Warning: Every investor should read this before buying speculative biotech companies

You could lose your shirt investing in companies like Innate Immunotherapeutics Ltd (ASX:IIL).

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When you start investing, it's easy to get caught up by promising ideas and new technology that goes nowhere, costing you a lot of money in the process.

Companies like Prima BioMed Limited (ASX: PRR), Innate Immunotherapeutics Ltd (ASX: IIL), Pharmaxis Ltd (ASX: PXS), Cynata Therapeutics Ltd (ASX: CYP) and others are all investing heavily in researching their chosen treatments, which they hope will lead to life-changing (and financially rewarding) therapies in the future.

However, this lure of a bright future is like a naked flame for moths – a lot of the time, all it does is burn investors. Here are some key things to consider before purchasing any biotech business:

It's a binary outcome

It's common to think that by investing in an early stage company now, your patience and courage will be compensated for with a successful business, like this:

Investment + Patience = Treatment successfully developed = Profit

Unfortunately, that's not how it works. It's more like:

Investment + Patience + capital raising + plunging share price = 50/50 success or failure = _____?

At the end of the day, all it takes is a failed trial to see your investment worth $0 – like when Innate Immunotherapeutics plunged 95% on Tuesday.

That's a big problem, because:

Research is very expensive

There are 4 phases that every biotech researcher goes through. Each reflects greater complexity and a higher hurdle to prove that a treatment is viable:

Phase 1 > Phase 2 > Phase 3 > Regulatory approval (sales can commence after this)

As a rough rule of thumb, you could say that it takes at least 1 year to complete each Phase, although this varies hugely depending on the phase and the type of treatment and can easily be much longer (and rarely any shorter).

Following that, add a year for regulatory approval. It is often faster but there is always the chance that a regulator will require more research before approving a treatment, resulting in delays.

So as a rule of thumb it takes at least 4 years to get from pre-Phase 1 to having regulatory approval. Here's why that's concerning:

A fictional example

Imagine a fictional company, Magic BioPharmaCeuticals (ASX: MBPC). It has a successful Phase 1 trial under its belt, a market capitalisation of $60 million, $7 million cash at bank, and is burning $2 million cash per quarter in research and administration expenses.

We could say that the company is 'worth' $67 million, i.e., market capitalisation (the total value of all its shares on issue) + net cash.

If we take the rule of thumb that it will take at least 3 years (12 quarters) to complete phase 2 and 3, achieve regulatory approval, and commence sales, an investor is looking at $24 million in cash outflows. So, your $67 million at the time of purchase turns into at least $43 million and that's before the dilatory effects of capital raisings (issuing more shares to raise funds).

This works out to be about a 35% loss on your investment and that is before the company succeeds or fails. So it could look something like this:

You will lose at least 35% of your money on MBPC, and there is at least a 50% chance that the research either fails or is delayed longer than 3 years, resulting in even greater cash losses. Should you buy?

Most likely you should not. The only thing that could save you in that situation is if the market is more enthusiastic than you are, and offers to pay you a higher price for your shares. This is often why people buy these companies – in the hopes of a higher share price. However, it doesn't take too many years of constant cash losses to drain investor enthusiasm and I am yet to see a speculative biotech that can maintain a high share price.

This type of company is completely unsuitable for the vast majority of investors.

Motley Fool contributor Sean O'Neill has no position in any stocks mentioned. 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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