Micro-cap and penny biotech stocks (those with a market cap at less than $300 million) have a reputation for being extremely speculative, volatile, and unpredictable.
But they can also deliver returns beyond your wildest expectations.
In fact, some of these companies have become legendary for minting millionaires, as they rocketed from bargain basement to stellar valuation. Others, of course, crashed and burned along the way.
In this investment niche, little is certain, but a little legwork can give you an edge when picking the winners from the also-rans.
In a moment, I'm going to show you two things I always look for when I'm researching these special stocks for my Biotech Insider Alert subscribers.
But first, I'll tell you what not to look for. That's going to save you a lot of time...
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Forget About the Big-Cap Biotech Indicators
Unless you're fond of making yourself crazy, don't bother with the usual financial indicators when you do your due diligence regarding a micro-cap company. Price/earnings ratio or price/book multiple won't tell you much about a young biotech in the very early stages of developing a drug to treat Parkinson's disease.
In fact, you're likely to discover that the company is losing money, has been regularly in the red for a while, and will continue burn cash for some time to come.
Like the ($300 million to $2 billion market cap) small caps above them, micro caps generally produce revenue through public- and private-placement stock offerings, bank and private loans, licensing agreements, and even government grants.
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Generally, all of this revenue goes toward operating expenses, including payroll, plant maintenance, and most costly of all, research and development. Year after year of negative earnings is nearly universal among these tiny firms.
So instead of the usual financial indicators, you need to develop a sense of judging future potential, and that means product evaluation.
There's only one problem: Companies venturing into early clinical trials for the first time, as are most of these micro caps, have little or no scientific paper trail to follow.
At best, they'll have bench and pre-clinical data to offer. That means computer simulations, lab tests, assays, and animal studies. Data from these studies, however, falls notoriously short in predicting which medications will go on to pass through human trials and achieve FDA approval.
In fact, 93.8% will fail to make it through all phases of clinical testing. While pre-clinical studies are helpful in assessing toxicity and confirming proof of concept, they simply can't replicate the complexity of the human body.
There are two things prospective investors should look for instead.
How to Tell If Your Biotech Micro Cap Has Big Potential
There are two main guardian indicators to look for when assessing the risk for a micro cap: management and platform/development model.
Management: Many a biotech firm starts as the brainchild of some scientific researcher, working anonymously and unheralded in an obscure university lab, who has come across an interesting discovery that suggests a new approach to treating some particular disease.
And so the researcher finds seed money from private investors or a grant-making foundation, gets a company logo, appoints him or herself as CEO, and goes to work. Eventually, it may come time to make an IPO (initial public offering) and bring investors on board.
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At first, with every quarterly report, the news seems to get better. But sooner or later, the company repeatedly fails to meet its guidance, and the stock shares lose much, if not all, of their value.
Wrong pilot at the helm. Scientists do science well. Businesspeople do business well. Crossovers do happen - but not dependably or often.
Which leads us to this rule: Be very, very suspicious of company management headed by a scientist who has no business experience. These folks believe passionately in what they're doing, and they'll get you to believe passionately right along with them. But going from scientific passion to financial success should ultimately fall to the hands of someone with experience making that journey.
A company's chief science officer, of course, should be just that: a scientist. But in a CEO, look for years of experience in company and capital formation, market development, mergers and acquisitions, licensing, and corporate governance.
That won't guarantee your success, but it will go a long way in protecting against failure.
A solid development plan: For you to assess how your equity is doing at any given point, you need to have touchstones against which you can measure success or failure, and this is as true for micro caps as it is for pharmaceutical giants.
This means the firm you're investing in needs to have a solid business model (a plan for getting to profitability), a strong platform (a credible scientific basis for its pipeline development program), and mile markers, such as binary regulatory catalysts (clinical trial data releases and company guidance goals) that will help push share value upward.
Very often, you can find this kind of information in corporate presentations and quarterly earnings call transcripts, which you'll generally find on a company's website.
Look for well-defined goals, not pie-in-the-sky daydreams. There's a lot of space between "...We hope to cure lung disease someday," and "...We're initiating a phase 2 study for our medication in the treatment of bacterial pneumonia, starting next quarter."
Look for numbers: "We expect to earn $3 million in revenue per quarter in the coming year, a 3% gain over last year's numbers for the same time period," and not, "The company hopes to continue its positive progress in the coming months."
Look for dates: "We expect to announce topline date from our phase 2 trial by the end of Q3 2019," and not, "We continue to collect proof of our product's value and hope to have it ready for marketing next year."
Oh, and be sure the company is reporting regularly and promptly to the SEC, as required by law. If it doesn't, it will be delisted from exchanges like the Nasdaq.
The Trend Is the Ultimate Test
Once you're past these first steps, the one thing you need to consider before all others is this: Is this company's pipeline taking advantage of a fad or a trend?
Because it absolutely should be.
What is the health reporter on your local TV station talking mostly about? What kinds of medical stories are showing up on satellite radio or your go-to website? What sorts of health stories are you hearing from your friends and family?
"I hear they've found a cure for diabetes."
"There's this fabulous new diet pill that's supposed to work overnight."
"Did you hear all these Hollywood stars are having their double chins reduced?"
"It says on the news that West Nile Virus is spreading everywhere, but they're coming up with new vaccines every day."
If it's in the media, it's giving audiences a taste of hope, and that hope builds interest until it becomes a trend.
Any young company lucky enough to be riding that trend, even if it doesn't yet have an extensive clinical paper trail, can whet investors' interest and make strong profits in a short period of time.
Here's the Perfect Case in Point
You've undoubtedly heard a lot about the hot trend in legal marijuana stocks. Analysts expect global sales to reach $32 billion in 2020, up from $9.5 billion in 2017.
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That's a trend. But inside of it is another one: a proliferation of micro-cap companies working to develop FDA-approved cannabis-based medications. They include far more than raw marijuana smoked for health purposes
Researchers are trying them on everything from simple pain control to complex immune diseases. And they include not only extracts from the marijuana plant, but also analogs (similar-acting substances) made in the laboratory, which don't have the same intoxicating effects as marijuana plants.
They can be smoked, inhaled, melted under the tongue, taken by pill, absorbed through the skin, injected with a syringe, added to foods like brownies, or even administered in chewing gum.
Whatever the delivery route, cannabinoid drug sales are predicted to reach $50 billion over the next 10 years.
So we have a trend within a trend for these small cannabinoid biotechs to take advantage of. As their drugs begin to prove safe and effective, they'll make their way into the news. And the news, in turn, will spark more interest in their drugs.
And their stocks will rise from a few dollars (or even a few cents) per share to many multiples more.
Providing, of course, they have decent management and a solid development plan.
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About the Author
Ernie Tremblay has more than 25 years of experience in following and analyzing the latest developments in health, medicine, and related technologies. He understands the FDA approval process, as well as the "hard science" behind new, experimental drugs and the market demand for them - and has a comprehensive grasp of the complex dynamics that determine whether a new drug will be a breakthrough winner, or just another casualty of the FDA approval process.