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With a number of new economic signs showing that the U.S. and global economy could be heading lower due to the European debt crisis, and a potential "fiscal cliff," biotech stocks could be one of the best performing sectors in the coming months. Biotechnology companies are relatively immune to economic downturns and these stocks can surge based on clinical trial results, FDA approvals and other factors. But, the main reason I am writing this article is because I think many investors often misperceive and misprice the risks and therefore miss the upside potential when investing in biotech.

When I buy a biotech stock, there has to be a very good risk/reward ratio. While I might be happy with 10 or 20% gains in some stocks, a biotech stock needs to have huge potential rewards, like a multi-bagger. One recent example that shows the power of buying low priced biotech stocks that may have been perceived as risky is Sarepta Therapeutics, Inc. (NASDAQ:SRPT). This little biotech company recently announced positive clinical results for its candidate for Duchenne Muscular Dystrophy, which is called "Eteplirsen." A solid safety profile and positive test result could mean a new treatment for this serious and life-threatening disease and big future revenues for Sarepta. That has led to massive gains in the past several weeks. In July, it was possible to buy this stock for just about $3.50, but it recently surged to around $45 per share.

Arena Pharmaceuticals (NASDAQ:ARNA) is another prime example of risk and reward with biotech investing. Arena had been working on a weight loss treatment for years and the shares plunged in late 2011 to about $1 per share when the FDA brought up issues. This caused delays and, as a result, many investors did panic selling, taking the stock down to about a buck. When Arena shares were trading for about a dollar, many investors probably viewed the stock as too risky and either sold or refused to buy such a "risky" stock. Just months later, Arena received the FDA approval and the stock surged to over $13 per share. That means investors who were willing to buy the shares that were perceived by many to be extremely risky at about $1, ended up with over 1000% gains in a short time. This example shows how easy it is for investors to make big analytical mistakes when it comes to evaluating the real risks of a biotech investment. Sarepta shares are also a good example since many investors probably viewed the stock to have the most risk when it was just about $3.50 per share. Actually, the risk (in hindsight) was highest when the stock recently reached $45 per share, since it has now dropped back to the $24 level.

This brings me to Chelsea Therapeutics (NASDAQ:CHTP), which I believe could be poised to outperform Arena Pharmaceuticals and Sarepta Therapeutics shares. Both of those stocks have already seen huge gains going from single digits to double digits, but Chelsea Therapeutics shares are trading for just over $1, and the stock has the potential to be a multi-bagger. This company is working on a treatment called Northera or "Droxidopa" for dizziness and falling which occurs frequently in people who have Parkinson's Disease. While many investors sold Chelsea shares after the company was asked by the FDA for additional data, there is reason to believe that this might be the least risky time to buy the stock. Some investors may have felt this stock was not as risky when it traded for over $5 per share and FDA approval seemed likely, but in hindsight that was a much more risky time to be buying. Right now, the company still has all the upside potential it used to have, albeit with some delay in the FDA approval process. However, some investors are avoiding it because if it is trading for $1.30 instead of over $5, it must be more risky, right? To that, I say absolutely not. Now let's look at 3 areas of perceived risk and why some investors might be making big mistakes when it comes to analyzing the risk and reward:

1. The risk that the drug will not be approved: The chances of approval still seem very strong, and the delay appears to have very little impact on whether this can be eventually approved. This treatment has been approved and used in Japan for many years, where it already generates about $50 million per year in sales. With a track record of safety in another first world country for over 15 years, it adds to the likelihood that this treatment would be suitable and approvable in the United States. Another reason why eventual approval appears likely is because earlier this year an advisory panel voted 7 to 4 in favor of approval. This adds further credence to the theory that the drug has a strong chance for FDA approval once it gets the additional data requested. But, with downside risk of about $1.30 and upside potential that is many multiples of the current stock price, that is the kind of risk to reward ratio that makes sense to me.

2. Management risk: After the FDA requested more info, and the stock plunged earlier this year, the CEO left the company. This caused many investors (myself included) to be very concerned. In fact, I was ready to give up on this stock until more facts and analysis came out. Upon further reflection, it became more clear to me that the CEO departure was the right decision for the company and that his departure will have absolutely no impact on whether or not this drug gets approved. The buck stops with the CEO and with many disappointed shareholders, the CEO departure was the right thing to do for many reasons. In fact, I believe the board and a major shareholder demanded management changes. It is clear that the company is moving forward with the FDA approval process and it now has different management in place. The CEO departure and the resignation of a VP of marketing and sales was also smart for the company in terms of conserving cash so that the company can use funds to get this drug approved. (With a delay in the approval, keeping a sales and marketing VP makes no sense.) The management changes allow the company to save about $3.5 million per year and still keeps it focused on the steps needed to gain FDA approval.

3. Balance sheet risk: This is always an issue I check before investing in any biotech. While some biotech companies are short on cash and even have major levels of debt, this is not the case for Chelsea Therapeutics. It has about $41 million in cash on the balance sheet and no debt. That gives it enough money to operate and make progress for another shot at approval.

Now let's consider the risk of not investing in Chelsea Therapeutics: Investors could be missing out on substantial upside potential. This stock was trading for about $6 earlier this year and based on estimates from the company, it could potentially generate between $300 to $375 million in annual sales within 3 to 5 years of approval. It's possible to make a case for a share price of as much as $28, once those sales levels are achieved.

Overall, I believe that some investors are making the same type of risk analysis mistakes with Chelsea that were made when investors were selling Arena shares for a dollar or Sarepta shares for about $3. When you carefully and logically evaluate the risks, it is clear this company is pursuing the approval and that it still has a strong chance of approval. With downside of just about $1.30 and with the upside potential of a multi-bagger, it becomes easy to see why investment analysts at Zacks have recently given this stock a strong buy rating. A recent PropThink article states "shares of Chelsea Therapeutics could be rejuvenated as new Phase III results are expected to be reported by year-end." The article also mentions that Wedbush analysts have a $5 price target on the stock right now. With the huge gains in Sarepta and Arena, some investors might want to take some profits and consider Chelsea Therapeutics shares as it has the potential to join the club of single digit biotech stocks that turn into multi-baggers.

Key Data Points For Chelsea Therapeutics From Yahoo Finance:
Current Share Price: $1.35
52-Week Range: $.70 to $5.74
Dividend: none
2012 Earnings Estimate: a loss of 76 cents per share
2013 Earnings Estimate: a loss of 60 cents per share

Key Data Points For Arena Pharmaceuticals From Yahoo Finance:
Current Share Price: $8.75
52-Week Range: $1.27 to $13.50
Dividend: none
2012 Earnings Estimate: a loss of 21 cents per share
2013 Earnings Estimate: a loss of 11 cents per share

Key Data Points For Sarepta Therapeutics From Yahoo Finance:
Current Share Price: $24.25
52-Week Range: $3 to $45
Dividend: none
2012 Earnings Estimate: a loss of $1.09 per share
2013 Earnings Estimate: a loss of $1.59 per share

Data is sourced from Yahoo Finance. No guarantees or representations are made. Please consult a financial advisor before making investments.

Source: This $1 Biotech Stock Offers Limited Downside With Huge Reward Potential