An Article by The Daily Crux, interviewing Alex Daley of Casey's Research

Wouldn't it be great if there were a sector where you have the edge over theGoldman Sachs of the world?

A market where small players can outmaneuver the big guys - and where having knowledge of that market gives you a distinct advantage over day traders?

Such a market exists - biotechnology. Small and mid-cap biotech firms don't get a lot of close coverage by analysts, so with the right expertise it's possible to beat the masses to the early profits.

Our colleague, Alex Daley, the chief technology strategist for Casey Research and senior editor for Casey's Extraordinary Technology, recently sat down with The Daily Crux to reveal valuable insights on investing in this explosive sector:

• Why biotech is offering hope to millions of chronically ill people - and serious profits for bold investors
• Why nine out of 10 biotech therapies are destined for the trash heap - and how to improve your odds of investing in the winners
• Key factors you need to know when evaluating biotech stocks
• ...and much more.

When Alex talks technology, smart investors listen - he's worked with Microsoft, Facebook, MySpace and many other household-name tech firms, as well as renowned research universities like MIT and Harvard.

He's also been a featured guest on CNN, CNBC, BBC and other major media.

So grab a cup of coffee and discover some of Alex's strategies for uncovering profitable biotech stocks.

The Daily Crux: Alex, for readers who aren't familiar with your letter, Casey's Extraordinary Technology, can you touch on what you do?

Alex Daley: Well, like the name says, we cater to extraordinary technology. We're focused across the tech sector, on everything from semiconductors, to internet stocks, to biotechnology, across the globe from the U.S. to China, India, and other markets.

We're opportunistic investors. We're looking for early- to mid-stage, high-growth technology companies... companies that can post 40%, 50%, 100%, or 200% revenue growth, year over year. The global macroeconomic situation is of far less concern to companies like this... It often presents them with unique opportunities, because they are generally reinventing a market or creating an entirely new one.

Crux: We understand you're especially bullish on biotech right now. Why is that?

Daley: There are several reasons we like biotechnology right now.

Number one, the industry is maturing. Over the last decade - since the completion of the human genome project in the year 2000 - our understanding of genetics and our ability to manipulate and work with genetics has increased exponentially. We are on the verge of what I would call a revolution in medicine.

There will be a change over the next decade or so where the majority of true blockbuster drugs on the market will be biologically based. They will be large-molecule, protein-centric, or even genetic therapies, whereas today the pharmaceuticals industry is dominated by small molecule chemicals... The drugs we're used to seeing today range from statins to Viagra to NSAIDs.

These new drugs are inherently different. They are targeting the biological processes that go on within our body and attempting to manipulate or stop those processes, using the same basic building blocks that underpin biology itself - proteins are the stuff life is made of.

So there's the potential to treat a whole range of diseases where we currently only treat the symptoms or can't treat at all. There is truly a revolution going on in biotechnology right now. For the first time, the majority of new drug candidates are seeking FDA approval are now biotech.

Where we are right now with biotech is similar to where we were in the 1950s and 60s with basic pharmaceuticals - there were huge advancements made in drugs during that period which helped extend life expectancy and improve quality of life for hundreds of millions of people. We believe the next 20 years will be more revolutionary for global health than that 20-year period.

Another reason is demographics, which are working in the favor of investing in health care in general, and biotech specifically. Simply put, the world's population is aging. This is not a uniquely U.S. problem of the Baby Boomers aging and spending an increasingly large amount of their money on health care, more and more of GDP being devoted to keeping people healthy, or however you want to look at it.

This also includes Japan... much of the European Union... even India and China are having similar demographic shifts. In fact, it looks like India may be first. They have the largest aging population out there. Japan will follow, then the U.S., China, and Europe, shortly thereafter.

Within the next 25 years, more than 30% of many populations across the world will be seniors... and the basic economics of being a senior is that an increasingly large percentage of personal spending goes towards medical care. So that works in favor, of course, of continued investment within the medical field.

This also extends to the growing middle class around the developing world. From Brazil to China to India to Russia, a huge new middle class is emerging globally that will demand better healthcare... or any at all, as many of the world's poor have near zero modern care available to them today.

The reason we like biotechnology companies over hospitals and things like that, is it's a sector that is information-driven. So the margins for successful companies are potentially huge. We're not talking about companies with huge expenses in real estate and personnel that scale inline with revenue and are always going to have them operating at razor-thin margins. Biotechnology companies tend to have large upfront costs in research and development, but once in market, their costs can grow much more slowly than revenue and profitability can benefit from economies of scale.

