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Editors' Note: This article discusses micro-cap stocks. Please be aware of the risks associated with these stocks

If it were easy to find the next biotech "hot stock" everyone would be a millionaire… and there would be far fewer heart breaking data announcements. Unfortunately, this is not the reality of the industry. But with the emergence of companies like Pharmacyclics (PCYC), Celldex (CLDX), Acadia (ACAD), and Galena (GALE) within biotechnology, investors are constantly wondering what steps they can take to help find the next great biotech movers. Below are four different stages of clinical development, including the risks and rewards that are involved with such investments, to help you identify value at different stages of development.

The Unknowns

Before a company such as Pharmacyclics can support a $9.2 billion market cap, it has to go through the growing pains of being a micro and, in some cases, a nanocap stock.

It's hard for many to fathom that Pharmacyclics once had a market cap of only $40 million -- by the way, this was less than five years ago. Today, we have a lot more data about Pharmacyclics's drug Imbruvica: It has earned an FDA approval, has been awarded several breakthrough and Orphan Drug designations, and is expected to be one of the biggest winners of the next decade.

However, in 2009 the drug was unknown; but what should've made it appealing is that it had little competition with large market potential if proven successful. This is the first indicative element investors should seek -- though it's often very unnoticeable -- but can be found scattered throughout the market. Here's an example:

Arch Therapeutics (OTCQB:ARTH) is developing a biocompatible synthetic peptide called AC5. This product is designed to stop bleeding and to control leakage, which is one of the most basic of functions in healthcare.

At home, we use Band-Aids to stop bleeding; in surgery physicians use hemostatic agents. While this may sound like a very boring space to consider for research and investment, there has been little to no innovation at all within it. Yet, as an industry it is quite large. What does this mean? Well, the time is ripe for new innovation and new discoveries. If a company such as Arch could prove that its product can stop bleeding safely and quickly, it could very well replace Band-Aid and enter a multi-billion dollar industry. In early testing, it took AC5 just 15 seconds to achieve this feat, which is many times quicker than competing substances. Keeping this in mind, AC5 could be used at home, in surgery, in the battlefield, etc.

Granted, investors must acknowledge the risk with companies of this size. The majority of data comes in later months/years and there are more failures than successes in this stage of development. Arch doesn't have a great deal of cash, but has spent just $1 million in the last year, as the development of AC5 is inexpensive due to the availability of its components and the nature (spray in surgery) of its clinical trials.

Essentially, when a clinical product has little competition in a field with very little innovation, and a company is unknown while touting a great product, the gains can be tremendous. In essence, the first thing investors should seek is a company that few are talking about, but has large market potential and a strong product under development.

Good Data, But Unanswered Questions

Next, as companies grow in market value, it is important to produce good data.

At this point, a company has often exceeded the level of nano or microcap, but not always. There is often value scattered throughout the industry that is unrealized, and then all of a sudden a stock produces a single-year 300%-500% performance.

For example, NewLink Genetics's (NLNK) has a market cap of $550 million, and its entire valuation rests on the company's ability to prove its HyperAcute cancer platform to be effective. HyperAcute is an immunotherapy platform that consists of novel biologic products that recognize and attack cancer cells. It is being tested to treat pancreatic, lung, and prostate cancers along with melanoma.

The company's most advanced program is in treating pancreatic cancer, in which more than 85% of patients survived over one year in a 69 patient study. However, there was no control group, which is always dangerous in biotechnology, as historical averages are not always relevant. Oftentimes, companies do not test a drug against a control group in early trials, then produce very strong data against historical survival rates. But then once a drug is tested against a control group, or a drug that has already shown an advantage over standard of care, the product being tested does not look as effective.

NewLink is currently testing HyperAcute Pancreas in a large 700+ patient Phase 3 trial, which will show the product's effectiveness against a controlled group. Currently, data looks promising. However, with current unanswered questions, the larger study will tell us a lot more in regards to the future of this platform. If it proves successful against a control group then NewLink's stock will likely double, or more, but if unsuccessful, much of the company's valuation will be lost.

This brings up the point of seeking strong data and market valuations that do not reflect the potential of a drug. Clearly, an investment here is also risky, as there are unknown questions regarding future data. Though it is less risky than investing in the unknown companies, as explained above. The good news is that there is still significant upside potential for stocks in this category, as a successful Phase 3 trial for HyperAcute Pancreas would immediately change the company for the better, as would bad data for the worse.

