The Five “C”s of Biotech Investing

The stock market is a fascinating place!

The concept that you can trade stakes in companies with billions (trillions?) of dollars daily is pretty strange when you think about it…

Within the stock market, many different groups can have very different return profiles.

Take the utilities as an example. They are mainly regulated businesses that have excellent stability and pay dividends. As a result, they tend to do well when the stock market is very volatile. They are considered a "defensive" group where investors rotate when concerned about the economy.

They also often trade off of interest rates because of the dividend yields. The utilities have some of the most distinct characteristics of any industry group.

Another one that has very distinct characteristics is the biotechnology group.

Now, these characteristics are the polar opposite of the utilities. The biotechnology sector has created a group of stocks that use the stock market to finance their research and development.

This means that many (most) of these companies not only are not profitable but don’t even have any revenue or product!

Often, your stock purchase finances their product development testing.

As you can imagine, a group defined by most stocks not having revenue or even products can be VERY volatile.

It is also a very esoteric group.

We can easily explain a retailer like Starbucks Corporation (NASDAQ: SBUX) to an investor.

However, outlining the biochemistry of a potential schizophrenia drug and the multiple testing phases necessary to figure out if it is viable is next-level detailed. This is knowledge that very few people possess and creates some excellent investing opportunities.

We have been lucky to have met some outstanding experts in this area and made some great returns. Those returns, however, are some of the most unusual in the stock market.

Of any five biotech stocks, it feels like one or two go to $0, another one loses us money, the fourth one makes us a +50% return, and the final one is a multi-bagger. 

Do the math, and that is an excellent total return. That kind of volatility, though, is not for everyone!

One of the experts who has guided us is Jason Napodano, of the biotechnology research service Bio5c. Jason has followed the group for almost thirty years. He earned an undergraduate in biochemistry and followed up with an MBA.

He now has a research service where he ranks almost 300 different biotechnology stocks on a "Five C" scoring system. You can check out his site here and subscribe.

Last week, we had an opportunity to speak with him on the HX Podcast, and you can listen to the episode here or watch it on YouTube .

We encourage you to check out the full episode, but here we will summarize his "Five C"s…

1. Catalyst

As we mentioned, biotechnology is an unusual group where you often own stocks without revenue or products. What they do have, however, are catalysts.

Jason walked us through how there are essential conferences, test results and other reporting periods that will be important for the path of the stock price.

He focuses very much on when and what the next catalyst is. Also, understanding the expectations for whatever is going to be reported will help you make sure you can make the right move when the catalyst happens.

2. Charisma

We often talk about a similar concept but refer to it as the size of the "total addressable market" or "TAM". We also discuss how "sexy" an idea is to the stock market!

Some companies may be working on a drug that will be the fourth drug in the market and has a high likelihood of approval and some slight advantages. That may be low risk, but it is also low "charisma," which will impact the return.

On the other hand, you might see a drug that addresses something that has never been done before and has a HUGE market in front of it. It might be much riskier, but the "charisma" also means there is a lot more upside.

3. Credibility

Another one that is big in our process is looking at the track record of the management involved in the company.

Do they have a history of success? Importantly, do they have a history of meeting the guidance they give?

This is key to finding the stocks that will work out best and can make the ride much smoother.

4. Capital Structure

Again, this group is very different from almost any other group out there.

These companies most often have no revenue or products. They exist purely as funding vehicles for the research and development to discover if their drugs will work.

While raising the money, they often will go through multiple financings. Some of these financings might be pretty complex. 

You may have a significant drug coming, but if you are going to buy the stock today and be diluted to almost nothing through the financings, then you will never see that upside.

This is an area where many "science" focused investors don't do enough work and end up being right about the drug but wrong about the stock.

5. Cash

This one goes right with #4 above. I can't repeat it enough – most of these companies have NO revenue. That means no cash is coming in for anything other than financing.

That means they are burning cash. The process of testing these drugs is also costly. Often going into the hundreds of millions of dollars and even occasionally more.

It is crucial to understand how much cash the company has today and how much "breathing room" they have to realize their drug's potential.

We don’t know that investing in biotechnology stocks is for everyone.

There are some great returns to be made, but the volatility is unlike anything else in the stock market. Without an expert guiding you, we would dissuade investors from speculating in the group.

If, however, you find the proper guides – the returns can be incredible. 

We think Jason (or JNAP) is one of those guides and encourage you to check out his service!

Have you ever invested in biotechnology stocks? Tell us more in the comments section online, or email us at [email protected].