Biotech Investing: 3 Ways You're Doing It Wrong

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When it comes to industries that offer investors a higher than average risk-versus-reward scenario, biotech investing arguably takes the cake.

Since the benchmark S&P 500 bottomed out in March 2009 the index has gained about 200%. In contrast, SPDR S&P Biotech ETF , including dividends, has risen more than 265% over the same period. With gains of close to 800% from GW Pharmaceuticals , more than 500% from Intercept Pharmaceuticals , and a shade over 400% for Puma Biotechnology over the trailing 52 weeks, it's easy to see why biotech investing lures in so many new investors each year.

Of course, whereas this sector can create instant winners overnight, it also has the potential to make hard-earned money disappear in the blink of an eye. For instance, more than one-quarter of all biotech stocks are down by at least 10% over the trailing year despite a 20% gain in the S&P 500 over the comparable period.

Biotech investing: It sounds easy, but ...

One of the big variables that creates this gap in performance is that biotech investing relies on looking deep into the future more so than any other industry. Biotech companies are usually valued not for their revenue and profit/loss results from the prior quarter (which may not even exist if it's a clinical-stage biotech), a typical starting point for stock analysis with nearly all other industries, but instead are assessed based on the size of the patient pool their developing and existing drugs will treat, as well as the forecasted peak annual sales potential of those therapies.

It sounds so easy , but there are so many people who are unsuccessful biotech investors.

Three mistakes biotech investors make

Let's have a look at the three most common mistakes biotech investors make so you don't fall into the same trap, because, as these totals above show, if you do take advantage of the opportunities that the biotech sector offers your reward could be huge.

Mistake No. 1: Chasing penny stocks .

This mistake isn't confined just to the biotech sector, but the habit of chasing penny stocks is among the easiest ways to lose money investing in biotech stocks.

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Inexperienced traders often forget that the price of a stock isn't what matters -- the market cap does. However, their eyes light up when they see a stock trading for just $1, $2, or $3 per share because they believe its "low price" gives it a better chance to double from its current level.

But stocks trading in the low single-digits are often there for a reason. For biotech stocks that are wholly clinical in nature that reason may require a little more digging, which is something short-term traders usually don't have the patience to do. But rest assured, a reason is almost always found.

Take Amarin as a perfect example. Amarin has one drug approved by the Food and Drug Administration, Vascepa, for persons with really high triglyceride levels. Amarin tried to get Vascepa's indications expanded to cover a significantly larger portion of the population (those with triglyceride levels of between 200 mg/DL and 499 mg/DL) last year, but the FDA ultimately rejected this move . Though its share price below $2 may look tempting, especially considering that it's down by more than 65% over the past year, it remains to be seen if Amarin can generate the support from the FDA or the funds to eventually complete a costly and lengthy cardiovascular outcomes trials. And even if completed, investors have to wonder how many years it'd be before Amarin has a real shot at turning a profit. While its share price might give off a hint of undervaluation, the story behind the stock would merit a wise biotech investor to keeping distance.

Penny stocks also commonly have concerns about cash burn and/or dilution. When a biotech is in the clinical development stage it tends to burn through its cash on hand. This means investors are constantly wondering if their investment will have enough capital to not only finish its trials, but to simply survive. In order to maintain enough cash in the coffers to run its business many biotech stocks will turn to share offerings which do raise cash, but also come with the negative effect of diluting existing shareholders.

Mistake No: 2: Allowing emotions to get the better of you.

Secondly, far too many biotech investors allow their emotions to get the better of them, leaving them blinded to the long-term-growth drivers that they should really be focused on.

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A case in point here would be the weight control management sector and biotech stocks like VIVUS and Arena Pharmaceuticals . Both VIVUS and Arena have a faithful following of supporters -- just check the comments section of any Motley Fool article if you need proof. Yet the overwhelming love for these stocks has left many of their shareholders blindsided by hefty losses in each stock. "Why?" you ask? Because investors were unwilling to believe there could be another side to their investing thesis.

As we've learned now after watching VIVUS' weight-loss drug Qsymia since it launched in 2012 and Arena/Eisai's Belviq since it launched in 2013, the demand for weight-loss therapies so far hasn't been that strong. Insurers have been slow to latch onto coverage and consumers simply haven't been willing to pay much, if at all, out of their own pocket to get their hands on these fat-busting drugs. With the possibility of even more competition on the horizon as a decision date from the FDA on Orexigen Therapeutics ' Contrave nears, it would appear that the investing fervor surrounding the sector may be for naught.

Mistake No. 3: Not seeking pipeline diversity.

Lastly, far too many novice biotech investors focus on companies with very few existing drugs or that have just a handful of compounds in development. By doing this, investors are giving themselves only a limited chance of long-term success.

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Allow me to use a baseball analogy to better describe this. Imagine I asked you to hit a home run over the fence, but that you only get one pitch with which to do so. Now, imagine I have 20 baseballs in a bucket and I said you have to hit a single home run over the fence. In both scenarios you win if only one ball clears the fence. Which would you rather choose?

If you said the latter you're thinking like a true biotech investor because you're spreading your risk around over a number of developing and existing drugs. If a few developing compounds fail to succeed in clinical studies then your downside risk is mitigated by the fact there are more than a dozen other experimental compounds that might succeed. In contrast, a pipeline with only one or two drugs has the potential to blow up in biotech investors' faces if things don't go according to plan.

You can only grow more knowledgeable

Keep in mind that even if you avoid these common investing mistakes there are still no guarantees you'll succeed at biotech investing. But I'd certainly suggest that your chances of success will have gone way up by taking these points to heart.

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The article Biotech Investing: 3 Ways You're Doing It Wrong originally appeared on

Sean Williamshas no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen nameTMFUltraLong, track every pick he makes under the screen nameTrackUltraLong, and check him out on Twitter, where he goes by the handle@TMFUltraLong.The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insights makes us better investors. The Motley Fool has adisclosure policy .

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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