It’s really tempting to fill your portfolio with biotech stocks. This is because biotech investors who find the next breakthrough stock are able to double, triple or quadruple their money almost overnight.

Take Dendreon (Nasdaq: DNDN), a maker of a pricey prostate cancer drug, for instance. As I’ve noted before, the stock soared from under $3 in March 2009 to above $20 a month later, when tests showed that its drugs helped extend lives. (Shares eventually moved past $50 but have recently plunged, since doctors have been slow to prescribe the $90,000 drug, despite de fact that it is covered by Medicare).

In the biotech industry, risk clearly equals reward. But companies with drugs that have yet to undergo clinical testing are at the beginning of a very long road before they may secure actual product sales.
 
Passing the biotech drug test
First,  the company must perform “preclinical” testing to prove that the drug isn’t fatal and doesn’t have serious side effects. Then it must register the drug with the Food & Drug Administration (FDA) to conduct three more phases of rigorous trials, which include:

Phase I — A bigger trial that looks at the drug’s efficacy and safety compared with a group taking a placebo. The primary focus remains on safety.

Phase II — Uses a larger sample of patients (often 100-200 people) to see whether the drug tangibly improves patient outcomes while avoiding adverse affects. This is the hardest hurdle for a drug to pass, so many wash out at this point simply because they fail to prove any real benefit.

Phase III — These are far larger drug trials and can often involve several thousand patients. The tests try to determine whether the new drug is clearly better than an existing drug on the market. Due to the sheer size of these tests, firms often need to spend a lot of money to complete them. Luckily for them, at this point investors start to expect that the drug could eventually reach the market, so raising money can be a bit easier. If all checks out, then the drug may soon be on a path for FDA approval.

Simply getting past these clinical hurdles is only part of the problem. The other involves cash.

Securing biotech drug funding
Biotech firms spend tens of millions of dollars to bring a drug to the market. Because of these huge cash needs, most need to keep going back to the public for fresh injections of capital. As an alternative, they can find a strategic partner, usually a large, well-established drug firm that can pay for the new drug’s further development in exchange for rights to sell (and pay royalties) in case it is approved.

In many instances, such a partnership is a prelude to an outright acquisition of the young biotech firm.

Does risk equal reward?
As companies advance through the clinical trials, the share price upside is no longer as good as an early-stage biotech play. On the other hand, risk is also reduced. The key risk factor following clinical trials is money (beyond the obvious risk that the drug doesn’t get approved). Many promising biotech firms run out of cash before they can reap financial reward.

This is why in important to study the balance sheet of a biotech firm carefully. As a general rule, avoid biotech stocks that have less than one year’s worth of cash — known as the burn rate.

If a company has $20 million in cash and is burning $10 million every quarter (a $40 million burn rate), chances are it will likely have to raise more funds by selling more shares. This dilutes the value of the shares earlier investors already own. And this usually pushes a stock down very quickly.

The best way to play biotech stocks
Early-stage companies: Early-stage plays require a certain kind of investor with a strong background in this area — and a healthy appetite for risk. Unless you have the experience to successfully navigate these waters, you might be better served to move on to a less volatile stage in the drug-development process.

Middle-stage companies: For Phase II biotechs, look for companies with diverse investments in a number of smaller biotechs with drugs in Phase II or later clinical trials. Additionally, look for stocks which analysts believe to be undervalued. For example, Ligand Pharmaceuticals (Nasdsaq: LGND) has investments in more than 50 biotechs with drugs in Phase II or later clinical trials. Its shares are valued at about $12, but Jeff Cohen, who follows biotechs at Ladenburg Thalmann, thinks all of the company’s stakes are worth a collective $21.

Late-stage companies: To find the best Phase III biotechs, look at companies that offer innovation as part of their research and development process. A healthy amount of cash on hand to outpace their burn rates is also a key component.

Celsion Pharmaceuticals (Nasdaq: CLSN), for example, uses heat-sensitive nanoparticles to place cancer-treatment drugs within tumors precisely. The company has secured patents in the United States and Japan, and is currently undergoing 600-patient Phase III trials for the treatment of liver cancer.

The FDA has given Celsion “fast-track status” for its liver cancer Phase III test, which is a huge endorsement of the technology and may pave the way to an expedited approval.

As it stands, Celsion’s current cash balance equals about four more quarters using an annualized burn rate of about $23 million. This burn rate would sharply accelerate if and when the FDA approval comes. Biotech investors like catalysts, and Celsion’s interim update on Phase III trials — due in September — looks like a solid one.

Action to Take –> Investing in biotechs holds plenty of promise for investors, but also ample peril. For the risk-averse, taking a position in middle and late-stage companies can help mitigate the downside, while keeping the potential reward. For those with stronger stomachs, early-phase investments offer the greatest potential returns.

P.S. — If you devote a portion of your portfolio to “swing for the fences” plays, you should watch this video. It shows how six shocking events could lead to hundreds of percent gains for prepared investors.