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Six Rules for Biotech Investing


Biotech stocks are like Daisy - extraordinarily attractive and the object of Hoofy's (and bulls in general) affection.


One of the first articles I wrote when I started writing for the 'Ville three years ago was "Five Rules for Biotech Investing." With Thomson reporting a surge by individual investors and generalist healthcare funds into biotech, this subject is worth revisiting. I'm also adding a sixth rule that has unfortunately proven true time and time again.

These rules apply specifically to the type of biotech investments I focus on – what my firm calls "development-stage" biotech companies. My firm defines dev-stage biotech as a company whose market cap is primarily related to a drug not yet on the market. At my last survey, there are around 275 of these companies listed on the exchanges.

Rule 1: Never Fall in Love

Biotech stocks are like Daisy – extraordinarily attractive and the object of Hoofy's (and bulls in general) 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 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 more than 50% are common when bad news hits a company's lead product. For example, a stock in the Model Portfolio we maintain at our firm 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.

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. Given the political climate in 2007, regulatory risk is nothing to sneer at. If the drug is the third or fourth to enter a sector, or if it is a so-called "lifestyle" drug that does not treat a life-threatening condition, then you can expect significant regulatory 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.

In biotech, bad news means you sell first and ask questions later. It is very rare when bad news has little effect on a stock. Bounces to prices above the initial open are also somewhat rare.

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.

Rule 6: Bail If Management Bails

I hate this rule, but it is a good one to save declines in your portfolio. If a member of senior management or a board member sells stock ahead of a major binary event (data from a key trial, FDA regulatory decision, "imminent" partnership), follow along. It doesn't matter what their reasons are for selling. 95% of the time, whatever binary event is coming will end up being negative.

Is this insider trading at its illegal worst or merely karmic coincidence? It's a mix, but I don't really care. Time and time again I've observed such sales being followed by bad news and a steep price decline.

How much should you sell? Use the insider's sales as a guideline. If they blow out 50% of their holdings, match them. If they close out their positions, run for the hills. Exactly what you'll need to sell depends completely on how much risk the position represents in your portfolio, of course.

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No positions in stocks mentioned.

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