As you may know by now, the healthcare sector is my bread and butter when it comes to investing.
Over the years of covering healthcare stocks, I've discovered that there are many ways to make money.
On one hand, large-cap pharmaceutical stocks have the ability to provide a steady dividend, while still achieving capital appreciation. On the other hand, small-caps offer potentially explosive returns, but contain more risk.
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Today, we're going to take a look at how to invest in small-cap names that typically don't have many (or any) drugs on the market, but offer the highest potential growth.
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When to invest in a small-cap biotech?
Some investors (those who can accept more risk) like to invest in a company when it's in the earliest stages of a drug's research, and then get out fairly quickly.
Others like to pare their risk by entering in the later stages of drug development, banking on Food & Drug Administration (FDA) approval, or the applicable regulatory approval in other countries.
Then there are investors who wait until the drug is approved, preferring to invest in a company that operates like a real business with actual sales, rather than one that still has product in development.
However you choose to invest in biotech, you can make huge profits if you know where to look. So let's take a look at the three main stages when you can invest
The three stages of potential biotech stock investment
Early stage
Investors can get excited at the promise of a new drug, even before there is any proof that it works. The mere concept of a new therapy to defeat cancer or battle diabetes can attract investor dollars before the drug even enters the clinic (human trials).
Even in phase I trials, where a small study of a few dozen healthy volunteers is used to better understand how the drug works inside the human body, investors may feel the potential reward is so high that the considerable risk is worth taking.
Investors who put their money into a company that has drugs in early development usually stand to profit the most. At this point, the stock price is typically low, as the company hasn't yet shown that it has a sustainable business, or that its drugs are safe and effective.
Mid-stage
If a drug succeeds with phase I clinical trials, it moves onto phase II. This usually comprises testing on several dozen patients who have the targeted disease. Researchers aim to prove that the drug is safe and effective in this limited patient population.
As for investors who join in after phase II data is released, they have some comfort in knowing that the drug has passed its first real test. However, plenty of drugs have done well in phase II and for various reasons failed in phase III.
Sometimes, this has to do with the small number of patients tested in Phase II. Other times it concerns the design trial. What you'd ideally like to see in a phase II trial is one that is 'double-blinded' and 'placebo controlled'. These are studies in which patients, doctors, and the company do not know who is receiving the new drug and who is receiving placebo (or the current standard therapy).
Phase III trials, which involve hundreds or thousands of patients, are usually conducted this way. So by running phase II in the same fashion, investors can feel more confident that the drug will have similar results in the later stage trial.
If the drug is successful in phase II trials - the first indication that it actually works against the targeted disease - the stock will often spike. This is when many early investors head for the exits, taking their profits and avoiding the risk of a failed phase III, which happens quite often.
Should the post-phase II spike occur, it's a good idea to take some profits off the table - even if you're in the position for the long-term.
Late stage:
As just noted, just because a drug reaches phase III, it doesn't necessarily mean it's a slam-dunk for full approval. Many drugs, even those that have positive data in phase III, do not get approved.
There are numerous reasons why the FDA can put the kibosh on a drug: Safety concerns, manufacturing issues, trial design, or just not being convinced of efficacy, are all reasons that regulatory agencies will continue to reject drugs.
Investors who get involved with a biotech stock after Phase III data is released, but before official approval, can benefit greatly once the drug gets the green light to go to market.
But without doubt, the easiest and safest time to invest in a small-cap biotech is after the drug receives approval. However, those investors will obviously not have the same return as those who were willing to take on more risk.
For investors who can afford to stick with the drug approval process, the profits can be life-altering when the drug gets approved and eventually goes on to be a big seller. For example, investors who sunk $10,000 into Celgene (Nasdaq:CELG)10 years ago have over $1.4 million today.
This article was written by Marc Lichtenfeld for the Smart Profits Report.
