How to Evaluate Biotechs That Aren't Profitable Yet

Many investors are holding off buying stocks until they've had a chance to check out the many earnings releases now coming in. There are worries that corporate profits in the coming quarters won't live up to investors' expectations, and these concerns are forcing the major indices to sway.

It doesn't help that in recent months investors have returned to their speculative ways, bidding up share prices of companies that still face challenged outlooks. This is coupled with emerging signs that the economic recovery will be tepid at best.

In November, I talked about using PEG (price/earnings to growth ) ratios as a tool for valuing profitable biotech companies. Perhaps now is the time to look at ways to evaluate the other type of biotech companies -- those that have yet to make any money.

Biotech stocks have a number of unique advantages that are driven by a variety of factors. For example, the combination of technological and scientific advances, the aging baby-boomer population and increased corporate partnerships, just to name a few, make this sector attractive for growth over the next decade.

However, there are two perceived disadvantages of growth stocks. One is volatility, which is often associated with risk. Second, inefficient markets result when not all buyers have the same information. This is due in part to the unique problems inherent in properly valuing growth-stage companies.

Most investors may not understand the value of a drug that is not yet approved for sale. As products progress through the regulatory cycle, though, visibility is increased and the risk is reduced. Opportunities are created because the investment community sometimes ignores this progress as it happens. Investors get excited when a prominent medical journal publishes results or the product passes a major regulatory hurdle. However, the real value changes as clinical trials prove that the drug actually works.

Investing in these stocks is further complicated by the speed with which events get discounted. Scientific discovery requires long periods of trial and error. Every day, science is discovering new rules for medical science. Sometimes medical researchers go down a dead end, other times they uncover a new mystery. This is the nature of scientific discovery; it can't be rushed.

So when doing the homework on biotech stock investing, these are some guidelines that are helpful:

Product pipeline: Look for companies with at least two drugs in clinical trials. Then the company has something to fall back on if for some reason one product proves to lack efficacy. Another approach is to look for companies diversified around a specific disease class or that have a niche technology that can be used as a platform for a range of different drugs.

Collaborations: Companies that fail to link up with a corporate or academic partner can have trouble surviving. To ensure survival or lower risk, biotech companies will engineer several collaborative agreements with various pharmaceutical companies for research or marketing. Look for substantial milestone payments and cash commitments when the deal is announced, not just "talk" about a research alliance.

Management: Early-stage companies may or may not have the right people in senior management. It's important to have someone with a proven track record of taking a drug through the regulatory hurdles or to the marketplace. Look at the financials and go to the section on management to see who's working there and what they've accomplished in the past.

Cash: For many biotech companies, the release of a commercial product is often many years away and requires millions of dollars. Thus, a company's burning of cash in ongoing research and development, its "burn rate," is a critical measure of its longevity. Look for companies that have a minimum of two years of cash reserves.

Beyond these factors, you still have to do an individual review of any biotech stock you would consider for purchase, and know its story. This brings me to ImClone(IMCL Quote). Many of you know that I've been following the company.

With the latest developments on ImClone, it's best that investors avoid the company at all costs for the time being. I know I was optimistic earlier, but now it appears the company is faced with more serious allegations that could hinder further clinical development of Erbitux, an experimental treatment for colon cancer.

ImClone's management is on edge with news that the U.S. House Committee on Energy and Commerce is investigating the possibility that ImClone misled investors by hiding negative information about its Erbitux research.

I can only speculate on what lies ahead, but I'll keep it short. On the one hand, the Waksal brothers could be cleared of any wrongdoing, and the company could conduct additional clinical trials on Erbitux. On the other hand, the company could be saddled with serious lawsuits and investigations that impede Erbitux's development.

With all the negative news coming out about ImClone, it looks like the latter scenario for the near future.