3 Reasons Investors Are Scared of Biotech Stocks

Biotechs offer the possibility of monster returns. Overnight doubles aren't out of the question. Triples and quadruples as a drug successfully progresses through the clinical trial process are the norm.

And yet many investors shy away from the industry. Let's take a look at why.

Down on bad news
Biotechs face many succeed-or-fail binary events over the course of drug development. Clinical trials, Food and Drug Administration advisory committee meetings, and FDA approval decisions all offer an opportunity for a monster pop or a monster drop.

As drugs succeed, they're given a larger value, but that means if a drug subsequently fails, it has a larger effect on the stock price. Phase 1 failures tend to have very little effect on stock prices. Phase 2 hurts a little more, especially for companies with limited pipelines. Drugs that fail in phase 3 are quite costly.

For example, shares of ZIOPHARM Oncology (NASDAQ: ZIOP  ) were cut by two-thirds this week after its cancer drug palifosfamide�failed a phase 3 trial in metastatic soft tissue sarcoma. The smaller phase 2 trial suggested the drug was working, which built up the value of the company. The drug did delay tumor progression by a month, but the increase wasn't statistically significant.

Down on good news
These days, it doesn't take bad news to send shares down. Good-but-expected news is often enough to do it. After the excitement of the binary event is over, investors flee. It's "sell the news" without the "buy the rumor."

For example, Navidea�Biopharmaceuticals� (NYSEMKT: NAVB  ) dropped 12% following the approval of its lymph node diagnostic Lymphoseek this month. The approval was widely expected after an earlier FDA rejection for issues at a third-party manufacturer.

In December, ARIAD Pharmaceuticals (NASDAQ: ARIA  ) experienced the same issue with a double-digit drop after its leukemia drug Iclusig was approved by the FDA. Strong data and a fast-track designation got the drug approved quickly.

Down on unexpected news
The worst risk is the kind that can't be foreseen.

At least with binary events, investors can see it coming. Data from a clinical trial will be released. The FDA will make a decision about whether the drug is approvable. The exact date might not be known, but at least it can be pinpointed to a month or two, with many events coming in a smaller window than that.

But sometimes events come out of left field. And they're almost never the good kind.

Shares of Affymax� (NASDAQ: AFFY  ) , for instance, are down more than 90% year to date after the company had to recall all of its red blood cell stimulating drug, Omontys, that treats patients on dialysis with chronic kidney disease. The drug caused allergic reaction in some patients, which was occasionally fatal.

Didn't you say something about monster returns?
I did.

While there's a lot of risk investing in the biotech industry, there's also the potential for insane increases in share prices. Regeneron Pharmaceuticals (NASDAQ: REGN  ) , for instance is up 550% over the last 3 years thanks to the successful development and launch of its macular degeneration drug Eylea.

So how do you find the next Regeneron while avoiding companies like ZIOPHARM, Navidea, ARIAD, and Affymax? A little skill and a little luck.

Binary decisions that look like they're a shoo-in typically don't result in big returns; investors have already factored in the approval or positive clinical trial and sell after the news is released. When the result is negative, like it was for ZIOPHARM, it's even more costly.

Investing in less-than-sure-things is more risky, but it comes with much larger rewards. The trick is to find companies where other investors are discounting the risk more than is necessary, which allows you to buy with a margin of safety.

It's hard to predict a drug getting pulled off the market like Omontys was. Instead, investors have to make sure the potential return from a company with a drug already on the market justifies the risk. A commercial-stage drugmaker really has to be a bargain to justify the risk, especially given the lackluster launches recently.

While you can certainly make huge gains in biotech and pharmaceuticals, the best investing approach is to choose great companies and stick with them for the long term. The Motley Fool's free report "3 Stocks That Will Help You Retire Rich" names stocks that could help you build long-term wealth and retire well, along with some winning wealth-building strategies that every investor should be aware of.�Click here now�to keep reading.