stocks are good investing candidates for you and which aren't.

If you already know your risk tolerance, great. If you don't, you might want to complete a risk-tolerance questionnaire to help you determine your investing style.  

3. Understand the risks specific to biotech stocks

All stocks have risks. But biotech stocks have some specific risks that aren't applicable to stocks in many other industries. These risks include clinical failures, regulatory approval setbacks, commercialization problems, and loss of exclusivity/patent expiration.

The risk of clinical failure. Probably the most critical of these biotech-specific risks is the potential of failures in clinical trials. All biotech companies must thoroughly test their experimental drugs to assess the drugs' safety and efficacy in treating the targeted condition.

This process starts with preclinical testing. Some preclinical testing is conducted in vitro, which literally means "in the glass." That's a reference to lab testing in test tubes, culture dishes, and other ways that don't involve animals or humans. Other preclinical testing is done in vivo, which means "within the living." This kind of preclinical testing is performed using laboratory animals.

Biotechs that only have experimental drugs in the preclinical stage are especially risky. Most drugs never advance from preclinical testing into clinical studies.

If a drug looks promising in preclinical testing, though, the biotech can seek regulatory approval from the Food and Drug Administration (FDA) in the U.S. or the European Medicines Agency in Europe to begin a phase 1 clinical study. The primary purposes of phase 1 clinical studies are to evaluate the safety of an experimental drug, including identifying possible side effects, and to determine the ideal dosage range for the drug.

Around 37% of drugs that are evaluated in phase 1 clinical studies fail, according to the Biotechnology Innovation Organization (BIO). The successful drugs advance to phase 2 clinical studies. These studies test the efficacy and appropriate dosage levels of the drugs. 

Most drugs -- nearly 70%, based on BIO's analysis of historical data -- aren't successful in phase 2 clinical testing. The ones that are move to phase 3 clinical studies, large clinical trials needed to assemble sufficient statistical data that the drugs are both safe and effective. Almost 42% of drugs fail in phase 3 testing.

Overall, only 11% of experimental drugs that begin clinical studies jump all the hurdles needed to file for regulatory approval. 

Regulatory approval setbacks. Biotechs still face the risk that drugs that have been successful in clinical studies won't win regulatory approval. Nearly 15% of drugs submitted for approval get a thumbs-down from the FDA, according to BIO. 

In some cases, the biotech can conduct additional clinical studies to persuade regulatory agencies to approve an experimental drug. However, frequently a regulatory rejection means the end of the road for a drug.

Commercialization problems. You might think that once its drug wins regulatory approval, a biotech has it made. Not necessarily. Companies must persuade insurers and government healthcare programs to pay for a new drug. 

In the U.S., this process involves working with all of the major insurers and pharmacy benefit managers, as well as Medicare and Medicaid, to provide coverage for a new drug. In Europe, biotechs must negotiate with each country individually for a new drug to be covered.

On top of these negotiations, biotechs must build sales teams to promote new drugs to prescribers. In many cases, companies also market directly to consumers via online, print, and TV advertising. Despite all of these efforts, there are significant risks that a biotech will be unsuccessful in achieving commercial success for a new product.

Loss of exclusivity/patent expiration. While biotechs often compete against other drugmakers, they enjoy protection for a while from potential rivals seeking to market generic or biosimilar versions of their drugs. Biologic drugs receive a 12-year period of exclusivity from biosimilar competition, while non-biologic drugs typically have a five-year exclusivity period.

In addition to the exclusivity periods, biotechs usually secure patents on their drugs. These patents expire 20 years after the filing date.

Once a biotech's drug loses exclusivity and patent protection, rival companies can legally launch "copycat" versions of the drug. This nearly always causes a sharp decline in sales for the biotech's drug.

4. Know what to look for in a biotech stock

The perfect biotech stock to buy would be one that has a broad lineup of approved drugs on the market. Each of these drugs would generate billions of dollars in annual sales. They would have a long way to go before the loss of exclusivity or patent expiration. And they would enjoy virtual monopolies for the conditions they treat.

This perfect biotech stock would also have a deep pipeline with a lot of candidates in phase 3 testing. The company would be super-profitable with fast-growing revenue and a mountain of cash built up to use in rewarding investors through share buybacks and dividends. And the stock would be dirt cheap.

Unfortunately, such a biotech stock doesn't exist. However, these ideal qualities of a perfect biotech stock represent the things you should look for, and they fall into four main categories: current product lineup, pipeline, financial position, and valuation. The closer a given biotech stock rates on each measure, the better investment choice it should be.

