Banking on Buyouts in Biotech: Is It Smart?

by Jeff Reeves | August 24, 2012 10:50 am

[1]Is it safe to buy biotech stocks, when the rumours/news is out about their buyouts? — Ashwani

Is it ever “safe” to buy biotechs? These are some of the most volatile investments on Wall Street — able to make or break your portfolio overnight.

For starters, let’s be honest about most biotech stocks. They’re simply launching pads that in a best-case scenario see their innovative drugs pass clinical trials with flying colors and win FDA approval, causing the stock to blast off. Then shortly after, Big Pharma comes knocking with a buyout that sends the stock screaming even higher[2].

Worst-case scenario, on the other hand, is a failure of the new treatments that results in the company blowing up on the launch pad.

The result can be either huge profits for investors or a painful loss. There’s rarely a middle road.

Understand this first and foremost: Biotechs and upstart medical device stocks are a risky game.

Second, remember that buyouts are the name of the game — so rumors constantly circulate with varying degrees of truthfulness. Unscrupulous investors may be simply looking to “pump and dump,” so always take everything with a grain of salt.

That said, buyouts happen — and can deliver big profits when they do.

Take Human Genome Sciences (NASDAQ:HGSI[3]), bought out by GlaxoSmithKline (NYSE:GSK[4]) for $14.25 a share after trading as low as $7 just weeks before the deal. Or Amylin Pharmaceuticals (NASDAQ:AMLN[5]), bought by Bristol-Myers Squibb (NYSE:BMY[6]). The Amylin-BMY deal[7] kept creeping up before finishing at $31 a share, providing a quick doubler for AMLN shareholders.

These are the dream stocks. But don’t forget the nightmares out there.

Those are companies like MAKO Surgical (NASDAQ:MAKO[8]), which is down 41% this year, back to 2010 valuations, as its technology for knee-replacement surgery hasn’t panned out as investors planned. Other flops include Dendreon (NASDAQ:DNDN[9]), down 35% year-to-date, and Progenics Pharmaceuticals (NASDAQ:PGNX[10]), which lurched down about 50% just a few weeks ago.

There’s nothing inherently wrong with biotech investing, but unless you’re willing to do the legwork on FDA trials and medical studies, and unless you have a good knowledge of science to fully comprehend how the drugs work and what they treat … well, I’d steer clear.

Small-cap biotechs are exciting because of the profits they can deliver. But if you’re a novice with no medical background and no interest in getting lost in journal articles on genetic disorders, you’re better served investing in a safer and more accessible corner of the market.

But if you don’t mind the risk and relish the research, there are big profits to be had — particularly if a hit drug makes your holding a buyout target. That’s the ultimate payoff for a biotech investor.

Just beware that if you’re reading the rumor on Seeking Alpha or TheStreet.com, some of the buyout hopes may already be priced in as a premium … and if it doesn’t happen, you’ll be left holding the bag.

Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.”[11] Write him at editor@investorplace.com or follow him on Twitter via @JeffReevesIP. As of this writing, he did not own a position in any of the stocks named here.

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