3 Keys To Investing In Biotech Stocks

by: Marc Lichtenfeld

There's a children's book called "Alexander and the Terrible, Horrible, No Good, Very Bad Day." It chronicles a kid's day that starts off with him waking up with gum in his hair, and it gets worse from there.

On Monday, many biotech investors had their own versions of Alexander's day, if they had money in two specific stocks…

Peregrine Pharmaceuticals (Nasdaq: PPHM) dropped 78% in one day after the company disclosed that its stellar Phase II data for lung cancer drug bavituximab was not valid. The company blamed a vendor's mishandling of the information.

Regardless of who's at fault, investors in the stock were nearly wiped out just three weeks after they were popping corks on champagne bottles.

On September 7, the stock soared over 46% on news that bavituximab nearly doubled survival time to 11 months from 5.6 months. The stock closed at $4.50 that day. Monday, the last trade went off at $1.16.

Questcor (Nasdaq: QCOR) also saw its stock price riding a roller coaster, but Monday was the scary downhill part. The company is under investigation by the Federal government for the way it markets its only product, Acthar gel, sending the shares plummeting 37% lower to close Monday at $19.08.

The stock traded as high as $58.91 earlier in the year.

These two examples show how lucrative and unpredictable small-cap biotech investing can be. Even if you had adhered to The Oxford Club's recommended trailing stop policy, it wouldn't have helped in these situations.

When they fall, biotech stocks can fall hard, especially if the news is really bad or expectations were hyped beyond reality.

But there are a few steps you can take to increase your chances of making money and, more importantly, not losing it all after one press release hits the wires.

  • Spread your bets - Small-cap biotech stocks have the ability to become 10-baggers. They also have amazing stories. So it's easy to be tempted to put money in just one or two names and dream of buying your own island in the Pacific after the company cures cancer. But unless you're incredibly lucky, it doesn't often work out that way.

Instead, take the amount of money you were going to put into one stock and spread your risk across five to 10 stocks. That way, one blow-up doesn't destroy the whole portfolio, and you increase your chances of picking a winner. It might only take one big win to make up for a few losses or stocks that go nowhere.

  • Watch what the big boys are doing - Investors like to follow people like Warren Buffett. When Buffett is investing in Phillips 66 (NYSE: PSX) or any other company, it makes existing shareholders feel confident. And often, other investors buy shares after hearing that Buffett owns a stake.

Warren Buffett doesn't invest in biotech, but fortunately there are a few institutional investors who have strong track records and are worth paying attention to.

My favorites are the Baker Brothers. Julian and Felix Baker manage money for the Tisch Family and invest primarily in biotech. One has a Ph.D. in immunology from Stanford, the other studied business at Harvard. They have had successful early positions in big winners like Seattle Genetics (Nasdaq: SGEN) and Pharmasset - the latter was acquired by Gilead Sciences (Nasdaq: GILD) for $137 per share.

Of course, not every position of theirs works out, but knowing what positions they have large stakes in is a great place to start looking for ideas.

Another very smart investor is Sam Isaly of Orbimed Advisors. He recently added Auxilium Pharmaceuticals (Nasdaq: AUXL) and Illumina (Nasdaq: ILMN) to his portfolio.

  • Take some profits along the way - You've won the biotech lottery. The tiny company that you picked got its drug through the FDA process and was approved. The share price took off. Maybe the drug goes on to become the next blockbuster. Or maybe it's unable to penetrate the market at all. But if you take some profits after the initial pop, you'll lower your risk, put some money in your pocket and be able to better handle the ups and downs of the stock since you'll have less at stake.

If the drug does go on to become the next great cancer fighter, you'll still participate in the upside. But just because a company has a great product, doesn't guarantee it will sell. Several years ago, Nektar Therapeutics (Nasdaq: NKTR) and Pfizer (NYSE: PFE) created Exubera, an inhalable insulin.

The drug was approved and expected to become a big seller. After all, who wouldn't want to use an inhaler instead of giving themselves a shot?

Well, Exubera fell flat on its face. It only generated $12 million in revenue (instead of the expected peak of $2 billion annually) and Pfizer pulled the plug, taking a $2.8-billion charge. It took years for Nektar to lose the stink from Exubera, and its share price wallowed in the single digits after having spiked to over $20 earlier.

Investing in biotech isn't about hitting that one home run. To be successful, you need to manage your risk properly. So that when one of your stocks blows up (and it will, it happens to all biotech investors), it won't burn all of your investment capital.

And if you have just a couple of winners, that could be enough to turn a very bad day into a very good year.

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.