Many small biotechs won't have any approved drugs yet. For the biotechs that do, companies with multiple drugs with strong and growing sales will be less risky than others. It's also a good sign when a biotech has best-selling drugs in multiple therapeutic areas. Diversified revenue sources are nice to have with any stock.

Pipelines can be difficult to evaluate. However, a pipeline that has several drugs in late-stage testing is preferred because they have less risk than experimental drugs in earlier-stage development. You can also check out what analysts and other industry observers have to say about early stage clinical results to get a sense of whether there are any yellow flags with what might otherwise seem to be positive results.

Established biotechs will have stronger financial positions than small clinical-stage biotechs. Strong revenue and earnings growth is a big plus. Regardless of the size of the biotech, though, look at the company's cash position. A small biotech with no approved products could have to issue new shares if it doesn't have enough cash, which causes dilution in the value of existing shares. (Think of a pizza with eight slices that's cut into 16 slices. Anyone who had a slice initially has less pizza to eat after the second slicing.)

With larger biotech stocks, you can use traditional metrics such as price-to-earnings and price-to-earnings-to-growth (PEG) ratios to assess valuations. The key here is to compare these valuation metrics for a given biotech stock against its peers to determine whether it's relatively cheap or relatively expensive.

The valuations of smaller biotech stocks with no approved drugs are tied to what investors think about the biotechs' pipeline prospects. It's difficult to know how reasonable the growth prospects are for pipeline candidates that haven't been approved yet.

One important thing you can look at with small biotechs, though, is any partnerships that they have established with larger drugmakers. A major drugmaker wouldn't partner with a smaller biotech without performing due diligence on its pipeline candidates. Having a big partner doesn't mean that a small biotech's pipeline isn't risky, but investors can usually have more confidence in a small biotech's pipeline candidate when a major drugmaker has put significant money on the line betting on the success of the experimental drug.

5. Evaluate the top biotech stocks and ETFs

The 10 biggest biotech stocks claim market caps (the total market value of a company's outstanding shares) of at least $30 billion, with several having market caps of more than $100 million. These are the exceptions, though. There are hundreds of biotech stocks with much smaller market caps. In addition, several biotech ETFs are available that hold positions in many individual biotech stocks. Your risk tolerance will dictate which of these biotech investment alternatives are the best fits for you. 

To give you a sense of how to evaluate biotech stocks and ETFs, we'll look at a few examples that might appeal to investors with different risk tolerances. Note that there are no options provided for investors with low-risk tolerances. Why? Biotech stocks and ETFs probably wouldn't be well suited for these investors.

Biotech Stock/ETF

Risk Tolerance Level of Investors Who Might Like the Stock/ETF

Alexion Pharmaceuticals (NASDAQ:ALXN) Moderate
Amgen (NASDAQ:AMGN) Moderate
Editas Medicine (NASDAQ:EDIT) Very high
Vertex Pharmaceuticals (NASDAQ:VRTX) High
SPDR S&P Biotech ETF (NYSEMKT:XBI) Moderate

Alexion Pharmaceuticals. Alexion currently has four approved products, all of which target rare diseases. The biotech's biggest blockbuster, Soliris, recently won FDA approval for treating another condition, neuromyelitis optica spectrum disorder. Sales are climbing for all four of Alexion's drugs, with tremendous growth for its newest product, Ultomiris, which market researcher EvaluatePharma thinks will be the biggest new drug launch of 2019.

The biotech's pipeline includes three late-stage programs targeting rare diseases. In addition, Alexion has four early stage clinical programs.

Alexion appears to be in a strong financial position. Its revenue and earnings continue to grow rapidly. The company also has a substantial cash stockpile that it can use to reward shareholders through stock buybacks or to make strategic business development deals to fuel growth.

While many biotech stocks have sky-high valuations, Alexion is one of the most attractively valued biotechs on the market. Its forward price-to-earnings multiple, which uses estimated earnings rather than historical earnings, and PEG ratio are both low compared with most other biotech stocks.

Alexion faces some risks, including key patents for Soliris beginning to expire in 2021 and the possibility that its clinical programs won't be successful. 

Amgen. Amgen currently claims 18 approved products. Seven of these generated sales of more than $1 billion in 2018. At least two more of the biotech's approved drugs, Kyprolis and Aimovig, appear to be on the way to becoming blockbusters.

The company's pipeline includes six late-stage programs, including the pursuit of additional approved indications for three already-approved drugs, plus three biosimilars in development. Amgen also has 26 programs in phase 1 and phase 2 testing.

