Here are my 5 C's of Biotech Investing. Find a small biotech with all five of these core characteristics and you'll find a good trade!

1) Cash:  This is pretty basic. The company must have cash. Any biotech with less than six months of cash on the books is probably a biotech to avoid. Investors often fret over dilutive offerings. Many investors (for some reason) get angry when the biotech company they own raises cash. To this I pose a simple question, "Would you rather them go bankrupt?" Regardless, the first thing you should do when someone introduces a new biotech investment to you is to check the balance sheet and statement of cash flows. Look at the SEC Form 10Q or 10K quarterly operating burn. Find the cash balance as of last quarter. Divide the cash balance by the quarterly operating burn rate. If that number is less than 2, avoid.

2) Catalysts: Again, this is pretty basic. Stocks need a reason to go up. A stock with "nothing" going on for over six months is probably a stock that is going to trend sideways or down. Why buy something today when you can probably buy it in six months for the same price, eh? Most of these catalysts are binary events, meaning if the results are good the stock is going to soar. Many investors will buy a few months ahead of a big binary event in biotech with the goal of scoring big on success. Find a biotech stock with a major catalyst in the coming months and you'll probably find a stock that is hot on the message boards or in the social media. That hype is what makes the stock go up. Learn to play the catalysts and do your best to avoid snoozers!

3) Charisma: For a biotech stock to be a good investment, you have to be able to explain quickly and accurately what the company does in two minutes or less, and the person you tell it to has to leave the conversation going, "Wow, that's incredible!" What's charisma? Charisma is the "wow factor" of the technology. It's targeting an unmet medical need with a revolutionary new approach. It's the platform, it's the pipeline, and it's the peak sales potential. There are hundreds of generic molecules to treat dozens of common diseases. Try to avoid "me too" drug developers or biotech companies that are clearly peddling unnecessary advancements of something we already have and are fine using today. 

4) Capital Structure: Potentially as important as what the company does is who owns the company and what does the capital structure look like. Keep in mind, stocks are valued on market capitalization, not price. There are hundreds of ridiculously expensive $0.50 stocks. All the capital structure information can be found in the SEC filings. After you peruse the balance sheet and cash flow statement, take a quick tour of the statement of stockholders equity. Massive amounts of warrants, stock options, and convertible debt weight down the share price. Warrants above the current stock price tend to act as a ceiling as investors sell existing shares to exercise new positions. Convertible debt acts as an anchor to stock prices because the pending conversion can loom massively dilutive. Most investors despise reverse splits. Avoid NYSE or NASDAQ listed stocks trading below $1 per share - they are probably going to reverse split in the next six months. Stick to stocks above $5 and have strong institutional and insider ownership. 

5) Credibility: The final C relates to a direct assessment of the management. Biotech investors sometimes forget, these publicly traded companies are run by real human beings. I've been a professional stock analyst since 1999. I've sat across the table from some amazing people. Some are brilliant scientists. Others are incredibly astute businessmen or women. Many have high integrity. I've also sat across the table from some truly clueless idiots, flawed scientists, and terrible business persons. If you are going to go big with a biotech investment, make sure you know the management. Talk to them, sit across the table from them, look them in the eye - challenge them on everything! Look at their past. Look at their credentials. Talk to professional investors and get their feedback on them. Avoid - at all cost - a company where the management is questionable. Developing a biotech or pharmaceutical product to the market is not an easy task. Selling a biotech or pharmaceutical product is even more difficult. If you are not100% confident that this management team can get the job done, move on because chances are they will screw something up along the way.

Following my "5 C's" certainly does not guarantee a good investment, but it's an excellent starting point and checklist for due diligence. Of course, the drug has to work. A company can have all 5 C's, but if they drug bombs, it's a bad trade. You also have to pay attention to valuation! The point of the 5 C's is to provide investors core characteristics that I've found make stocks fundamentally strong before the key question of, "Does their drug work?"

It's important for investors to keep in mind, fundamentals drive stock prices. That being said, I'd encourage investors not to focus specifically on current fundamentals, but on the first derivative of fundamentals - the change in fundamentals. If quality is rated on a scale of 1 star (worst) to 5 stars (best), in biotech, a stock with a fundamental rating of 2 stars that is heading to 3 or 4 is a better investment than a stock with a fundamental rating of 5 stars heading to 4 or 3. I love turnaround stories and hate buying things that everyone else absolutely loves. This is where the 5 C's can help you identify names and be a contrarian!

My final advice: Be smart! Biotech stocks can make you or lose you a lot of money, quickly. Momentum is important, but try not to be the last idiot that jumps in. You're better off finding a down-and-out biotech stock that everyone has written off and focusing your due diligence on, "What would turn this story around?" Check my 5 C's. If you find something interesting - let me know!

Jason Napodano

Revised: July 2015