In response to a recent article about an interesting biotechnology stock, a reader recently asked me how to handle the volatility that tends to come with investing in a clinical-stage biotech. This is an excellent question, as it gets to one of the primary challenges that vex long-term investors who find themselves attracted to the potential rewards associated with hitting upon the right stock.
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Introduction to Biotech Investing
Since 1981, academic research has shown that smaller-capitalization stocks have higher returns than larger-capitalization names. Subsequent research has pointed to a value premium within small caps, demonstrating the outperformance of stocks with lower valuation ratios. Further research has shown that firms’ profitability also impacts the stocks’ long-term performance, with low-profitability stocks underperforming. Combine these elements, and you might reasonably conclude that the more expensive (i.e., growth-oriented), low-profit small caps provide poor waters for long-term investors fishing for a “whopper.” Yet, it is those same waters where one tends to find biotech stocks.
Biotechs are companies that use the principles of biology and technology to spearhead medical innovation. They research and develop new drugs, therapies, diagnostic tools, vaccines, and bioengineered solutions.
Significant differences exist between the large firms in the space and the smaller firms. Unlike the more prominent firms, which tend to generate substantial profits from treatments already brought to market, smaller biotech firms frequently aren’t profitable and require hefty financial support for research and development. Their success hinges on various factors, including the results of clinical trials and FDA approval. An approved drug could trigger a substantial surge in the stock price, but failure can lead to significant financial losses.
The Role of Clinical Drug Tests and the FDA Approval Process
As with any scientific endeavor, the pathway to success is paved with rigorous testing and validation. The FDA approval process is critical for biotech investors to understand. It unfolds in three distinctive phases. The first phase, Safety Testing, assesses the safety and appropriate dosage of the drug in question by testing it on healthy individuals. Next, the Efficacy phase is carried out to investigate the drug’s effectiveness and potential side effects on patients suffering from the medical condition it aims to treat. Lastly, Clinical Testing, the most rigorous and comprehensive of all phases, measures the drug’s safety and effectiveness over the long term, utilizing a larger patient group for a more accurate evaluation.
The outcomes of these FDA approval stages heavily influence the trajectory of biotech stock prices. Positive outcomes at each stage can result in considerable increases in stock prices, while news of adverse outcomes has the potential to cause dramatic price declines. Completing Phase 3 successfully is a monumental achievement, often leading to a substantial surge in stock prices. However, investors must understand that even successful Phase 3 outcomes don’t guarantee profitability, especially for companies grappling with financial challenges.
Keeping track of a biotech company’s progression through the FDA approval process is vital for investors to gauge the company’s potential for growth and profitability. Comprehending the intricacies of these tests, the financial standing of the company, and the potential outcomes allows you to make informed decisions and also aids in mitigating risk.
Factors to Consider When Investing in Biotech Stocks
Investing in biotech stocks is an exciting venture but requires careful consideration. Here are some key factors to keep in mind.
A detailed evaluation of the company’s research pipeline can increase your odds of success. Seek out companies that are developing diverse and innovative drug candidates at different stages. The array of promising treatments can be a solid indicator of future growth.
Keep an eye on clinical trial results, too. They provide a crucial peek into a company’s potential for success or failure. Positive outcomes may lead to a skyrocketing stock price, while negative results can have the opposite effect.
When it comes to financial health, scrutinize aspects like revenue growth, cash flow, and the company’s ability to sustain research and development. Understanding these financial details can be vital in making informed investment decisions.
Finally, don’t overlook the company’s leadership. A top-notch managerial team with solid experience in the biotech industry can significantly determine a company’s success. A team with a proven track record of bringing products to market is always a good sign.
It Helps to Be Realistic
Investing in clinical-stage biotechs is not for the faint of heart. The companies burn substantial levels of cash in research and development, with high failure rates. The stocks rise and fall dramatically on breaking news, making the ride somewhat volatile. Further, momentum can prolong up-and-down runs, often illogically pushing stock prices to unwarranted highs or lows, where they can stay longer than seems rational.
Yet, biotech stocks can have a lotto-ticket-like profile. Those companies that successfully usher a treatment through the various phases of clinical testing and eventually bring it to market can reap a windfall of profit. They are high-risk, high-reward opportunities that are appropriate only for investors with the patience to ride through the inevitable volatility and who can afford to lose.
In response to a recent article about an interesting biotechnology stock, a reader recently asked me how to handle the volatility that tends to come with investing in a clinical-stage biotech. This is an excellent question, as it gets to one of the primary challenges that vex long-term investors who find themselves attracted to the potential rewards associated with hitting upon the right stock.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
