One crucial thing to consider before investing in risky biotech shares

Consider this before owning shares in companies like Resapp Health Ltd (ASX:RAP) and Innate Immunotherapeutics Ltd (ASX:IIL).

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The recent collapse of biotech companies like Resapp Health Ltd (ASX: RAP) and Innate Immunotherapeutics Ltd (ASX: IIL) has thrust the risks of the sector into sharp relief – again. In case you missed it:

In both cases the collapse followed the failure of a trial to show positive results. Research companies need to prove that their therapy is successful in a variety of trials, to justify regulatory authorities such as the US Food and Drug Administration (FDA) giving the company approval to sell.

So, when a company only has a sole product that it is researching and that therapy is found to be unsuccessful, typically the only assets are cash in the bank and a treatment that doesn't work. This is why shares plunge so heavily. Usually for drug or medical treatment developers, there are 3 phases of trials, each progressively more rigorous and complex.

Investors can easily get tripped up by investing in companies in these research stages, particularly when early research appears promising. In my view, investors should treat all research stocks with extreme caution, for 3 reasons:

  • Especially at the pre-clinical or Phase 1 stages, it is very easy to massage trial data to get the conclusions that you want.

The easiest way to do it is by excluding certain results from your conclusion. Excluding results is scientifically valid for a number of reasons, but it is very difficult for external shareholders to tell if the science is good or if the result was (even unintentionally) cherry-picked by being selective with the data.

This is why double-blind, randomized-controlled trials conducted by external parties are so important. You don't even need to know what a double blind, randomized controlled trial is (though you should learn) just know that if your company is running one, that's good science.

  • The threshold to success is very high, and can appear understated

First, the threshold to getting your drug/treatment scientifically and regulatorily validated is very high and success is far from guaranteed. This is a hurdle that is difficult to explain because it differs depending on the product and intended customers, but the difficulty is hugely underestimated by investors.

Secondly, even excluding manipulation via the first dot point above, the early results from a drug/treatment/thing can sometimes be misleading for one key reason:

This reason is because the people that trial new drugs are often those that are desperate – people who are really sick and/or don't respond to any existing treatments. So, in Phase 1 and sometimes Phase 2, there is sometimes an artificially narrow band of patients being tested. Who is to say that a drug is not more or less effective on the sickest 1% of patients? Will it prove equally useful across the population with different age, weight, gender, at earlier vs later stages of a disease, and so on?

  • The outcome is typically binary

If the treatment does not work then the company is, as a general rule, worth next to nothing if it has no other prospects. All those years and all that money poured into research, it's very hard to extract any value from these intangible things for shareholders. Even companies with real products and multi-millions in sales like Sirtex Medical Limited (ASX: SRX) have seen savage falls in their share prices when clinical trials are unsuccessful.

My default position is to say 'no' to companies that have no sales and only one product under research, and I believe that should be your approach too. From an investment perspective it is too hard to quantify the risks, and the penalties for being wrong are swift and ruthless.

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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