The promise and pitfalls of biotech investing

The biotechnology sector has long been the wild west of the ASX – reserved for adrenaline-junkie investors who feel small-cap mining doesn't offer enough risk or excitement.

Still, biotech attracts scores of hopeful followers, and you'd be hard pressed to find more fertile soil than Australia. Our country consistently punches above its weight on the global stage producing 3% of the world's medical patents, while having only 0.3% of the global population. The local biotech sector is capitalised at twice the OECD average as a proportion of the stock market.

When biotechs get things right and clinical trials are successful, the payoffs can be enormous. Just ask the granddaddy of them all, CSL (ASX: CSL), whose share price has risen 17,458% since listing in 1994 thanks to a string of successfully approved antibody and haemophilia treatments.

Nonetheless, biotechnology is still a risky business, and the first thing to consider before making any stock purchase is whether the company has an approved product or is still conducting clinical trials. There's a big difference between being close to the finish line and actually having something on the pharmacy shelf.

Take Sirtex Medical (ASX: SRX) and Mesoblast (ASX: MSB), for example. On the one hand, Sirtex's radiotherapy for liver cancer patients has been approved since 2002. Though recently Sirtex has had its share of troubles with clinical trials, it's important to note the differences. The company's studies aimed to demonstrate that SIR-Spheres would work better than competing therapies and thereby expand its market. They weren't trying to prove that it works; those trials were completed years ago.

Sirtex sold 12,500 or so doses this year, it's churning out cash and has no debt. A successful investment depends on the price you pay for the stock, but investors can at least sleep a little better knowing that the company isn't going to go bankrupt anytime soon. With a product already in the marketplace, competitive dynamics and profitability are also more accurately measured.  

'Pre-revenue' companies

Mesoblast, on the other hand, has never actually earned any money. The 2016 annual report didn't beat around the bush, ‘We have never generated any revenue from product sales and may never be profitable'.

That most of Mesoblast's products are in late-stage development is undoubtedly a better place to be than other biotechs lingering in a Phase I no-mans land, but it also means expenses are growing exponentially. Phase III trials generally account for around 60% of total clinical trial costs, which almost always stretch into the tens of millions for large studies. The company will have a lot of big bills to pay in the next few years – which means a higher risk that it will need to tap investors for cash with a dilutive capital raising. 

This is the biggest mistake we see investors make when buying biotech stocks. They buy with hope that trials will work out – often encouraged by excitable management and a clever marketing department – despite no special insight into the clinical trial process or compounds under review. Even management doesn't know whether the treatment works – that's the whole point of running clinical trials.

A 2014 study of biotech success rates published in Nature found that only two-thirds of clinical trials make it past Phase I, then just 32% of Phase II trials proceed to Phase III. And, even if they make it that far, there's still a 40% chance they won't move from Phase III to commercialisation. How the product in question stands up to competing therapies in the marketplace is a whole other fish-filled kettle.  

Early-stage biotechs are unlike most other stocks because they're specifically designed to bleed cash and roll the dice with investor funds. Yes, there are people who have made money buying biotech stocks before they have approved products. There are also people who win Powerball with a single ticket. More ‘pre-revenue' biotechs go nowhere than go up 10-fold, and betting the farm that you've found an exception is a great way to end up without a farm.

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