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Investing in biotechnology stocks is not for the faint of heart. The sector is rife with jargon, scientific complexity, huge regulatory hurdles and potential setbacks that can send a company's share price into the basement.

Yet it also holds great potential for investors, and can generate huge returns if you buy the right companies at the right time.

In Canada, there is a whole universe of biotechnology companies to choose from, including firms developing everything from cancer drugs to cholesterol treatments to antidepressants and cattle vaccines.

But if you don't have a PhD in biochemistry, how do you choose which companies will do well?

It's a tough call, said Douglas Loe, an analyst at Versant Partners Inc. in Toronto, because biotechnology is so different from other specialty sectors such as oil and gas or precious metals. With a gold company, "if you know what the price of gold is today, you can decide based on that metric alone whether you want to be long, short or indifferent to Barrick Gold Corp." With biotech, on the other hand, "you have layers of scientific risk on product development that extend beyond the basic economic analysis that you can employ on almost any other stocks."

There is a big risk that any individual drug may not do what it is expected to do - which is why the results of clinical trials are so crucial. Regulators may also balk at approving a drug, and even if it is approved, there has to be a demand for the product in the marketplace.

'You May Get Lucky, But Chances Are You Won't'

These risks make it crucial to carefully evaluate companies individually, and to diversify, Mr. Loe said, so investors interested in the sector should pick a broad array of companies in different stages of development whose products target different medical needs.

"It's way too risky to just pick one, especially if you are investing in names that are not [yet]profitable," said Philippa Flint, an analyst at Bloom Burton & Co. who was formerly a biotech executive. "You may get lucky, but chances are you won't."

She noted that biotech companies are subject to "binary events" where they get either extremely good news (successful data from a trial, or regulatory approval for a product) or very bad news (failed data, or rejection by regulators), and these can send shares soaring or plunging.

Instead of diversifying among a number of smaller firms, investors can also look at larger biotech companies with a wide range of products in different stages of development. There are few of these in Canada, but Valeant Pharmaceuticals International Inc. (formerly Biovail Corp.) and Paladin Labs Inc. have several drugs on sale and in the works - and long histories of profitability.

Evaluating Biotechs

When evaluating individual biotech investments, one key factor is the experience of the management team - especially whether they have previously brought products through the development stage to market, Ms. Flint said.

It is also important to find out how much cash the company has, and how long it will last, she said. "Ideally, you'd like to have a company that has at least two years of cash on hand." Many of the companies in the sector regularly report their "burn rate" of funds, or give estimates of the length of time their cash will hold out.

When the cash does run down, it is crucial that biotech companies can successfully raise more money to keep them going. Indeed, a survey of Canadian life sciences companies being released Thursday shows raising capital is expected to be the single biggest challenge facing those firms in the next two years.

The Question of Money

Financing for the sector fell dramatically during the recession, and has not yet recovered, said Wayne Schnarr, a health care consultant at investor relations firm Equicom Group and a former biotech analyst. Early in the decade, development stage companies based in Canada raised about $1-billion a year in global public markets, he said. In 2008, however, the number fell to around $700-million, and in 2009 and 2010 it was closer to $500-million.

"The sector is surviving on half as much money as it was 10 years ago, and there are more companies," Mr. Schnarr said.

Much of the money that is available is going to companies with later-stage products, he said, so those with products earlier in the life cycle may be hard-pressed to raise enough to survive. Always, companies that have positive data from their clinical tests find it easier to raise funds, he said.

But there are some recent financing success stories. In December, YM BioSciences Inc. of Mississauga raised $43-million (U.S.) through a secondary offering of shares. The company has several cancer treatments in various stages of development, with three products in clinical trials.

Around the same time, Bioniche Life Science Inc. of Belleville, Ont., raised almost $30-million in two offerings in Canada and Australia. The company has a treatment for bladder cancer and several products for animal health already on the market, with others in its pipeline.

What will matter most in 2011 is whether these and other companies get successful data from their clinical trials, and if they get positive responses from the regulators to approve their products. For those who get good news, stock prices will rise and funds will be available. Still, Mr. Schnarr said, it will likely take two or three years of success to get back to the point where the sector is raising $1-billion a year.