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Investing in development stage biotech companies is risky business. We’re talking about companies with no material product revenues, high cash burn rates and fairly high failure rates. At the same time, successful drugs can generate huge returns. And if you can find a stock that gives you a 500% return, that supports a lot of failures.

An effective strategy here begins with realizing that it is nearly impossible to predict the success or failure of a given drug in development. At any time during trials, a drug may fail to show efficacy or may be found to be too dangerous for use. The company may be insufficiently funded to complete development. The FDA may choose not to approve the drug or require additional costly trials. Even once the drug is approved, there may prove to be no significant market for it, or other competing drugs may show greater efficacy and limit sales.

Given this, we can come up with a set of characteristics to look for in a development stage biotech, and buy a basket of such stocks meeting our criteria. We know we won’t hit a home run with all of them, but if we can manage to succeed with some and bail out of others before we lose 100%, we can ensure a good rate of total return.

Questions to ask when evaluating development stage biotechs:

1. How long will the company’s cash last?
Developing drugs is expensive. Running clinical trials is expensive. Launching a new drug is expensive. Will the company be able to move drugs forward in the pipeline with existing cash to the point where additional equity or debt can be sold, or a partnership entered into with a larger drug company to fund development?

2. Does the company have multiple drug candidates?
Is the company betting its entire future on one drug, or are there multiple drugs with promise in the pipeline? One-drug companies are coin tosses; a failure in a trial will often mean the end of the company.

3. Do the company’s drugs address a market need?
The drug may get approved, but as with any other product, there may not be a market for it. It may target too small a niche, not be cost-effective compared to older drugs, or address a condition that people are willing to tolerate without treatment.

4. How soon might the company expect to begin marketing a product?
If we’re still 5 years away from having a product in the market, we’re probably too early. If product revenues aren’t close, are there any potential milestone payments coming up? Releases of new study data that might lead to a partnership?

5. How enthusiastic is the market about the company?
Has the market already decided that the company’s new cancer drug will be a blockbuster even though it’s only in Phase I? We’re not looking for $1 Billion plus market capitalizations unless a substantial portion of it is in cash.

In light of all this, I plan to post a series of short writeups over the next few weeks on small biotech companies that I feel look interesting and can be bought using a basket approach to mitigate the risk of each individual company. Each of these is highly speculative and carries a substantial risk of significant losses, but I believe that in the aggregate they offer an attractive opportunity.

Source: Five Questions To Ask On Dev-Stage Biotechs