Phase II Is the Sweet Spot for Biotech Investing

I recently received a call from an investor relations representative who wanted to know if I’d be interested in hearing about a small biotech company with a drug candidate in Phase II trials.

Would Rory McIlroy have liked a do-over on Sunday at Augusta?

Phase II trials are my favorite time to get involved in a biotech company. I’ll explain why in a moment. But first, a quick review of the phases of clinical trials.

The Three Distinct Phases of Clinical Trials

Before a new, experimental drug is tried in humans, it’s put to work in test tubes and then animals. Once it’s ready for human trials, it’s tested in three distinct phases.

The Phase I trial is conducted with a limited number of subjects, usually fewer than 50. In cancer trials, the drug will be given to patients, sometimes as a last resort. For drugs targeting many other diseases, they’re given to healthy volunteers so doctors can better understand how the drug reacts inside the human body.

If a drug is deemed safe after this period, the company will proceed to Phase II. This trial usually consists of a few dozen to several hundred patients receiving varying dosage levels of the particular drug.

The data that’s considered most accurate are from a trial that’s “double blind” (neither the patient nor the doctor know if the patient has received the drug) and placebo controlled (compared to a placebo or standard of care). Some, but not most, Phase II trials are double blind and placebo controlled.

In Phase III, companies test hundreds to thousands of patients. If the data proves that the drug is safe and effective, the company will usually apply for approval.

Naturally, the more patients who take part in a trial, the greater the chance the drug fails. For example, the drug may not work, or there may be unexpected side effects. This is especially common in cancer trials, where the response rates are low, even with approved drugs.

Positive results in Phase III can push a stock higher as investors begin focusing on approval and the sales and profits that could follow. However, it doesn’t always work that way. Many drugs with seemingly strong Phase III results have been rejected by the U.S. Food and Drug Administration for one reason or another. This can crush investors who followed a drug stock all the way to the end.

For example, MannKind Corp. (NASDAQ: MNKD) has seen its stock rise and fall sharply several times. Investors got their hopes up on the Valencia, Calif., company’s inhaled insulin product Afrezza, only to see the FDA reject it time and again over safety issues.

This is one reason why Phase II is the real sweet spot for biotech investing.

Phase II Trials: A Profitable Time to Be Involved in Biotech Stocks

Phase II is often the most profitable time to be involved in a small-cap biotech stock. Many times, Phase II results are positive. Sometimes it’s because the drug works. And other times it’s because the trial is rigged to provide positive results.

For example, Cel-Sci Corp. (AMEX: CVM), a Vienna, Va., company that stirs passion (both positive and negative) among biotech investors, ran a Phase II study on the head and neck cancer drug Multikine. However, rather than test the drug against other existing treatments, Multikine was given along with an existing treatment.

At the end of the trial, Cel-Sci boasted of a 12% complete response rate. But it was impossible to determine if the two out of 19 patients who had a complete response saw their tumors disappear due to Multikine or due to the other treatment.

So, why would a company do that? To show positive results in the hopes of raising additional capital.

There are also times when the science is conducted properly and Phase II claims are valid, but the drug isn’t able to replicate results in a Phase III trial. Remember, a Phase II trial usually contains a much smaller sample size, which can easily distort results.

Very often, when a company reports strong Phase II results, the stock takes off as it is the first real indication that it might be approvable. Investors get excited; potential partners begin sniffing around; and the media begins to cover the drug’s potential. Even though at this point things are just starting to get promising, it’s often a great time to take the money and run.

Phase III, on the other hand, is fraught with risk. These trials are expensive to run, and there’s no guarantee that the drug will again show strong results. For example, there have been some instances where the drug replicated its earlier results, but there was a stronger-than-expected response from the placebo group, narrowing the difference that the drug made and making it appear less effective.

Phase II Takes Off and Fails in Phase III

There are many instances of stocks that have taken off during or after Phase II results, where investors made lots of money but then suffered losses when the drug failed in Phase III.

A few real world examples -- Medivation Inc. (Nasdaq: MDVN) investor did well despite a disastrous Phase III trial that resulted in the San Francisco company's stock plummeting.

Medivation had a drug for Alzheimer’s called Dimebon. The Phase II results were outstanding. They showed a slower deterioration and fewer side effects than the existing therapies, including Pfizer Inc.'s (NYSE: PFE) Aricept. Despite skeptics’ doubts, the New York company's stock ran in anticipation of Phase III results. If the data were strong and the drug was approved, it would likely be an immediate blockbuster.

After the stock doubled, I recommended that investors take profits off the table. Note that with small-cap biotech stocks that can plummet on one piece of news, investors should take their risk capital off the table once the stock has risen 100% or more.

So with investors now playing with the “house’s money,” after taking their initial investment back, it's time to wait for the Phase III results.

It turns out, the drug didn’t work. Pfizer's stock was crushed, but because investors sold half at a 100% profit, they still pocketed a 37% gain. Not bad for a failed drug.

If The Smart Money Leaves… Take Your Profits and Follow

There have been several other instances where something similar has occurred, including Delcath Systems Inc. (NASDAQ: DCTH) of New York, and MELA Sciences Inc. (NASDAQ: MELA), based in Irvington, N.Y. Although in these cases the Phase III trials were not deemed a failure, the FDA rejected the applications for approval until more questions are answered.

Lastly, after positive Phase II results, you sometimes see the early investors and the venture capitalists exit the position. They’ve made their money and don’t want to stick around for the risky Phase III. If the smart money is leaving, it may be a good idea to follow them out the door. At least with part of your investment.

There’s nothing wrong with hanging around and seeing if a small biotech company can get the ball across the goal line and get its drug approved. But considering that less than half of all drugs in Phase II actually make it to the market, it’s a smart idea to take profits along the way when you can.

Marc Lichtenfeld is a Senior Analyst at InvestmentU.com. See related articles by Marc here.