Biotechnology stocks have the potential to provide investors with incredible returns. Biotechnology firms use living organisms to manufacture products. Biotechnology and pharmaceutical companies both produce medicines, but products of pharmaceutical companies typically have a chemical basis.
Biotech stocks have the potential for significant investment gains if a product is deemed effective and safe. However, biotech stocks also come with risks due to the possibility that some products under development may never make it to market.
Biotech firms face many regulations, including from the Food and Drug Administration (FDA), adding the risk of uncertainty surrounding developing new drugs. Given the complexity of biotechnology, investors often experience challenges in determining a product's effectiveness and chances of success.
- Biotechnology stocks have the potential to provide investors with incredible returns.
- Biotech stocks also come with risks due to the potential that some products under development may never make it to market.
- Biotech firms face many regulations, including from the FDA, adding the risk of uncertainty surrounding developing new drugs.
- Given the complexity of biotechnology, investors without a medical background can face challenges in determining a product's effectiveness and chances of success.
- Even analysts at financial institutions can have a poor track record when trying to predict the performance of biotech companies.
How Biotechnology Stocks Can Surge
Few sectors in the market see small single-product companies go from having tiny market capitalizations to having a worth of over hundreds of millions practically overnight. The business of curing diseases can be a lucrative one, and investors will jump on the bandwagon for any stock that shows the promise of a big breakthrough.
As an example, Novavax Inc. (NVAX) is a biotech company that produces vaccines. In early 2020, when the COVID-19 pandemic began, biotech companies like Novavax joined the push to produce a coronavirus vaccine. The company secured nearly $1.6 billion in funding from the U.S. government.
As a result, the stock price surged. On Feb. 3, 2020, the stock traded at $6.81. It soared to almost $300 before settling down substantially by May 2022, when the share price was around $62.
Risks of Biotechnology Stocks
Along with the opportunity to make significant gains comes the potential for devastating losses. Some companies in the biotechnology sector are relatively small, with no more than two or three products. As a result, news releases concerning clinical trials and approval from the Food and Drug Administration (FDA) are deciding factors in the direction of the company's stock. Biotech companies can live and die by these announcements.
For example, on July 15, 2021, the FDA Cardiovascular and Renal Drugs Advisory Committee (CRDAC) voted to recommend not approving FibroGen's roxadustat. The medicine was designed for the treatment of anemia (insufficient red blood cells) due to chronic kidney disease (CKD) in adult patients. CKD causes the gradual loss of kidney function, which can lead to kidney failure.
As a result, FibroGen's (FGEN) stock price plummeted by the next morning. On July 15, 2021, FGEN closed the trading day at $24.84, but following the bad news, the stock price gapped down the next day, opening at $15.23 on July 16, 2021. FGEN eventually closed for the day on the 16th at $14.35 per share, representing a 42% decline from the previous day. As of May 2022 the stock hadn't recovered, and was trading around $9 a share.
Typically, when a company's stock price gaps down, investors don't have a chance to sell the stock before the market open. For example, if an investor had bought FGEN at $24 and placed a stop-loss order at $20 with a broker, the stop-loss should limit the loss to around $4 ($24 - $20). However, during a volatile move, the sell order would not likely be filled at $20, but instead, the investor would be sold out of the position near the opening price of $15.23 on July 16, 2021.
Challenges With Researching Biotech Stocks
It's easy for investors to focus on the huge potential for capital gains when investing in biotechnology stocks. Investors can also get wrapped up in the story of a small biotech firm that has the potential to revolutionize its industry if its products come to market. However, as impressive as these products appear, it can be challenging to ascertain the probabilities of success for a drug.
It can also be quite challenging to research a company's products for those without a medical or science background. For example, HUMIRA, manufactured by AbbVie Inc. (ABBV), is designed to help people with Crohn's disease, which is a chronic disease that causes inflammation in the digestive tract.
Investors researching AbbVie to determine what HUMIRA does and its effectiveness would find that HUMIRA is a medicine called a Tumor Necrosis Factor (TNF) blocker. Besides Crohn's disease, HUMIRA is also approved to help adults with ankylosing spondylitis (AS) and people 12 years and older with moderate to severe hidradenitis suppurativa (HS).
Although the descriptions above might sound impressive, many investors without medical knowledge would likely find it challenging to understand the diseases being treated, how the body might react, and how effective the treatment is for each condition.
Since biotechnology companies can be complex, investors may turn to investment analysts at large financial institutions for guidance. The buy and sell ratings made by these companies can be used as a tool to determine whether or not the stock is a viable investment decision.
However, an investment bank might issue a buy rating on a company, sending the stock price higher, but months later, it's revealed that the company's drug isn't effective or fails a clinical trial. The stock would likely fall, and the investment firm would downgrade the stock, changing its rating to a hold or sell. Oftentimes, investors would be stuck with losses since they couldn't exit out of their position quickly enough.
In the past, stock analysts have come under scrutiny due to transparency and the close relationship they have with the companies they cover. Buy-side analysts work for companies that purchase or actively trade the securities they cover, such as mutual funds.
Conversely, sell-side analysts work for companies that create and service products for the buy-side by often selling research about the companies they cover. Investors should do their homework since analysts are compensated differently, depending on the firms they represent, which can influence their ratings or create a bias.
The Bottom Line
The biotechnology sector can be very rewarding for those who remain cautious and do their homework. It's easy to get caught up in the dream of making huge gains or the intriguing stories of how a company's products can change the world. However, the volatile nature of biotech stocks is a double-edged sword, meaning these stocks can produce enormous gains but also significant losses if a drug fails to perform or come to market.
Investing in the biotech or biopharmaceutical industry involves extensive research by investors to determine the nature of the products, the company's strategic advances, and the risks involved if the product doesn't work. As a result, it may be wise to consult an investment professional or financial advisor before purchasing biotechnology stocks.