Biotech Investing – Not For the Weak of Heart
Investing in small cap biotech companies is not for the weak of heart. You must be ready for violent price swings, heavy manipulation, failed trials, not so great trials where there is still hope, and the ever fun, positive trial results that are not positive enough. Small cap biotech investors range from the get rich quick crowd to the devout long believers to the hedge fund traders taking advantage of everyone else. It is easy to get convinced a small company has the next best treatment for cancer or has a pill to treat Alzheimer’s and also that somehow, you have discovered this gem of a company before the big institutions have had time to drive up the price. It is hard to remain objective, understand the process and not get frustrated by the huge amounts of volatility. Yes, you can score big with small cap biotech but limiting the losses is just as important. Most drugs or devices do not make it through the FDA approval process. There are multiples hurdles for the companies to overcome and as an investor it is prudent to be aware of all the large amounts of risk associated with small cap biotech investing.
I make the clear distinction between small cap and large cap biotech because they are completely different beasts. Large cap may have hundreds of products in development and many already approved while the small cap is typically single digit products in the pipeline without an approval yet. That brings me to the first thing that is typically assessed with a biotech, the pipeline. The drug or device pipeline is the ongoing research and development work currently being conducted by the company or by other organizations affiliated with the company. The pipeline is essentially the product line of a biotech. It is where you will find the drugs and devices of the future meant to solve healthcare issues or cure rare diseases. It also requires an extreme amount of due diligence. What many suggest the first thing investors should do with biotechs is completely understand the pipeline. If the device or drug does not make sense to you, it may not be a suitable investment. This is also the reason many research analysts in the biotech industry also hold a PhD. Some of the time, the science is too difficult to comprehend for the average investor but other times the mechanisms of action are clear. When the science is clear, novel, and has heavy research supporting it then that company becomes a investment prospect.
Although the pipeline may make sense to you and the path to multi-billion dollar drug sales looks smooth, there still exists the major hurdle relating to FDA approval. All of the pathways and timeframes related to the FDA requires its own novel. Suffice to say, it is extremely costly and time consuming process, which weighs especially heavy on typically underfunded small biotechs. From preclinical to Phase 3 trials is a long bump, and sometimes a disappearing road. It can be filled with positive results or with dilution, delays, and failures. Either way, the pipeline and the approval process should be well understood before you start becoming a believer.
I will write another piece focused solely on the people involved when investing in biotechs but the last and most exciting thing to mention is the potential with small cap biotechs. You hear things like 5x, 10x or 20x in reference to certain biotechs. This is the reward side of the major risk involved with these companies. The market cap can increase by multiples overnight upon approval, partnership or breakthrough. Prior to investing, you should also know the potential market the pipeline devices or drugs fit into and how big (in terms of sales) that market is. The other thing you should try to discern is how much penetration in that market the company you are researching will have. This is a hard number to determine and may require information from several sources to help you get an estimate. It is also a number that the company hopes to increase over time via heavy spending on a sales team or partnerships with bigger firms. Estimating market penetration must also take into account patents and the approval conditions described by the FDA. Getting approved is great but the drug or device must also be broadly labeled with a limited set of restrictions to help it gain immediate traction with doctors and patients. Clearly, there are a lot of important factors involved with biotech investing. I have broadly covered a few and hope to delve deeper into these topics over time.