The biotech sector remains the Wild West of stock investing. There is no other fully legitimate sector that has such intense price swings and volatility. The reason being is that the pharmaceutical and medical industries are trillion-dollar businesses. All it takes is a research team with a potentially valid idea to create a company and start the drug approval process.
Now, don't get me wrong. It's not an easy process, and most firms fail when it comes to getting product to the market. In reality, it's an onerous process to get a drug or medical device approved in the United States.
The process is extremely costly and time consuming, sometimes taking years and costing millions of dollars. However, if the company is successful, incredible wealth can flow to the owners and shareholders.
Every company has its ups and downs when it comes to the FDA approval process. This excitement and disappointment is what drives early-stage biotech share prices. I am not a scientist and do not claim to understand the nuances of drug approval. Fortunately, it is not critical to have a medical degree or Ph.D. to make money in biotech stocks.
A recent example of this extreme volatility is the biotech company Dendreon (DNDN). The monthly price chart shows an explosion from below $5 to above $55, then back down below $5. It's a classic case of euphoria followed by disappointment.
This is just one example of literally hundreds of biotech companies that exhibit extreme volatility. Investors need to be aware and ready for the extreme moves inherent in biotech stocks before investing.
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The true key to success is to diversify across a variety of early-stage biotechs rather than just one or two. This substantially increases your odds that one or more of your investments will be profitable enough to cover the losers.
While I firmly preach the importance of diversification across multiple biotech names, I am often asked what biotech I would invest in if I could only choose one. This is often a difficult question to answer, but right now, I do have a favorite biotech stock.
Merrimack Pharmaceuticals (MACK) is by far on the top of my list right now as a stock that could easily triple from its current trading range. The company possesses all five of the critical characteristics crucial for biotech success.
These features are strong management, manageable debt, sufficient funding, a multi-product pipeline and products moving closer to approval. Remember, however, that companies can possess all five of these characteristics and still struggle for years.
MACK is very special as it not only possesses all five of the characteristics needed for success, it has two additional ones: insider buying and partnerships with large pharmaceutical companies. Those two bonus features are why MACK is my No. 1 biotech buy.
In the past three months, insiders, including the CEO and members of the board of directors, have collectively purchased 507,400 shares. When senior management has enough faith in their company to purchase large numbers of shares, it's a strong bullish signal.
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The next special success characteristic of MACK is its partnerships with large firms. The company boasts a license and collaboration agreement with Sanofi (SNY) related to its MM-121 product. In addition, MACK has a relationship with Actavis (ACT).
These relationships put the company's cash and equivalents at $182.5 million at the end of the third quarter. This is more than enough to carry the company into 2015 without outside revenue. Remember, early-stage biotech companies are cash hungry and revenue short. Having a war chest of near $200 million gives MACK a huge advantage.
Technically, MACK has fallen from its recent high near $5 into a value buy zone. Buying here with a stop at $3.35 and an $11 target makes solid investment sense.
Recommended Trade Setup:
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-- Buy MACK between $3.75 and $4.75
-- Set step-loss at $3.35
-- Set initial price target at $11 for a potential 132%-193% gain in 90 days
Disclosure: Dave Goodboy owns shares of MACK.