Best Biotech Stocks

With the biotechnology industry growing at a rapid rate, these stocks may be tempting to add to your portfolio. Here’s what you need to know before you buy and the best biotechnology stocks you can buy now.

What are biotech companies?

Biotech companies use research and development to create innovative products that can be applied in healthcare, agriculture and many other areas, as well as the development of drugs to treat diseases and medical conditions. Companies can sell new drugs only if they have an approval from the Food and Drug Administration (FDA). The drug development process takes five steps:

1. Discovery and development: At this stage researchers try to find a promising idea and they conduct experiments to find out what are potential benefits, side effects, best dosage, etc.
2. Preclinical research: At this stage researchers are trying to figure out if the drug could cause serious harm to people (toxicity).
3. Clinical research: This has four phases and in each phase, researchers have to answer specific questions. Phase 1 studies are usually small-scale and can last for a couple of months, while Phase 3 studies are large-scale with 300 to 3,000 participants and can last 1 to 4 years. The clinical research is the stage that has the biggest impact on the stock price of the biotech companies.
4. FDA drug review: At this stage, the drug developer can file an application to market the drug.
5. FDA post-market drug safety monitoring: Drugs are monitored even after the approval to ensure their safety, dosage, and usage.

Liquidity is crucial with biotech stocks

The research and development process can take a lot of time and it can be very expensive; therefore, it’s necessary for the biotech companies to raise enough to meet capital requirements.

They usually turn to financial markets for this purpose and they secure capital with initial public offerings or by issuing bonds. Financing is critical, so it makes sense to check their balance sheets to look for liquidity issues. Financial analysts calculate liquidity ratios to answer this question. Current ratio is one of them and it is calculated by dividing current assets and current liabilities.

If they are equal, this ratio is going to be equal to 1, but it is better for a biotech company to have a higher current ratio and it can be higher than 2 or even 3. Biotech companies with low liquidity ratios might have to raise new capital, which could lead to dilution of the stock, so you have to watch closely how fast are they burning cash.

What to look for in biotech stocks

Investors usually focus on companies with several drugs in the pipeline that are in Phase 2 or Phase 3 of the clinical research. Phase 2 drugs are riskier, but in case of success, the reward can be amazing.

The size of the market and competing drugs, both approved and in development are also an important factor. The best way to research the biotech stocks is to analyze their portfolio of drugs, both existing and in development. To do that, you have to be able to figure out if the drug can get FDA approval, but also you need to understand the market potential for new drugs. Instead, you could use the estimates of the analysts who are covering the sector.

Two ratios that are based on consensus estimates to value biotech stocks can be useful for this purpose. Forward price to earnings ratio is calculated by dividing current price by the consensus estimate for the current year and the PEG ratio is calculated by dividing forward price to earnings by the long-term growth consensus estimate.

A low value of these ratios indicates that a stock is undervalued.

How risky is the biotech sector?

The biotech sector is well-known for its volatility and huge one-day moves. In 2018, Edge Therapeutics, Inc. (NASDAQ: EDGE) dropped 92 percent in one day after the company decided to stop a Phase 3 study of its drug. This can happen with the companies that have one or few promising drugs.

So the number of promising drugs is one of the key issues for determining the risk. Obviously, there are plenty of examples of huge single-day gains and they happen after the drug moves from one clinical research phase to another. The clinical research stage of the drug is also important.

According to the FDA website, approximately 33 percent of drugs move from Phase 2 to Phase 3 and only 25 to 30 percent of Phase 3 drugs move to Phase 4.