Anticipating an Exciting Year

The company is known; it has produced good data; now we are looking at future catalysts.

After a company has been identified by the broader market and its data widely known, comes the category of those with major pending catalysts such as partnerships, patent news, or additional data on secondary products.

Oftentimes, these stocks have already seen large gains, but could still trade higher if the good news continues to fall in the company's favor. The best example might be Celldex Therapeutics.

Celldex's breast cancer drug successfully shrunk tumors and extended life in patients who had failed prior treatments, or those patients facing the greatest risk of death. This particular drug, CDX-011, is considered by many to be safe heading into FDA meetings. Furthermore, the company also has data to present on its Phase 3 brain cancer drug -- rindopepimut -- and early data on an orphan product called CDX-1135. Resultantly, Celldex still has multiple catalysts to drive its stock higher.

Due to data that is already known, these companies carry less inherit risk, as investors are aware that at least one product will likely earn an FDA approval. But in the case of Celldex, many expect it to succeed with other clinical programs because of its success with CDX-011. This naturally poses a risk, as shares of Celldex could be under pressure if future data takes a negative turn or if the company does not find a marketing partner. Still, the risks associated with Celldex do not match the uncertainty and doubts that plague those stages already discussed.

In regards to its Phase 3 brain cancer drug, Celldex has already expanded the trial by 75 patients, noting early signs of anti-tumor activity. And its orphan product has shown great data in mice models, leading to its first human trial in Dense Deposit Disease (DDD). However, this information is known, and is considered in the valuation of the company. Hence, the short-term upside isn't as great as those in earlier stages of development -- Celldex has seen gains of 900% since 2012 - through the unknown and data stages of development.

If Celldex's pipeline proves successful, the stock could very well double, but then fundamentals such as sales and profits will have to drive long-term value, and this brings us to the last stage of biotechnology development.

Preparing to Launch

The final stage that comes with investing in developmental biotechnology companies come either right before or after an FDA decision. This is the point where valuation comes into question and fundamentals are forced to carry the stock, not the speculation that stems from analyst projections and the excitement prior to launch.

Pharmacyclics and Acadia Pharmaceuticals are probably the best examples for investors seeking companies in this stage of development. Both companies have gone through each and every stage in the journey to become multi-billion dollar biotechnology companies.

Pharmacyclics's drug has already been FDA approved and Acadia's anti-psychotic is expected to be FDA approved in early 2015. Thus, Pharmacyclics is about one year ahead of Acadia in the development process, but both drugs are expected to be blockbusters.

Pharmacyclics's cancer drug is estimated to earn peak global sales of more than $6 billion once it is FDA approved in all tested indications. Acadia's pimavanserin is expected to earn sales of $2 billion, also with the help of added indications. As of now, most analysts believe that both companies will reach these marks, as some have even more bullish estimates.

The difference is that Pharmacyclics shares sales with Johnson & Johnson, approximately 50%, and is responsible for 40% of the costs. This means Pharmacyclics will earn peak sales around $3 billion on the drug. When we look at market valuations of $9.2 billion and $2.2 billion for Pharmacyclics and Acadia respectively, investors can see that Acadia is the more affordable stock.

As I explained, although Pharmacyclics is about a year ahead of Acadia in the developmental process, it is also much more expensive. Perhaps this means that investors could find upside in Acadia over the next year as it marches towards its FDA decision date. Regardless, investors must seek valuation inconsistencies in companies to find the best opportunities. Oftentimes, the speculation and excitement of a company will make it very expensive prior to an FDA approval, and other times there is upside left on the table.

Conclusion

After an FDA approval, speculation and excitement is no longer relevant as product sales then have to drive company value. At this time, a company is transformed from development to commercial and the valuation drivers change. However, for investors who were able to identify the company at its earliest stage (likely in the preclinical phase), gains have already been tremendous, and investors must decide whether or not to take gains off the table.

Theoretically, as a company progresses into new stages of development, the risk diminishes as more questions are answered. However, as this occurs valuation must become more of a question -- and investors have to determine whether or not upside still exists. With that said, we have concluded our look at the developmental cycle of a biotechnology company, through the clinical phase and at different levels of valuation. Hopefully, this will aid you in identifying future investments and in how you gauge risk and upside at each stage of development.

Source: Understanding The Investment Opportunity In Developmental Biotechnology