2 Tips for Investing in Biotech Stocks With High Growth Potential

The biotech industry is a strange part of the stock market in that it is highly regulated by the federal government. So a pharmaceutical company has to first prove that its drug is safe and effective via clinical trials before it’s allowed to market it to doctors.

From a healthcare perspective, that makes a lot of sense. But from a financial perspective, it’s kind of wacky. A biotech company has to spend a lot of money before it can make any money. And if the drug fails its clinical trial, the company might not make any money at all.

That can be terrifying to investors. Nonetheless, many biotech companies go public without profits or revenue, precisely because their need for cash is so great. In the biotech world, it has become normal (albeit scary) to invest in stocks that have no drugs on the market.

And, in fact, people can and do make money. Here are two suggestions for how I approach it. I’ll use Novavax (NVAX 2.80%) and Nano-X Imaging (NNOX 1.86%) as examples.

1. Spend your time researching small caps and micro caps

I had terrific success buying Novavax at $6 and $4 a share. The company was a tiny micro cap when I made my first purchases. A little over a year after I had bought my shares, the price had spiked to $330 a share. It was roughly a 60-bagger for me.

One of the happy lessons I take from my Novavax experience is that it’s a good idea for biotech investors to make small investments in tiny stocks with promising science. By tiny stocks, I mean those that trade under $10 or have a market cap under $1 billion. You want to look for under-the-radar stocks.

The market hated Novavax when I bought my shares. The company had to do a 1-for-20 reverse-split to stay listed on the Nasdaq. In November 2019, the market cap had shrunk all the way to $106 million.

Now flash-forward to February 2021. Same company, same CEO, same scientists — and it’s a radically different situation. That month, Novavax reported positive phase 3 data from its COVID-19 vaccine trial. And many people were calling the vaccine best-in-class.

When the stock hit $330 a share a few days later, the company was valued at a cool $19 billion. And many people (including yours truly) thought Novavax stock was still undervalued, given how massive the market opportunity was for COVID vaccinations, and how good the company’s data was.

When Novavax traded hands at $4 a share in November 2019, the market was at maximum pessimism about the shares. And when the Novavax share price hit $330 in February 2021, it was the ultimate in optimism. In both cases, Novavax had zero drugs on the market.

It’s dangerous buying a $19 billion biotech without any drugs on the market. I didn’t buy Novavax at $330. But my family did buy shares of bluebird bio (BLUE 6.50%) at $220 a share. That was a $10 billion biotech without any drugs on the market, and we watched it sink all the way down to the single digits.

So that’s my first tip for investing in biotechs without any drugs on the market: When you’re making an initial investment, stick to the cheap stocks, the micro caps and small caps, with great science and great prospects. Make sure your company has enough cash to bring its top drug prospect to market.

And if you back a winner, let that winner run! I didn’t take any profits until Novavax stock was over $80. I took more profits at $125 and $330 and bought those shares back when the stock got a lot cheaper. But the key to my great returns were those first early purchases during Novavax’s darkest days.

2. Look for moats

Biotech stocks are technology companies. I love tech stocks because they can scale very quickly and make investors a lot of money.

But what’s perhaps most exciting about tech stocks is that a company might have a moat that gives it an advantage over rivals. Some moats I love include subscription to a service, the razor-and-blades model, and network effects.

Are there any healthcare companies with moats? Absolutely. Intuitive Surgical (ISRG 1.00%) has a moat, and Doximity (DOCS -1.83%) has a monster one. I think InMode (INMD 2.61%) has one too. I own all these healthcare stocks because they’re highly profitable, but also because these companies have big advantages over rivals, and can scale up and up.

Finding a moat is a way to “value” a biotech stock, even if it has no revenue or profits yet. Nano-X has a radically different X-ray machine than is available on the market now. The company’s device relies upon cold-cathode technology, making it a far cheaper device ($10,000 to manufacture, as opposed to a $1 million price tag for a high-end CAT scanner).

But the big news was the business plan. The company will give its machine away at cost or below cost (razor) and make money every time the machine is used (blades). It’s this fantastic business model that reminds me of the moats in some of my most-rewarding stocks. That’s why I am highly bullish on Nano-X. And for a while, the market felt the same way, and the stock spiked a lot higher.

NNOX data by YCharts

Like we saw with Novavax, it’s common in biotech investing to see a lot of volatility and extreme shifts in valuation. And we’re seeing that with Nano-X now. It’s 2022, and the high-end device is still not on the market yet. Impatient investors have sold the stock, sending it from a high of $90 all the way down to $9 back in April. But (and this is the important part), there’s been no actual bad news from the FDA yet.

In the world of biotech investing, the FDA is the biggest stumbling block and the most important issue. If Nano-X gets its device cleared by the FDA, happy day. If it’s blocked, disaster. And the way I improve my risk-reward ratio is by adding shares when the stocks are super cheap.

Taylor Carmichael has positions in Doximity, Inc., InMode Ltd., Intuitive Surgical, Nano-X Imaging Ltd., and Novavax. The Motley Fool has positions in and recommends Doximity, Inc., InMode Ltd., and Intuitive Surgical. The Motley Fool recommends Bluebird Bio. The Motley Fool has a disclosure policy.