This Bet Pays Off More Than 80% of the Time

You would have made 78% in one day...

 

Last month, a small biotech company – Synta Pharmaceuticals – suffered a huge drop in its share price. The company announced its lead drug, which treats skin cancer, failed in a pivotal Phase III trial. The stock dropped 78%...

 

 

 

Short sellers profit when stocks crash. And investors who "shorted" Synta's – who bet against the drug's approval – walked away with a big paycheck. But shareholders who stuck by Synta were probably shocked...

 

Synta's management had done everything right. It ran a "placebo controlled" Phase II trial (that's the middle hurdle) before it went to Phase III (the final hurdle). That's a truly rare move – 99% of all biotechs wouldn't bother proving their drugs are better than a sugar pill. And Synta's Phase II results were so good, drugmaker GlaxoSmithKline offered $1 billion in royalty and milestone payments to get the rights to the drug.

 

If I had been younger, I may have told my readers go long on Synta. But I knew better... I knew a dirty little secret you probably won't hear from any other biotech analyst: Picking biotech losers is far easier than finding winners.

 

On average, 70% of all drugs in Phase II trials fail. One-third of all drugs in Phase III are duds. All in all, only two out of every 10 drugs makes it through clinical trials. And even when drugs pass clinical trials, nothing guarantees the FDA will give its seal of approval.

 

Biotech stock prices hinge on hope and confidence rather than solid financial footing. Any clinical failure or FDA rejection can send a biotech stock crashing. Shorting these stocks is a fantastic way to make money with a lot less risk than your typical biotech trade. And the rewards can be huge...

 

In February alone, you could have made one-day gains of 90%, 53%, and 80% as three drugs failed to make it past the FDA, causing a crash in the drugmakers' stocks. If you want to look for the next biotech crash candidate, here are some criteria to help you narrow down your search:

 

1) A difficult disease. Zero in on companies developing drugs for "difficult" diseases like skin cancer, lupus, or Alzheimer's. This area has produced a lot of high-profile failures – like Synta's – in the last 10 years.

 

2) A lousy drug or pipeline. Companies that are only developing one drug are almost always ideal short candidates. You can also look for Phase III trials conducted without positive Phase II data. It happens all the time in biotech. And these drugs fail twice as frequently as conventional Phase III programs.

 

3) Incompetent management. The reason most promising drugs fail is that management often botches the clinical trial, either skipping Phase II or recruiting only a few test patients. This is the toughest for an individual trader to evaluate, but it's something I track in my day-to-day analysis of the sector.

 

4) Unjustified prices. Speculators can go into frenzy in anticipation of FDA approval or positive clinical results. Unrealistic expectations will send stocks soaring, sometimes to an incredible 20-50 times projected sales. But once the suspense is gone, the stocks often have only one place to go... down.

 

Good investing,

 

George Huang

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