Biotech Investing for Beginners: Your 7-Step Guide

Biotech investing can be tricky. The industry is complicated, and the stocks are volatile.

But the profit payoff can be life-changing.

Biotech newsThat's why we've created the "Biotech Investing for Beginners Guide" with Money Morning's Biotech Investing Specialist Ernie Tremblay.

Even if you've owned stocks for years, biotech investing can be daunting. Many of the metrics we use to evaluate other stocks - like P/E ratio, profit margin, earnings per share - don't always apply to biotech stocks.

"The reason is pretty straightforward: many low- and mid-cap biotechs haven't yet made a profit, and probably won't for years to come," Tremblay said. "Unlike big pharmaceutical companies, these smaller startups focus their time, money, and effort on research and development, rather than marketing new products."

It can take years for drugs to be approved, meaning these companies go years without turning a profit.

Tremblay recommends beginner investors first analyze a company's drug pipeline and find out what pressing medical needs the firm targets.

But that's only the first step a biotech investor needs to take. Here's a step-by-step beginner's guide to investing in biotech stocks...

Biotech Investing for Beginners, Step 1: Calculate the Burn Rate

A company’s burn rate is how fast it spends money versus brings money in. Investors should look for companies with enough cash on hand to operate for the next 13 to 18 months.

All the numbers you need to calculate a company’s burn rate can be found on Yahoo Finance or any stock screener.

You’ll start with two numbers: capital expenditures and negative cash flow from operating activities. Add them together, and that’s the burn rate. If the numbers were from quarterly data, divide by three for monthly burn rate.

Then calculate how much cash the company has to “burn.” Add cash and cash equivalents to short-term investments.

Then divide that total by the monthly burn rate and you’ll see how many months the company has until it runs out of cash.

Biotech Investing for Beginners, Step 2: Find the Convertible Debt

investing for beginners Tremblay says that you want to find stocks with as little convertible debt as possible.

Convertible debt occurs when a company borrows money from a lender and issues warrants to cover that debt.

"A warrant is a promise (bond) that gives the lender the right to purchase stock, often at a highly discounted, predetermined rate (strike price), in the future," Tremblay explained.

This is a great way for well-established companies to come up with financing. But it's risky for startups.

The problem is that lenders can – and often will – borrow shares and sell them short when the share price climbs. Then they’ll cover (repurchase the shares) at a very low price by exercising their warrants. This is called convertible arbitrage.

If this is done with a big group of shares, the lender can force the stock price to fall when it should be climbing.

The convertible debt figure can be found in a company's 10-Q SEC filing.

Those are just the first two steps of Tremblay's seven-step biotech investing for beginners guide. Continue reading for the next five...

Biotech Investing for Beginners, Step 3: Analyze the Market Cap

Market cap is the sum value of a company's outstanding shares, based on the current share price.

"If the cap is very small, below about $250 million, the price-per-share can be extremely volatile on very low trading volume, so liquidity may be a problem - you can find yourself needing to sell with no one there to buy."

But you shouldn't necessarily head straight for large-cap stocks either. Sometimes companies over $5 billion have already reached their limit for growth.

Find something in the middle of that range, or a large-cap stock that has a broad-spectrum product portfolio.

Biotech Investing for Beginners, Step 4: Find the Volume/Average Volume

A biotech stock's volume average is crucial. If shares are not liquid enough, you can't quickly the exit stock if the need arises.

The 7 Biotech Indicators

  1. Burn Rate
  2. Convertible Debt
  3. Market Cap
  4. Volume/Average Volume
  5. Beta
  6. Short Interest
  7. Bollinger Bands

"Stocks that trade on average about 350,000 shares per day are a good bet. Fewer than 300,000 is getting into dicey territory. Under 200,000 is the Wild West," explained Tremblay.

Volume also helps you gauge investor sentiment.

"A PPS downturn in lower-than-average volume probably indicates the stock's movement has little importance and does not indicate a trend. The same price movement in high volume, however, can mean that institutions are bailing out, so it may be time to take the hint and follow their lead."

Biotech Investing for Beginners, Step 5: Analyze the Beta

Beta is a good measure of a stock's volatility.

A beta of one is equal to the volatility of the market. Higher than one indicates greater volatility than the market and lower than one means lower volatility.

"This number can give you some perspective on days when the stock market seems calm but one of your positions is jumping higher or lower for no apparent reason."

It also helps you determine the right stocks for you. If you're a long-term investor, you'll want stocks with lower betas. They'll move more gradually.

Biotech Investing for Beginners, Step 6: Assess the Short Interest

"An increase in short interest (expressed as short percentage of the float) can indicate a trend in market sentiment away from the stock, while a decrease in short interest can mean more confidence in the company's prospects," said Tremblay.

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But that's not the only reason to evaluate a biotech stock's short interest. Biotech stocks with low trading volumes and share prices are particularly susceptible to price fluctuations.

"It doesn't take much for a few hedge funds to sell large blocks of shares short, driving down price and creating negative momentum that scares longs into selling as well. At the same time, it's not uncommon to see anonymous campaigns to devalue a stock by disseminating false or misleading information about the issuing company through blogs, articles, and message boards."

This can even happen despite positive news from the company. So if you see a large percentage of short interest, it could mean institutional investors are trying to force the share price down.

Tremblay recommends looking for stocks with a short interest of less than 20%.

Biotech Investing for Beginners, Step 7: Analyze the Bollinger Bands

Finally, the last step is identifying a biotech stock's Bollinger bands.

Bollinger bands are a volatility indicator that can graphically show you a stock's standard deviations from a simple moving average over time.

"Touching the upper line repeatedly indicates the stock is probably overbought and may be headed downward soon - time to sell," said Tremblay. "Touching the lower line repeatedly tells you the stock is oversold and should head upward - time to buy."

If a stock crosses over one of the lines and remains there for a few days, it's most likely consolidating at a new high or low level.

The Bottom Line: None of these seven steps alone can let you know whether a biotech stock is a buy or not. But when they are all taken together, you'll have a much better idea of the stock in question. This seven-step guide will help you minimize risk, maximize profits, and pick out only the best biotech stocks to invest in.

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