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Here’s why you should avoid Australia’s biotechnology sector

Many investors find investing in biotechnology stocks to be incredibly appealing. Not only do most companies within the industry enjoy tax benefits due to their high level of research and development (R&D) investments, they are also capable of delivering gigantic returns when tests and trials go according to plan.

However, while investing in biotech stocks can be very rewarding, it can also lead to disaster. Biotechnology companies tend to be smaller businesses and therefore focus most of their attention on one (or a small handful) of trials at any one time. The costs and time involved in developing these treatments can be tremendous, making failure extremely costly for shareholders.

Extreme risk

That was certainly the case for shareholders of Sirtex Medical Limited (ASX: SRX). The stock fell by as much as 62% shortly after the market opened this morning, wiping more than $1.2 billion from the company’s market value, after it announced that the primary endpoint of its SIRFLOX study was not achieved (although its secondary endpoint was achieved).

While you can read more about that here, in summary, the clinical trial hoped to prove that Sirtex’s SIR-spheres treatment might be suitable as a first-line treatment in the fight against liver cancer. Ultimately, the result shows that there was no “statistically significant improvement in the overall Progression-Free Survival (PFS)”.

Indeed, investors had bid the stock to such a price that success was almost completely priced in. While UBS had recently given the stock more than a $50 price target, the stock was already sitting on a trailing price-earnings ratio of 92x as of yesterday’s closing price of $39. Given the results of the trial, such a large fall perhaps shouldn’t have come as such a surprise.

Unfortunately, Sirtex isn’t the only biotechnology stock to have suffered a demise recently. While its fall will no doubt impact the market the most given its sheer size and success rates over the last few years, GI Dynamics Ltd (ASX: GID) and Acrux Limited (ASX: ACR) have also caused plenty of pain recently.

Acrux has developed a treatment called Axiron which is a Testosterone Replacement Therapy. While the treatment has shown plenty of promise, the US Food and Drug Administration (FDA) recently flagged the increased risk of heart attack and stroke associated with the treatment, casting significant doubt over the product’s future. Meanwhile, GI Dynamics also came under enormous selling pressure after the FDA requested further information regarding the risk/benefit profile of its key product, EndoBarrier, after an unexpectedly high number of patients became ill during the trial.

The safest way to play the sector

Investing in the biotechnology sector is extremely risky and investors should only ever invest as much as they can afford to lose. Rather than taking an unnecessarily high level of risk on these stocks; investors could instead look towards established healthcare stocks such as CSL Limited (ASX: CSL), ResMed Inc. (CHESS) (ASX: RMD) and Cochlear Limited (ASX: COH). All of these companies have proven track records and offer upside potential with far less risk attached.

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Motley Fool contributor Ryan Newman does not own shares in any of the companies mentioned. You can follow Ryan on Twitter @ASXvalueinvest.

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