In many respects, Peter Lynch is considered to be one of the most successful growth investors of all time.
However, even this legendary growth investor tried to stay away from early-stage biotech stocks at all costs. He explained why in an article in the mid-90s.
The answer was simple: Lynch knew how difficult it was for a company to get from the development stage to the sales stage. Therefore, no matter how exciting a company's prospects, he understood that it would always be a gamble investing in a company with unproven products.
Specifically, on the topic of a company's chances of success, the former fund manager noted:
"Herein lies the problem...The odds are slim (I figure, 1,000 to 1 or so) that a great idea from one of the microscopes will ever become a saleable product. With all the companies now involved in the business of developing new drugs, predicting which company's drug will be approved by the FDA is no easier than picking which turtle egg from a mess of turtle eggs will become a turtle and make it to the sea. To usher a would-be saleable product through all three of the FDA's mandated trials can take from 5 to 15 years and cost from $100 million to $500 million.
This, more or less, sums up the proceeds from the entire biotech group. Only about a dozen companies out of 225 have had products approved, and more than 90% of the companies in the biotech group are stuck in the "pre-revenue" stage, which is the new euphemism for not earning a living."
The companies' names and the numbers may have changed over the past 25 years, but the principles of biotech investing have not.
The chances of getting a treatment from the early inception stages through all of its trials and to the customer are extremely slim. It costs a huge amount of money to progress a drug through a trial, and any setbacks can be extremely costly. It is usually the shareholders that have to make up for the extra cash required.
Lynch also noted in his article that investors, both professional and non-professional, like to jump into a stock as soon as it has reached the Phase II trial stage, believing it is almost close to having the treatment approved. But this isn't usually the case. The third and final trial is the most rigorous, costly and risky.
Even if a treatment does make it through this final stage, the company will still require money to fund the new treatment's marketing and sales. Once again, shareholders may have to put up the extra cash.
Because of all of the above factors, Lynch tried to point out that investors do not have an edge in the biotech sector. Even experienced healthcare professionals may not have much of an advantage. These professionals may know their sector, but they can't tell the future.
As such, Lynch came up with three primary observations about the biotech sector, which still seem to be relevant to this day.
"The three most important lessons I've learned from my conversations are these: (1) Don't buy a biotech company because it announces an exciting new drug that hasn't yet been tested; (2) Don't assume that because an exciting drug has survived the first two trials, it's a shoo-in for Phase III; And (3) the investor's edge I'm always talking about often doesn't work in biotech. Investors who ignore these rules may end up getting nothing for something."
It could be worth considering these comments from one of the greatest growth investors of all time before deciding to take a gamble on any early-stage biotechnology business.
Disclosure: The author owns no share mentioned.
Read more here:
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- Seth Klarman: Know What You're Good At
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