Are You Playing a Dangerous Biotech Valuation Game?

For several years, biotechnology has been a safe haven, as investors capitalize on speculation leading to Food and Drug Administration approvals. However, the marketing phase of high-profile momentum biotech stocks has proven itself to be a dangerous space. This fact is even more evident with the performance of Ariad Pharmaceuticals , an event that should be noted by all investors.

What happened to Ariad?
In the three years prior to October 2012, shares of Ariad rallied more than 1,200%. Since then, shares have fallen by nearly 80%. So, what happened between these two periods to create such a difference in performance?

First off, strong clinical data and bullish outlooks for the company's leukemia drug Iclusig created optimism. Many believed that Iclusig could go on to earn peak revenue in excess of $1 billion as a treatment to various forms of the disease.

As a result, Ariad's market cap surpassed $4.5 billion before the company ever sold one drug. Then, in 2013, realization set in, and sales were slow to appreciate, most likely because of blood clots and heart-related side effects.

The stock slowly but surely trended lower, and then on Oct. 9, Ariad lost 70% of its value when side effects proved too severe to support investors' hope of Iclusig being a front-line therapy for chronic myeloid leukemia, or CML.

Ariad isn't the first
Now, there are many lessons we can take from the struggles of Ariad, but one of the most notable should be the high expectations that are being placed on drugs before ever reaching the market. With a $4.5 billion market cap, Ariad was valued for success but had yet to proven itself worthy.

In the past year, we've seen this play out with other companies, such as Amarin and Arena Pharmaceuticals .

Amarin saw its market cap peak at $2.5 billion in 2012 on the FDA approval of its triglyceride-lowering drug Vascepa. This is a product that had sales expectations in excess of $2 billion from some analysts, but recognized sales of just $5.5 million in its second quarter of launch. As a result, Amarin is now a $1 billion company.

Arena also peaked with a market cap of $2.5 billion in 2012, due to blockbuster expectations for its weight-loss drug Belviq. Yet, poor reviews from Consumer Reports and weak sales ($4.13 million realized last quarter) have pushed Arena's market cap to just over $900 million.

What does this mean to you?
With all things considered, investors must realize that multibillion-dollar pre-launch valuations don't always indicate that a product will be a success or that a stock will continue to trade higher. In fact, higher valuations often indicate higher expectations, and often times, we are placing these high bets with management that has no prior drug launch experience.

These facts make me extremely cautious heading into next year's drug launches. The most notable company is Pharmacyclics . This is a company that has multiple breakthrough drug designations for ibrutinib in treating various blood cancers. Analyst upgrades have pushed this stock higher as it awaits its first FDA approval with peak sales estimates in excess of $6 billion.

The problem is that Pharmacyclics now trades with a market cap over $8.5 billion, and that's including a three-day 16% pullback. The expectations are sky high, and like Ariad, leave very little room for error. Therefore, one piece of data viewed as a negative or any problems with the FDA could send this stock crashing lower.

The same could be said for Sarepta Therapeutics , a company trading with a market cap of $1.5 billion. Its Duchenne muscular dystrophy drug, eteplirsen, has peak sales estimates of $600 million, meaning that Sarepta is already trading at two times peak sales! Eteplirsen is innovative, but with a small patient population and uncertainty surrounding future FDA dates, Sarepta could also see a large post-approval loss.

Final thoughts
As we look through the biotech industry, we could really go down the list of late-phase companies with FDA approvals in the next year to identify potential risk. Ariad's large intraday loss is an eye opener, as is the performance from Amarin and Arena, both of which were market leaders in years prior. With that said, investors must at least entertain the notion that this next wave of biotech momentum could perform badly during the launch phase. If not, we are doomed to repeat history.

Two other biotechs to get on your radar
The best way to play the biotech space is to find companies that shun the status quo and instead discover revolutionary, groundbreaking technologies. In the Motley Fool's brand-new FREE report "2 Game-Changing Biotechs Revolutionizing the Way We Treat Cancer," find out about a new technology that big pharma is endorsing through partnerships, and the two companies that are set to profit from this emerging drug class. Click here to get your copy today.

The article Are You Playing a Dangerous Biotech Valuation Game? originally appeared on Fool.com.

Brian Nichols has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.

Copyright © 1995 - 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.