Amgen generates tremendous cash flow and has one of the largest cash stockpiles in the industry. The company also pays a dividend with an attractive yield. This strong financial position is a key reason investors with moderate risk tolerances might like Amgen.

The biotech's forward P/E ratio is low. However, some investors might be leery of Amgen's high PEG ratio.

However, several of Amgen's top drugs face intense competition. This situation is likely to weigh on Amgen's growth in the coming years. Amgen's pipeline is also risky, with 23 programs in phase 1 clinical studies. 

Editas Medicine. Editas Medicine is by far the riskiest of the biotech stocks on our list. The company has no approved products and is a long way from even the possibility of launching a drug commercially. 

The attraction for Editas is its pipeline. The biotech plans to begin the first in vivo testing of a CRISPR gene editing therapy in humans in 2019. This phase 1 study will evaluate Editas' lead candidate, EDIT-101, in treating Leber congenital amaurosis type 10, the leading genetic cause of blindness. Allergan is partnering with Editas on developing EDIT-101. Other than EDIT-101, though, Editas' pipeline consists only of preclinical programs. 

Editas has to rely largely on collaboration revenue from Allergan and its other big partner, Celgene, to fund operations. The biotech could have to raise additional cash through issuing new stock in the future.

For a company with no product revenue, Editas' market cap is quite high. However, the market cap reflects the tremendous excitement among investors about the potential for the biotech's gene-editing candidates.

But although CRISPR gene editing could be a game-changer in treating diseases, it remains a technology in its infancy. Editas faces considerable challenges in advancing its pipeline candidates. 

Vertex Pharmaceuticals. Vertex Pharmaceuticals has three approved drugs on the market, all of which treat the underlying cause of cystic fibrosis (CF). The biotech essentially enjoys a monopoly in CF right now.

It's likely that Vertex's pipeline will fuel more growth. The biotech hopes to win approval for a triple-drug CF combo in 2020. This regimen would dramatically increase Vertex's target patient population. In addition, the biotech's pipeline includes an experimental pain drug that's in phase 2 testing and a couple of early stage programs targeting rare diseases.

Vertex's financial position continues to look better and better as its revenue and profitability increase. The company has a significant amount of cash built up that it plans to use in adding more programs to its pipeline.

While Amgen has a low forward P/E multiple and a high PEG ratio, it's the opposite case for Vertex. The biotech's attractive PEG ratio is a sign of the tremendous growth expected for Vertex, with the anticipated launch next year of its triple-drug combo for treating CF.

There is a risk, though, that Vertex could run into regulatory approval problems. The biotech's pipeline candidates also face risks of failure in clinical studies.

SPDR S&P Biotech ETF. You might wonder why the SPDR S&P Biotech ETF isn't more suitable for investors with low risk tolerances. Although the ETF holds positions in over 100 biotech stocks, many of these stocks have high or very high risk levels.

For moderately aggressive investors, though, this ETF could be a smart way to profit from growth in the biotech industry. While some of the biotechs among the fund's holdings could experience pipeline setbacks or other issues, not all of them will.

The primary downside to buying the SPDR S&P Biotech ETF, other than risk, is that the fund has an annual expense ratio of 0.35%. However, that's not unreasonable, considering the broad basket of biotech stocks the ETF provides.

6. Invest cautiously

Whichever biotech stock or ETF you buy, invest cautiously. Don't put too much of your portfolio in biotech stocks, because of the risk and volatility associated with the industry.

If you're buying the stock of a small clinical-stage biotech, you'll want to be even more cautious. You might consider investing a small amount initially. If clinical study results increase your confidence in the biotech's prospects, you could then increase your position in the stock.

7. Monitor changing dynamics

The last step for investing in biotech stocks is to monitor changing dynamics. Bad news doesn't necessarily mean you should sell your biotech stocks, but it could prompt you to do so. Horrible results from a clinical study, for instance, could completely change your entire investing thesis -- especially for a clinical-stage biotech.

Keep your eyes on the competition, too. The emergence of new drugs could threaten even a big biotech's sales.

There's also the possibility that the reimbursement environment changes dramatically. For example, major changes to the U.S. healthcare system that limit the ability of biotechs to set drug prices would probably negatively affect stock prices.   

Back to those adjectives

Yes, investing in biotech stocks can be scary and risky. However, following these seven steps should increase the odds that your experience in investing in biotech stocks is both exciting and lucrative over the long run.

Now that you've got the basics, read on for some individual stock ideas: 5 Top Biotech Stocks to Buy in 2019