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When a woman, claiming to be the wife of a deceased general from Nigeria, writes to us saying she needs our help getting $10 million out of the country and in return we'll get 20% of the money, most of us know that's a load of bull. But when the CEO of a publicly traded biotech company tells us his drug is the next great thing, how do we know if he's being truthful, hopeful or is just a plain scam artist?

All stocks, especially those in the biotech sector, are susceptible to overhype, which leads to disappointed investors. I've had my share of winners and losers over the years, and have dealt with all kinds of companies. As a result, I believe my B.S. detector is pretty sensitive. Let me help you fine-tune yours. When evaluating biotech companies, consider:

  1. What kind of language does the company use?

Do its press releases sound like hype? Most reputable, science-driven companies won't use words like "stunning" or promote that something it accomplished has never been achieved before. Its language will be more guarded. Additionally, what does the CEO say? When discussing the effectiveness of his company's melanoma drug, Synta Pharmaceuticals (Nasdaq: SNTA) CEO Dr. Safi Bahcall once told me, "it's either water or it's not water. And we know it's not water."

He was right. It wasn't water. But it wasn't medicine, either. The Phase 3 trial was stopped early because the death rate among patients taking the drug was significantly higher than those who did not receive it. I compare that to the conversations I've had with the management team from Compugen (Nasdaq: CGEN), whose stock spiked 45% on Monday on news of a collaboration with Bayer (OTCPK:BAYZF). I've spoken with management many times, and while Chairman Martin Gerstel is an enthusiastic supporter and spokesman for the company, I've never once heard him make a promise that his company's technology will lead to marketable drugs. He certainly thinks it will, but there's a big difference between claiming it will and making sure investors understand there is still work to be done before anything is proven.

Additionally, Gerstel already made his fortune selling his former firm, Alza, to Johnson & Johnson (NYSE: JNJ) for $10.5 billion. He doesn't need to spend his time and energy on making money. He's in it to try to change the way medicine is developed. Some quick research on an executive's background may shed some light on their motivation for getting involved with a particular company.

  1. Are trials are placebo-controlled and double-blinded?

When a company runs late-stage clinical trials, particularly for cancer, you want the trials to be randomized, placebo-controlled, double-blinded trials. That means neither the patient nor the doctor knows if the experimental drug or placebo is being delivered. (In cancer cases, the placebo is whatever drugs are considered the standard of care, as it would be immoral to not treat a cancer patient.) Not knowing which drug is being taken is important to avoid a placebo effect – where a patient might feel better or a doctor might look for data points that suggest the patient is recovering based on the belief that the new drug is effective.

According to the Canadian Medical Association Journal, "A failure to blind observers in randomized controlled trials with subjective outcomes carries a high risk for bias." Additionally, by comparing the drug being studied to a placebo or standard of care, the evidence of whether it is safe and effective should be clearer than when it is simply being studied alone. Sometimes, for various reasons, a double-blinded, placebo-controlled study isn't feasible. But usually it is. If a company is running a Phase 3 trial that is open label (everyone knows that the patient is receiving the drug) and you can't find a valid reason for it – run, don't walk, away from the stock.

  1. How many patients?

Sometimes, a company will proudly announce the results of a clinical trial. In cancer drugs a 30% response rate can be enough to get approved by the FDA. But if, in a clinical trial, a company announces 12 out of 30 patients responded to the drug, that's not exactly an impressive sample size. Of course, if it's an earlier stage study, the trial did exactly what it's supposed to, which is to determine if the drug is worth being developed further. But a company that is hyping the results based on a small number of patients is more interested in promoting its stock than good science.

Not to pick on Synta again, but it recently issued a press release saying that four out of 15 breast cancer patients saw tumor shrinkage when taking its drug ganetespib. That's great. The problem is the study was supposed to enroll 70 patients. So why is the company releasing data on just 15? It's not like all 15 had a response rate. That would have been newsworthy. The recent data was not. So why did it release it early?

  1. Who is promoting the stock?

Do you ever get those promotions that tell you why a stock is going to skyrocket? If the company names the stock in the promotion, read the small print very carefully. There's a good chance the firm hired a stock promoter – which is usually a pump and dumper. A company can get a large amount of shares or cash (or both) in return for promoting the stock to retail investors. While those investors are buying, the promoter and company insiders are selling. Never buy a stock that you learn about in a promotion if the fine print says that the promoter has been compensated for sending you the information.

Investing in biotech stocks can be incredibly rewarding. But because these stocks can fly so quickly, there are people out there trying to help them take off, whether the science justifies it or not. It's in your best interest to be able to discern whether the CEO or other spokesperson is sensible or a hype artist.

Disclosure: Investment U expressly forbids its writers from having a financial interest in any security they recommend to our subscribers. All employees and agents of Investment U (and affiliated companies) must wait 24 hours after an initial trade recommendation is published on online - or 72 hours after a direct mail publication is sent - before acting on that recommendation.

Disclaimer: Keep in mind that Investment U and The Oxford Club do not accept or receive compensation from companies for writing about individual stocks, funds or any other kind of investments.