By Greg Jensen
Small biotech stocks are trendy. Let’s face it, the rewards to a company that introduces the next wonder drug for cancer, obesity or dementia are huge. From a trader’s perspective, these massive potential rewards can make very risky investments seem very tempting. On the other hand, most small biotech companies consist of an idea and a pile of debt. They often never make any money.
The obstacle course through clinical trials to FDA is long and tortuous. Drugs and medical devices alike face extreme scrutiny, as well they should. And for the companies and those of us that choose to invest in them, there is no reward without risk.
It seems that everybody has a favorite, and if you mention an interest in the markets at any gathering, somebody will give you a tip, confident that their favorite has found the cure for all human ills. This combination of public interest, huge potential, and lack of profit gives me a nasty case of déjà-vu.
If you are old enough to remember the dotcom boom of the 1990s, you know exactly what I’m talking about. In fairness, though, there is one fundamental difference: today’s small-cap biotech companies actually have a potentially saleable product. It is therefore unlikely that the whole sector will collapse, but the volatility of each stock requires that if you are going to enter the biotech jungle, you plan your trip well.
Here are a few rules of the road:
- Diversify: We all know this is generally a good idea. When you are looking for one big winner in a sea of uncertainty, however, it is even more so. Investing in any one of the following: Arena Pharmaceuticals (ARNA), Celsion (CLSN), Clovis Oncology (CLVS), Orexigen (OREX) or Zalicus (ZLCS) in the past would have been a good idea. Spreading an investment between them certainly was.
If you had invested one month ago, as you can see from the chart above, the successes would have more than compensated for the disappointments. The one year chart (below) is even more revealing. You may have been lucky or skillful enough to invest in ARNA 1 year ago, but your chances for positive return were obviously much higher if you invested in all five stocks.
- Protect the Downside: Whether your chosen method of protection is an options strategy or simple stop loss orders, as Nike would say, just do it! With volatile stocks, such as small biotech companies, downside protection can be relatively expensive, but with upsides measured in the hundreds of percentage points, living to fight another day is important. Stop loss levels should not be too close (these things move!), but when reached should be observed. It is amazing how a 35% drop in a stock can look like an opportunity to average a position when it happens. Small biotech stocks are sensitive to news, and big drops usually happen for a reason. Which leads us to . . .
- Understand That You Don’t Have Perfect Information Flow: This is really something to help you observe 2 in a disciplined manner. Unless you are a computer, a floor trader, a specialist in one individual stock or any combination thereof, you are behind the 8 ball. I am not accusing anybody of insider trading, but it is amazing how frequently big moves in these stocks seem to precede big news. Even if the move comes after news release, the chances are that you, as a small investor, will miss the initial opportunity. Don’t cry about it, accept it.
Many people traded successfully through the dotcom boom and bust by being disciplined. While the current situation with small biotech and pharmaceutical stocks is not the same, I believe the same lessons can be learned. Observing the three rules above will not guarantee a profit. You could just choose five or more losers. What it will do is allow you to invest in the sector in a disciplined, controlled manner and still have a chance of hitting the jackpot.