Source: Keith Fitz-Gerald, Money Morning
"For all their potential, biotech stocks remain among the most challenging for investors to identify, select and earn money on. However, with a little bit of guidance you can narrow your list to the stocks with the highest likely upside."
It's not enough to understand long-term trends. Today's investors need to have the ability to move quickly, especially when it comes to biotech stocks.
But here is what you need to know about biotech stocks: None of them are created equal.
For all their potential, biotech stocks remain among the most challenging for investors to identify, select and earn money on.
However, with a little bit of the right guidance you can narrow your list to the stocks with the highest likely upside.
In fact, I've developed a five-point checklist of what I look at when screening biotech stocks that I'd like to share with you.
It may not be a road map. The biotech sector just isn't that easy and "X" almost never marks the spot.
But it is a great place to start if you are serious about separating the pretenders from the contenders.
Five Steps for Successful Biotech Stock Investors
As you begin to break down a potential stock consider the following as it relates to your decision.
1) Choose your niche.
Biotech is a big term and an even bigger sector. There are literally thousands of companies trying to make their moves in everything from vaccines to nanotechnology.
There's quite literally no way you can know everything, so stick to the parts of the sector you believe have the biggest potential.
For instance, I think some of the biggest innovations and profits will come from biotech companies that link living systems with their digital counterparts.
So I tend to concentrate my biotech investments in companies that are exploring synthetic biology and computational bioinformatics.
To me it's a no brainer.
While there is no question that traditional biotech will be big, over the next few years we will see the line blur very rapidly between what we need to live and how we actually live—aided by technology.
Admittedly, I have a rather selfish reason. . .
Alzheimer's runs in my family, so in a way I'm chasing my own gremlins. You may or may not be chasing yours.
Point is, choose a niche you have an interest in and learn everything you can about it.
2) Stick to companies with the "right" kind of debt.
This one is tricky because obviously debt is a loaded word right now. With governments spending trillions on completely misguided bailouts, it's easy to forget that debt can also be used to generate profits, particularly in early stage companies.
When you think about it this makes sense.
The average medical tech company, for example, now spends tens of millions simply getting a drug ready for laboratory testing. Add to that millions more in human trials where maybe—just maybe—the drug will be approved.
Then there is the time. Often times the process takes a decade or more after the initial development.
As onerous as this sounds, keep in mind that it's against a revenue stream that could literally be in the billions. Come up with a blockbuster, and you can be in fat city for years.
What's a blockbuster? I define that as a drug or technology that could potentially generate sales in excess of a billion dollars a year.
But back to the debt. What you want to see in a biotech company is steady funding.
Conversely, companies that attract an initial investment, then burn quickly through it without being able to gather more funding, are one-shot wonders. With companies like that you might as well go to Vegas.
But if the debt comes as part of an overall set of progress payments in exchange for specific developmental milestones, that's a very different case indeed.
Take MicroMet for instance. It's a story about what can happen when a bidding war develops around progressive developmental payments for a promising group of therapies—in this case cancer immunotherapies.
Amgen (AMGN:NASDAQ) ultimately swallowed MicroMet for $1.16 billion (B), handing investor s the opportunity to capture 61.83% in the process. I know, because my readers were among them.
3) Understand that volatility is part of the package.
Just like debt, understand that there is good volatility and bad volatility.
Biotech companies with bad volatility tend to move wildly yet are still generally correlated to the markets. This suggests that they really don't have too much going for them.
The true winners often move independently of broader market conditions. Not always, mind you, but enough that you can screen for a kind of "anticorrelation," for lack of a better term.
This can be hard to do because many promising biotech companies have very small market capitalizations and even smaller daily trading volume.
It means you need to look behind the numbers to see if you can account for the price swings. Are insiders buying or selling? Or, has an institution stepped up with the sort of payment "plan" investment I've just referenced?
Many times the big pharma companies will set up a series of structured investments that keep them off the radar while simultaneously keeping values low enough to represent a solid risk/reward ratio.
Their thinking is sound. After all, why tip off the markets when that makes a sweetheart deal more expensive for them?
Be cognizant of the story behind the story.
4) Spread your risks.
Biotech investors need to recognize that the odds are stacked against them from the get-go. While that doesn't necessarily mean you will lose, the odds of winning depend on carefully placing your bets and maintaining an adequate book.
You really can't adequately play unless you're willing to put at least $5,000 on the table and be comfortable with the idea you may lose 90% of it before one of the choices you make pays off.
Michael Milken of Drexel Burnham Lambert famously used to use this strategy back in the late 1980s with junk bonds. He'd buy 100 of them knowing full well that 98% would blow up, and that the 1–2% that hit would hit so big he could laugh all the way to the bank.
His compensation was more than $1B in a four-year period—a new record at the time, according to the New York Times.
It's worth noting that he had only four losing months in 17 years spent trading.
Today he's heavily involved in medical research, presumably for the same reasons we are. . .because the sector holds great promise.
5) Look for the Jolly Roger
Recent venture capitalist estimates suggest that life sciences investments may fall to only $2.5B in 2012. This is because many venture capital (VC) funding sources have been burned over the past few years.
Instead of crying me a river, you can use that to your advantage.
VC firms are like a bunch of modern pirates, in that they go where the money is. That's why you want to figure out where they've hoisted the financial equivalent of a "Jolly Roger."
Right now buyouts are hot. Limited partners—aka venture capitalists—won't take on new investments unless they see a path to liquidity in five years or less. That includes a buyout by a major pharma or tech company or a licensing deal from one of the same.
In other words, VC firms want to identify their exit strategies before they take a stake and put up the funding.
It only stands to reason that if you can tie a specific VC to the areas in which you are interested in, and even more specifically to a particular company, then you've got a good shot at a picking a winner.
As for IPOs, they are not the magic tickets they used to be. In the wake of the botched Facebook IPO, the public has only learned to distrust the process.
At the end of the day though, for all its difficulties, investing in biotech can be one of the single biggest roads to profitability.
Just make sure you've got an idea where you're headed and a rock-solid grasp on risk management. The last thing you want to do is blow your money on a promise that really isn't there.