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Biotech Investing -- Clinical trial basics


I can always be found hanging out in the biotech sector


Note: With this article, we'd like to welcome David Miller to the 'Ville. David will provide his insights regarding the biotech and healthcare sector. We're sure you will find his comments helpful and we look forward to having him on board!

Investing in biotech is counter-intuitive for many people because success often involves buying rallies and selling dips. Understanding the rhythm inherent in the drug development process is crucial to becoming a successful biotech investor. When you're able to see how these rhythms affect the risk/reward ratio of your investment, buying rallies and selling dips won't seem so strange.

Before we start, it helps to understand when I say "biotech" in this article, it is shorthand for "development-stage biotech." Dev-stage biotech companies are those with no significant product revenues and/or whose market cap relies primarily on drugs still in clinical trials. If financial metrics other than cash on hand and cash burn become important to your analysis of a prospective biotech investment, you are probably not looking at a dev-stage biotech company.

Preclinical Stage

Preclinical testing of a drug is done on a lab bench or in animals. Common headlines from companies touting preclinical results are "Drug ZZ-104 demonstrates effectiveness in multiple tumor cell lines" or "ZZ-104 cures mice."

As a rule, never put money into a biotech based only on preclinical data. Between 1990 and 1998, of the 1,500 drugs the US government's National Cancer Institute (NCI) evaluated in animal models, only 10 made it to clinical trials. Fewer than one of those is likely to reach approval. Check the odds on the back of a lottery ticket and there are plays much better than 1 in 1,500.

My lottery example is an oversimplification, of course, but it serves to illustrate my point. Animal studies are incredibly useful as part of the whole due diligence process. Investing any significant sum of money based only on preclinical data, however, is foolhardy.

Phase I trial

A Phase I trial is the first time the drug is given to humans. In cancer trials, the drug is usually given to cancer patients. In non-cancer trials, the drug is usually given to healthy volunteers. A Phase I trial is usually 10-20 patients, each of whom receives one dose of the drug (cancer patients are again an exception in that they'll receive a "cycle" of the drug, usually several administrations over a period of 2-4 weeks).

Carefully compare statements made by the company at the beginning and end of the Phase I trial. If the company said to expect an early look at efficacy at the start of the trial, but mentions nothing about efficacy at the end when results are announced, be wary.

Investing based on Phase I trial results is legitimate, but still risky. All you know for sure after a Phase I trial is the drug doesn't kill people. The patient group is so small, there is a high likelihood demonstrations of efficacy are due to chance. Investments at this stage should be small.

Phase II trial

In a Phase II trial, the goal is to find the best dose, administration schedule, and specific patient population for the drug. Because these goals are not easily achieved, most drugs go through multiple Phase II trials. Phase II is always in patients with the target disease, enrolling anywhere from a couple dozen to a couple hundred patients. Investors should expect good indications of efficacy from Phase II trials.

It is important to understand not all Phase II trials are equal. With cancer drugs particularly, too many companies avoid randomized, controlled trials. Such trials, where a drug is compared to placebo or the current standard of care, are particularly necessary when the drug is used in combination with another drug.

For example: If I construct a Phase II trial studying ZZ-104 in combination with chemotherapy, how do I know if the subsequent results are due to the chemotherapy or ZZ-104? I can't for sure unless the trial randomizes patients into one group receiving ZZ-104 plus chemo and a second group where patients get chemo only. Some companies like to argue comparisons to previous trials of the chemotherapy drug alone (so-called historical controls) are sufficient, but historical comparisons are fraught with potential error.

Companies often randomize only among different doses the same drug. While this is a legitimate trial design and learning how patients respond to different doses is important, results from this kind of randomized trial are not equivalent to a randomized trial that incorporates a control group.

Investing at the Phase II stage is often the best balance between risk and reward a biotech investor gets. Beware, however, only 45% of drugs that make it into Phase II trials continue on to Phase III trials. If the Phase II trials are non-randomized and non-controlled, your monetary commitment should be smaller. If you have data from randomized and controlled trials to examine, then your confidence level and monetary commitment can be higher.

Phase III

Phase III trials are the next step. These are always randomized, controlled studies in the patient population that will be given the drug if it is approved. For cancer drugs, one Phase III trial is usually all that is necessary (always ask the company to be sure since this requirement is currently in flux). For most other drugs, two or more Phase III trials are required. The goal of a Phase III trial is to get results sufficient for the FDA to approve the drug for sale. Approval is the pivotal moment in a drug's development, which is one reason why Phase III trials are also called "pivotal trials."

The number of patients enrolled into a Phase III trial program ranges from a couple hundred for most cancer drugs to a couple thousand for most cardiac drugs to tens of thousands for preventative vaccines and general-use painkillers. In general, the more patients in a trial the better chance of avoiding false negatives

Watch to make sure the Phase III patient population and dosing are the same as in the successful Phase II trials. Beware the Phase III program that was not first verified in Phase II trials as it is much more likely to fail.

Investing after Phase III results are known is certainly an option. The odds are better, so the risk of loss is lower - as is the financial reward. What will drive the price of the company higher after the release of good Phase III information is FDA approval and sales. Just keep in mind investing after positive a Phase III result is not a sure thing because the FDA's decision process is rarely straightforward.

Biotech stocks are like Daisy - extraordinarily attractive and built to be objects of affection (for the Hoofsters in Minyanville, anyway). It's hard not to fall in love with an investment with such huge potential financial returns and whose products can cure terrible diseases. What's not to love? Just remember that for every hundred drugs that enter Phase I trials, 10-15 make it into Phase III trials and one or two will receive FDA approval.

At the beginning, I said biotech is counter-intuitive for many people because success often comes from buying rallies and selling dips. Here's what I mean:

The smart biotech investor "rewards" good clinical trial data by adding to his or her investment. Make your biotech investments prove themselves by compiling win after win in the clinical trial process. Since good data will increase the price, you'll be buying the rally. The smart biotech investor sells on bad data, which means he or she is selling the dips. This rhythm will seem strange at first. If you hold to this discipline and maintain a diversified portfolio, you'll dramatically increase your chances for success and be more likely to avoid devastating losses.

On Wednesday, I'll share my five rules for successful biotech investing. I developed these rules through personal trial and error, so hopefully you'll be able to benefit from my mistakes. That should be cheaper than benefiting from your own mistakes!

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