Egg Counting is a Dangerous Game in the Biotech Sector


To be a successful investor in the biotech sector you need two pieces of the puzzle to fall into place.

First, you need positive clinical-stage data to demonstrate the efficacy of a drug, or drugs, which ultimately leads to a new drug application filing and hopefully eventual approval from the Food and Drug Administration. Second, barring FDA approval , you need the company to successfully price and launch its newly approved drug. It sounds easy on paper, but there odds are stacked against biotech companies from the start.

Back in March, I looked at three unique ways you can take part in the rapid growth potential of the biotech sector without taking on an incredible amount of risk. Those methods were: buy into established biotech companies, buy into well-diversified pipelines, or buy a basket ETF which spreads your risk around to multiple companies. The idea was that the biotech sector does have concrete data we can use, but it also involves a bit of guesswork thanks to the clinical trial and FDA authorization process.

Source: Sara Hughes, Flickr.

However, nothing can be more detrimental to a current or potential biotech investor than egg counting. The one thing you must never do as a biotech investor is count your chickens before they've hatched! Confused? Let me explain.

Understanding the drug development process
Drug development begins in the laboratory in the preclinical stage and generally goes through three clinical-stage trials. The preclinical stage is where researchers often test the drug in animals and establish an early safety, efficacy, and side-effects profile. Should it prove worthy of a clinical study, a biotechnology company will file an investigational new drug application outlining its study intent with the FDA. If the company receives the agency's OK, it can begin human trials.

Phase 1, or the early stage of drug development, often involves a study of a few dozen patients to establish drug safety and tolerability, as well as determining proper dosage.

Should the results be positive a company will move onto phase 2 clinical studies, which involve a larger patient cohort and focus more on drug efficacy while still not forgetting about safety and side-effects.

Finally, if the data remains positive an experimental drug would move onto phase 3, or late-stage trials, where it would be tested in an even larger group of people for efficacy and safety and likely be compared against a current standard of treatment to establish non-inferiority or superiority. If all goes well here, it's off to file a new drug application with the FDA and cross your fingers!

Where investors go terribly wrong
Where I find that biotech investors go terribly wrong is in the faith they place in the early stages of the drug discovery process. Phase 1/2a studies, which often act as more of a proof-of-concept program, determine very little in the overall efficacy of a drug and are meant more as a jumping off point for determining the proper dosage and potential tolerability of an experimental product. However, I have noticed a recent trend in which investors are placing greater emphasis on early stage results, which is a dangerous game to play in the biotech sector.

The past week had offered two perfect examples. Both Omeros and Isis Pharmaceuticals delivered early stage clinical results that pumped up their share price by double digits. Omeros reported positive early stage safety and efficacy data on OMS824 for the treatment of stable schizophrenia, but optimal dosing is still being determined. Isis reported positive add-on data for its early stage study of ISIS-SMNrx for the treatment of spinal muscular atrophy in children. While noting that no children in its 9 mg cohort showed performance declines, optimal dosing is likewise still being determined.

I'm not trying to take away anything from these two companies as they both actually have quite a diversified pipeline brewing. What's worrisome, though, is the huge share price pop on data that could just as easily swing the other way in later trials.

Case in point would be Bristol-Myers Squibb's purchase of Inhibitex for $2.5 billion in early 2012 to get control of its hepatitis C compound INX-189, which had just completed phase 1 trials. Renamed BMS-986904, the experimental drug wound up causing the death of a patient as well as complications in numerous others and was subsequently shelved.

You can therefore imagine my shock and horror to see Clovis Oncology , a company with just three drugs in its pipeline (two early stage drugs and one preclinical), considering putting itself up for sale and hoping to get more than its current $2.2 billion in market value. As I discussed earlier this week, Clovis' entire valuation can be summed up by its $12 per share in cash and about $63 per share in "expectations" for rucaparib, which provided an 89% clinical benefit for 10 ovarian cancer patients, and CO-1686, which was effective in delivering a partial response in three of four non-small cell lung cancer patients with the T790M mutation. That's a lot of hope built into a company that hasn't even established ideal dosing for its lead drug candidates.

What biotech investors should do instead
If you really want to take part in the long-term high growth opportunity that is the biotech sector, your best course of action is to leave early stage drug data to day traders and instead focus on what you can really analyze -- predominantly late-stage and some midstage trial data.

Now don't misconstrue what I'm saying here; it is important to pay attention to a biotech's entire pipeline, from the preclinical stage to approved and marketed drugs. However, basing your buys and sells off of early stage data will more often than not be a bad idea. According to a study conducted by the Centre for Medicines Research International in the U.K., a whopping 82% of all phase 2 trials failed and about half of all phase 3 trials ended in disappointment. Those are some pretty poor odds following what was presumably early stage success.

Ultimately you may give up some of the biggest near-term gains in a biotech stock, but you'll be setting yourself up for much safer long-term gains.

A few great examples
Want a few good examples? How about Gilead Sciences's oral hepatitis C drug sofosbuvir or Merck's experimental osteoarthritis drug odanacatib. Both companies are well established biopharmaceutical names, they have well-diversified pipelines, plenty of cash flow, are profitable, and best yet, we have solid late-stage data to sift through to make an investing decision based on the prospect of these leading new drug candidates.

In the case of Gilead Sciences, sofosbuvir was successful in significantly outperforming the placebo in all four of its late-stage trials. Not only that, but sofosbuvir proved more effective in the most common genotype of HCV as well as less-common genotypes.

Merck, meanwhile, is planning to file a new drug application with the FDA early next year for odanacatib after an independent monitoring committee stopped its late-stage trial early due to the drug's overwhelming efficacy.

The point is that biotech savvy investors should base decisions on broad late-stage data rather than trying to count our chickens before they're hatched. Do that and I can practically guarantee you'll have a leg up on short-term-minded traders.

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Fool contributor Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.The Motley Fool recommends Gilead Sciences. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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