High Risk/High Reward Becomes High Failure

Aeterna Zentaris (NAS: AEZS) and Keryx Biopharmaceuticals' (NAS: KERX) cancer drug perifosine failed to show an effect in advanced colorectal cancer, and both companies plummeted 65% on the news. Fellow Fool David Williamson has the rundown, but let's do a little Q and A to tease out why this happened.

Was perifosine's failure a foregone conclusion? No, and anyone who tells you differently is pulling a late April Fool's joke on you. There was no way to know which way this one was going to go -- which was, of course, the problem.

Should you have discounted the shares more? Probably. I didn't see enough of a margin of safety at the levels the two companies were trading at going into the data release to justify buying. The likelihood of success was a crapshoot, as any phase 2 trial is.

But I thought it was a phase 3 trial? Yes, it was. But this was a hypothesis-driven trial without much basis for the hypothesis; it was a lot closer to the design of a typical proof-of-concept phase 2 trial than a phase 3.

In the actual phase 2 trial, the companies noticed a subset of patients who were responding well to perifosine, so they enrolled those patients specifically in the phase 3 trial.

But if the subset worked in the phase 2, why didn't it translate into phase 3 success? To understand how this works, imagine you pull 100 people off the street and try to find something that the vast majority has in common. If you look at enough variables, you're bound to find something. Now if you pull another 100 people off the same street, will you find the same trait in common? Perhaps, but remember the first was only an observation. If it's jester hats in front of Fool HQ, maybe, but if it's blue shirts, maybe not.

A conservative company would have run a phase 2b trial with the same types of patients to see whether they could confirm the hypothesis. Keryx and Aeterna Zentaris chose to take the more aggressive approach of moving directly into a large phase 3 trial.

Was that a bad move? Obviously in retrospect we can say yes, but it gave investors an opportunity to invest in a high-risk, high-reward investment. The trick was to remember that as the shares rise before the data release, the risk increases and the reward decreases. Investors who bought Keryx at the beginning of the year are sitting on only a 30% loss, which seems like a reasonable defeat considering the potential upside if the trial had been a success. Really savvy investors could have bought then and sold near the top for a solid gain without ever having to risk anything on the binary event.

It's impossible to make money investing in biotechs where the events' outcomes are widely expected. Just look at Astex Pharmaceuticals (NAS: ASTX) , which went up after an expected FDA rejection, or Affymax (NAS: AFFY) , which is trading lower than where it was before it received an expected approval.

Risk-tolerant investors can get multibaggers making educated guesses on more uncertain results. The trick is to find that margin of safety and keep the investment to a reasonable portion of your portfolio so the inevitable losses won't wipe you out.

The other option is to find growth stories that aren't as susceptible to binary events because the companies already have health-care products on the market. David Gardner and his team at Rule Breakers think they've found an excellent investment option. Find out what it is and why they like it in the Fool's free report, "Discover the Next Rule-Breaking Multibagger."

At the time thisarticle was published Fool contributorBrian Orelliholds no position in any company mentioned. Check out hisholdings and a short bio. The Motley Fool has adisclosure policy. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days.

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