2 'Rules of the Road' for Biotech Investing

I've learned over decades that there are a few keys to successful investing in the volatile but speculative biotech space, where we had several blow-ups yesterday. One-time market darling Bluebird Bio (BLUE) fell more than 35% on disappointing results from an early stage trial that used one of the company's gene therapies to treat sickle-cell anemia. Bluebird is at the forefront of the emerging immune-therapy area, and investors had bid the stock up to extraordinary heights. But it's now down 70% since June. Agios Pharmaceuticals (AGIO) also slumped more than 20% yesterday as an early stage trial to treat various forms of cancers wasn't as successful as investors had hoped. But the day's biggest train wreck was Threshold Pharmaceuticals (THLD), which until recently was on my Best Idea list. THLD fell some 80% on not one but two Phase III trial results that failed to meet their primary endpoints. That was a significant disappointment to me personally, as I own the stock. Threshold seemed to have all of the elements of my previous Best Idea Eagle Pharmaceuticals (EGRX), which was a massive winner for me earlier this year. THLD had multiple shots on goal, as well as strong support from some top-ranked analysts, a strategic partnership with a larger player and cash on hand to fund development. But unfortunately, the company's Phase III trial results didn't meet the expectations that I, analysts and even Threshold insiders (who haven't sold a share over the past year) had for them. Luckily, my THLD stake is relatively small -- like all speculative, small-cap stocks in my biotech portfolio. In my view, there are two important things to remember if you want to successfully invest in the sector: Focus on Big Names First, you should keep 50% to 75% of your overall holdings in large-growth names that are selling at attractive valuations, like Amgen (AMGN) or Celgene (CELG). (Your exact percentage will depend on your individual risk/reward profile.) These large-cap companies have real revenue and earnings growth, as well as deep pipelines and solid balance sheets. They often pay a dividend as well. You won't score many home runs with these names -- but good, solid singles and doubles are nothing to sneeze. These stocks will also lower your overall biotech portfolio's volatility and allow you to more easily to ride out the segment's inevitable, frequent bear markets. Hold a Variety of Small, Speculative Plays The rest of your portfolio should consist of small stakes in a myriad of promising but speculative small-cap biotechs. That's the best way to manage the inevitable blowups that happen during the complex drug-development process. You simply can't use stop-losses to mitigate risk. If a major trial fails, the associated stock can drop 75% to 80% in premarket trading, which makes even a stop loss of 25% under the current price worthless. The only way to lessen company-specific risk is through numerous modest positions in a variety of potentially lucrative small-cap plays. Big home runs like Eagle, which soared more than 450% during its time on my Best Ideas list, can more than make up for the occasional, inevitable implosion in the space. There's a high complexity to drug development and an inherently high failure rate. I've learned that lesson over many years, and have had many stocks that simply didn't deliver against expectations. The knowledge of that doesn't make it any less painful when a stock like Threshold implodes, but it does make it more manageable from a portfolio perspective. The Bottom Line Those are my rules of the road for investing in the biotech sector. They've been hard-won by many painful lessons investing in the space for a couple of decades, and I offer them up for your consideration.

2 'Rules of the Road' for Biotech Investing

Follow these maxims and you should do well in this volatile sector.

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