How Not to Pick Biotech Stocks

by: Dr. Kris

Are all of your stock picks winners? Sick and tired of making money hand over fist? Then look no further because I’ve got a couple of ways you can reconnect with the rest of us mere mortals by learning to spot losing propositions. If losing money is not your goal, that’s even more of a reason to read on because even seasoned investors can find themselves being lured into these money traps.

Losing proposition #1: The one-trick pony company
Although I’ve railed against this type of investment before, it bears repeating because apparently many people are still being taken in by this type of risky scenario. A one-trick pony company is one that makes only one product or offers only one niche service. Small biotechs that will be relying on FDA approval to market their lone drug or medical device is the most dangerous example of this breed. While product approval could translate into a lucrative payday for investors, the consequences of denial could be dire. The company’s stock most certainly will plummet and the company itself could very well go out of business.

You think this doesn’t happen? It financially ruined two personal acquaintances and inflicted so much psychological trauma on one that he suffered a nervous breakdown. Both were heavily invested in one-trick pony biotechs that were relying on FDA approval. Obviously, neither company received it causing their respective stocks to be flushed down the toilet. (The companies were Xoma (NASDAQ:XOMA), whose stock plummeted from $30 to around $1 in the early ’90s and the other was Northfield Labs, which went out of business last year.)

The latest addition to this list of biotech losers is Xenoport (NASDAQ:XNPT). Citing pancreatic cancer concerns, the FDA Friday put the kibosh on the company’s restless-leg syndrome drug that the company was developing with GlaxoSmithKline (NYSE:GSK). Xenoport stock immediately shed two-thirds of its value while pharmaceutical giant Glaxo lost a mere 1% on the news.

XNPT Chart 2-19-10

Losing proposition #2: Unsolicited takeover bids
On January 7th, medical and scientific equipment maker II-VI (NASDAQ:IIVI) made an unsolicited offer of $10 per outstanding share of Zygo (NASDAQ:ZIGO). Zygo stock rose over 30% on the news, closing the next day well over the $10 offering price on hopes of a bidding war.

What followed were several lawsuits but no other offers. Facing an uncertain future and angry shareholders, the company appointed a new CEO, Chris L. Koliopoulos, on January 19th and made him board chairman on February 12th. Several days later, the company’s board rejected II-VI's offer, causing the stock to drop over 9%.

ZIGO Chart 2-19-10

Comparatively speaking, this loss wasn’t nearly as bad as it might have been as stocks typically drop back to pre-announcement prices or even lower following a merger rejection. Might shareholders still be hoping for a better offer? That’s something I certainly wouldn’t bet on.

You’re probably wondering why someone would even want to get mixed up in these types of situations in the first place. The answer is simple: If the drug gets approved or the unsolicited offer spurs higher bids, you stand to make a lot of money. If you’re playing with some mad money then by all means enjoy yourself, but if a potentially large loss will deprive you of a good night’s sleep, then it’s your fiduciary duty to yourself to put your funds into a more conservative investment strategy. ‘Nuff said.