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Five rules for biotech investing


What's not to love?

To help me succeed as a biotech investor, I developed five rules I try hard to follow. Most of these rules were developed in response to serious mistakes I've made in my own portfolio. Hopefully you can learn from my mistakes, which should be significantly cheaper than making your own.

Before we get to the first rule, remember my definition of "biotech" from Monday's article: When I say "biotech," I really mean "development-stage biotech." Dev-stage biotech companies are those with no significant product revenues or those whose market cap relies primarily on drugs in clinical trials. Companies like Amgen are biopharmaceutical companies in my book and are a completely different investment, though some of my rules will still apply.

Rule 1: Never fall in love
Biotech stocks are like Daisy - extraordinarily attractive and built (for the Hoofsters in Minyanville, anyway) to be objects of affection. This is understandable. In my experience, many people find their first biotech investment when doing research on a medical condition of a friend or family member. It's hard not to fall in love with an investment with such huge potential returns and whose products can cure terrible diseases. What's not to love there?

I don't know of a biotech investor who hasn't had their portfolio decimated by a biotech love affair gone bad. The most important thing you can remember is that the purchase of a biotech stock is an investment. It is not an act of charitable giving. Since it is only an investment, you are allowed to be dispassionate in your evaluation of new developments. Be ruthless! Be cruel! It's OK. When verifiably bad news comes knocking, sell first and ask questions later.

Rule 2: Polygamy is your friend
If you wish you had dated more people in your youth, biotech investing is for you. Diversification is the difference between living to invest another day and financial ruin in biotech investing. You must spread out your risk capital over a wide number of biotech stocks to protect yourself when (not "if") bad news arrives. Since these stocks are so news driven, instant declines of 50% are common when bad news hits a company's lead product. For example, a stock in the Model Portfolio we maintain at Biotech Monthly went from $8 to under $2 (-75%) overnight on bad news. Because our Model Portfolio was diversified, our overall performance dropped only five percentage points (from a 64% gain to a 59% gain).

Rule 3: Early clinical success is no guarantee
Drug development goes through three phases of human clinical trials, each more rigorous and more informative than the last. If you're unfamiliar with these stages, my last article is a good place to start

The worst thing an investor can do is get really excited about preclinical data - data from animals or test tubes. While such data is interesting, it should not be the basis for any sizeable investment in a company. Government statistics tell us for every 1,500 drugs tested in mice, only one is approved.

Excellent Phase II trial data is worthy of a Hoofy jig, but not all Phase II trials are created equal. Gravitate your attention and money towards randomized, controlled Phase II trials. They generate the best quality data. Be far less enthusiastic about non-randomized Phase II trials - especially in cancer drugs where the study drug is used in combination with other drugs.

Good Phase III data is wonderful, but investing after this stage usually reduces the potential gain. Care is still warranted. At this point you are ostensibly investing in future sales potential, but you are actually taking on both regulatory (FDA) and sales forecast risk.

Rule 4: Reward good data, punish bad data
Because so many people break Rule 1, combined with the broadly misunderstood concept of dollar cost averaging, the tendency of biotech investors is to buy more stock on a price decline after bad or mixed news from a clinical trial. Your reaction should be just the opposite: Pare back or eliminate your positions when bad clinical data comes out. Add to your position (even at higher prices, yes) when good clinical data arrives.

The higher the quality of the data and the better the results, the more comfortable you can be with additional investment - provided you don't break Rule 2 in the process.

Rule 5: Commit to hard work
Biotech investing is 100% data and news driven. It is impossible to be a consistently successful biotech investor without working hard to keep up on the developments affecting your chosen investments. This means hours of research each month for each biotech company in your portfolio. It also means being a slave to news tickers, with the related ability to be able to drop what you're doing and pay close attention to your investment if crucial news hits the wires. While hard work is a cornerstone of any good investment strategy, be aware biotech investing is likely to take up more of your time than most other sector investments.

The trade-off is your hard work is rewarded handsomely when it affords you a competitive advantage over other investors. While good research always puts you ahead as an investor, I've not found any market sector where you can get such a significant head start via old-fashioned basic research.

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No positions in stocks mentioned.

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