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This high-risk sector is one ALL new investors should avoid

If there’s one sector that all fledgling investors should avoid, it’s the biotechnology/medical research segment. The combination of unprofitable businesses and continuous Research and Development (R&D) spending with uncertain outcomes is not good news for your investment returns.

Most investors entering the sector lack the expertise to really evaluate a company’s scientific claims/research updates, and are enticed in by the potential ‘billion dollar’ markets of stem cell research, new life-saving drugs, and so on.

Many companies in the sector, like Cynata Therapeutics Ltd (ASX: CYP) and Pharmaxis Ltd (ASX: PXS), have little money-earning potential when they get started. They use a sexy story to attract enough shareholder cash to fund early stage research which may or may not result in a saleable treatment many years down the line.

The trouble is that research companies can run out of cash several times during the course of their development and have to solicit more from shareholders, which is quite difficult with nothing to show in revenues. Many who comment on the sector suspect companies occasionally ‘play up’ or exaggerate their progress so far, or the ultimate potential of their research, in order to pump up the share price for a capital raising (issue of new shares to raise funds) further down the line.

There’s also no safe way to exit the business or recover expended costs should research prove fruitless. A company can’t very well say “well, we’ve got a treatment in Phase 2 that’s 3 years and $15 million dollars away from maybe being approved for use on humans” and expect to achieve an attractive price for all the millions of dollars spent reaching that point.

Shareholders trying to get out are also vulnerable to share price movements, because these companies are often quite small and illiquid.

Even businesses like Mesoblast Limited (ASX: MSB), once seen as one of the more promising prospects in the sector, are vulnerable to this vicious cycle of capital raisings, investor excitement, and subsequent disillusionment.

That’s not to say that all businesses in the biotech/medical research sector are terrible investments. CSL Limited (ASX: CSL) is surely the shining light that all biotechs aspire to follow, while Sirtex Medical Limited (ASX: SRX) is also an attractive prospect. Every now and then something like Medical Developments International Ltd (ASX: MVP) shoots into the spotlight on the back of a successful treatment, but for every Medical Developments, there must be a dozen Prima BioMed Limited’s (ASX: PRR).

Novice investors beware.

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Motley Fool contributor Sean O'Neill owns shares of Sirtex Medical Limited. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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