From time to time, we like to sit down with Fool community members who are experts in particular industries. In this interview, we reached out to zzlangerhans to talk biotech investing. ZZ is an emergency room physician and Harvard magna cum laude in biochemistry who has been a Howard Hughes research fellow in transgenic mouse models and an NRSA fellow in xenotransplantation. He currently maintains a high rating on CAPS while focusing exclusively on biotechnology companies.

In this, the first article in a two-part series, ZZ shares his approach to finding buying opportunities (and avoiding scams) in biotech stocks.

John Keeling: We all know biotech companies are risky and outside the circle of competence of most investors. Tell us about your background and what led you to focus in this segment of the market?

zzlangerhans: For the semanticians out there, many of the companies we call "biotechs" are not truly biotech but are actually small pharmas. To be a true biotech, the company should be developing biological drug candidates such as enzymes or antibodies. To align better with popular terminology, I lump all the small unprofitable drug developers under the label of baby biotech. For investing purposes, the small size and developmental nature of the company matters more to me than the composition of the pipeline.

I got into this field in 2006 after reading an article which contained a calendar of biotech company catalysts for the rest of the year. As the catalysts played out, I noticed that some caused share prices to double or drop by half. I was attracted to the volatility and started to investigate the companies more deeply. In 2007, I started my own database which has grown to include over 250 companies. I do draw on my background in molecular biology and medicine to a certain degree, but trading these stocks is really a discipline unto itself. You don't need to be a doctor or a scientist to make money trading biotech. The most valuable skills are paying attention to detail and being able to understand mass psychology.

Keeling: Focusing on "small, unprofitable biotechs" seems to be dialing in on the most risky companies within the sector. How do you find opportunities that offer greater reward than risk?

zzlangerhans: The first thing to do is take a broad look at the company itself: the pipeline, the management, the company's history of success or failure. Many people don't realize that a publicly traded company can be essentially a front for an unscrupulous group of individuals to enrich themselves while promoting a drug candidate or technology platform that they are fully aware is ineffective. The instinctive action is to take company PR at face value, but most things that seem too good [to] be true really are. With Safe Harbor statements in place, companies have the latitude and motivation to make many statements that are inaccurate, unrealistic, and misleading. That's not to say you can't jump aboard and make money off a scam, but trying to be the middle row of a pyramid scheme is extremely high risk. When I'm trading, I prefer to keep the "ick" factor to a minimum. If you want to avoid scam companies, search their names on all the investing websites and also Google them. Any well-written article accusing a baby biotech of being a scam should be taken very seriously.

Even after excluding the scam and questionable companies, it's important to maintain a healthy sense of skepticism. Clinical trials have a high rate of negative results. The more novel the therapy and the more difficult the disease is to treat, the higher the likelihood of failure. If you want to trade a company that is developing a completely new modality to treat melanoma, it might be wise to exit your position before they report the top line data from the phase III trial. Always pay attention to cash burn and cash reserves. Going long on a stock right before a dilutive financing is usually an avoidable error. Debt is another major red flag. Most of the bankruptcies I've seen so far resulted from overextension into debt. The nature of baby biotech stocks is to wax and wane, but bankruptcy is the death blow for your investment.

Keeling: And you're not talking about market timing here, correct? Sounds like you're looking for turnarounds and special situations. Where do you find them?

zzlangerhans: Baby biotechs for the most part will rise and fall. The likelihood of your choice becoming the next Genentech or Gilead is on the order of 1 in 100, although most devotees of individual companies seem to believe that their permanent rise is a certainty. Therefore, I prefer to find these companies when they're beaten down but not likely to go out of business entirely. Psychological and emotional factors seem to play a huge role in the magnitude of these valuation cycles, so it is important to remain calm and objective and never trade with money you'll need in the short-term. Always remember with investing, even when you're right long-term, you can be way wrong in the short-term. A few months ago I saw Exelixis (Nasdaq: EXEL) dropping rapidly and flagged it as a strong buy at $4.5. I eventually bought in at $3.7 and watched the stub drop below $3. I sold on the way up at $4.7 and now a month later it's over $9. Where's the efficient market here?

Many people use the run-up strategy, which I call the Bottle Imp. Identify a stock in depression with a major catalyst expected within six months to a year. Many of these stocks will rebound dramatically at some future point in advance of the catalyst. If you are successful, don't get greedy. Sell with a reasonable gain and whatever you do don't play through the catalyst. I was greedy with Biodel this year and turned a gain of $6,000 into a loss when I held too long and the share price dropped ahead of the FDA decision date. My strongest Bottle Imp candidate right now is Discovery Laboratories, which is exploring all-time lows despite an impending New Drug Application (NDA) resubmission for Surfaxin.

Buying after negative catalysts is another strategy that has to be utilized very carefully. You're just as likely to see a dead cat splat as bounce in biotech. Unless I feel that the drop was so extreme that I'm virtually certain to wind up ahead, I tend to step back and watch the share price settle for a week or two. I'm more inclined to buy after an excessive drop on an analyst downgrade. I put almost no weight on analyst ratings or price targets in this sector, as with a few exceptions I've found them empirically to be no better than chance.

Since the beginning of 2010 I've focused on identifying the low points of share price cycles. Rather than dwell on prior successes, I'll mention my more recent trades whose wisdom remains to be determined. For a long time, Savient Pharmaceuticals (Nasdaq: SVNT) was on my "put list" of stocks headed for potential disaster due to the market's overestimation of the value of the newly approved gout drug Krystexxa. Surely enough, the share price fell off a cliff last October when the company announced they had put themselves up for sale and failed to find a buyer. Despite an immediate drop of 50%, I waited for months to see if the share price would stabilize and eventually picked up 2000 shares at 9.85. The price dipped as low as 9.06 but has rebounded to the 10 range and I'm very comfortable with that position as we await the first reports on Krystexxa sales.

Another of my recent trades is Alimera Sciences (Nasdaq: ALIM), who in December received a surprising Complete Response Letter from the FDA for the Iluvien ocular implant for diabetic macular edema. I saw the CRL as a "soft" rejection with no additional clinical trials required, but the effect of the rejection on the share price was proportionately mild. I took a position in CAPS to help me monitor the stock and waited, and eventually the share price degraded to the point where I felt a trade was warranted. I bought 2000 shares at 9 which almost immediately rose to 10.3. In 2010 I would likely have booked my profit, but since I left so much money on the table last year I decided to keep holding through the Iluvien resubmission. Subsequent extended data from the Iluvien clinical trial dropped the share price back down to 8.5, so the conclusion of this story is yet to be seen.

Ultimately, to answer your question about where I find buying opportunities, it comes down to whether or not you trust your own due diligence.

Click here to read Part 2 of our interview with zzlangerhans.