What we're really looking at is a vibrant global marketplace where there's demand for anybody who can cure an incurable disease or treat something that creates a very low quality of life. If a company can raise the quality of life for any group out there in the world, no matter the demographics, there's a market for that. Add in the current changes in world demographics, there's an incredibly large market for a number of these different therapies.

Biotech is also one of the few sectors left out there where a small individual investor can still have a decided advantage over institutional investors.

A lot of the companies tend to be small to mid-cap stocks. They don't have a lot of close coverage by analysts, so it's possible to obtain a great information advantage by taking the time to dig deep into the clinical research, understanding the value of the drug or treatment, and really getting to know the management team and how well they grasp the market.

It's a really interesting funding environment as well. In addition to there being numerous companies with huge potential but not a lot of coverage yet, you also have companies that need to raise large amounts of capital... So this is one of the few sectors left in the U.S. that really has the incentive at the very early stages to turn to public markets. And there are a couple reasons why they've turned to public markets in particular, whereas many other companies would stay with venture capital or private funding.

First is the size, as I just mentioned... the amounts of money they have to raise. It's not uncommon for it to require anywhere between $500 million to $1 billion in order to bring a new drug to market. This is due to the huge regulatory hurdles these companies face globally, as well as the huge cost of being able to build the research pipeline necessary to build on that first success.

There are very few biotech companies that would actually be able to produce a good return for investors off a single drug. That requires a drug of blockbuster proportions... And the fact is, maybe one in 200 or 300 drugs ever actually becomes a true blockbuster with billion-dollar per year sales.

On the other hand, if a company can find a treatment that addresses multiple markets, or find multiple treatments to address multiple markets, then it's got the potential to make an incredible return for investors and become the next Genentech or Amgen. That's really what most of these companies starting with a single drug are aiming to do. But in order to raise that kind of money - $500 million or $1 billion over the course of a couple years' time - the public market is really the only place to go. The scale is simply too large for most venture investors.

Second is risk. It's increasingly being recognized that the rate at which these drugs are approved is dropping. It's dropped from where about one in seven therapies submitted to the FDA make it to approval in the U.S., down to about one in 10, as of the end of 2010. You're in a position where there are these billion-dollar gauntlets to get through, yet just one out of every 10 of those is actually going to make a drug that gets marketing approval. As a result, venture investors, even large bio-firms, are looking to spread the risk as best they can, across as many different therapies as possible. In order to do that, you need a lot more investors at the table.

So you have companies like Eli Lilly that recently announced that it was going to be inviting venture capital investors into its own internal research and development process. This means they're willing to give a share of future drug benefits from the items currently in R&D to external investors, because that will enable them to spread their capital across a much larger number of therapies. So you're seeing companies begin to bring in 30%, 50%, or even 80% external investment into the R&D process.

In the same way, companies on the public exchanges are able to spread that risk across a larger number of investors, which in turn gives those investors a chance to invest in a large number of therapies, and hopefully increase their chances of finding that one blockbuster drug - the one return that will make up for a number of potential losses.

Crux: What do you look for when selecting biotech stocks with huge potential?

Daley: That's really a question of investing style and what kind of companies best match that risk tolerance and reward threshold. There are hundreds of public biotech companies and thousands of private ones... So there's a huge number of companies that an investor can choose to put his or her money behind.

What we look for in particular to make a great biotech stock for our portfolio is a company that's going to give us a huge potential return, where the risk-to-reward ratio is going to be tipped so heavily toward the reward side that potential returns will more than make up for the risk that comes with it.

When it comes to companies with single therapies, we don't like to dive into early-stage companies, where the therapies haven't even been tried. We like to watch these companies as they move through the clinical trial gauntlet and get through what's referred to as Phase 1 clinical trials.

These are really early stage, small-group trials to ensure a particular therapy isn't accidentally killing people, doesn't have some horrific side effect, and generally looks to be effective. Many therapies can look effective in a laboratory, but when you actually try to use these treatments on human beings, any number of potential problems can occur.

Instead, we generally like to look for mid-stage companies that are approaching or exiting Phase 2, and are starting to ramp up the size and scale of their trials. In these cases there's often some confidence that the therapy could in fact be a blockbuster. At that point, we work very closely with the companies to understand the technology and its long-term implications.

So those are the kinds of companies we look for when we're looking at companies that have a single therapy... a potential, brand-new biotech company with hopefully something a little more than a one-hit wonder... a real blockbuster.

I'll give you a company that was in the news recently that falls in this category. A company IPO'd about this time last year called Aveo Pharmaceuticals. AVEO is its ticker symbol.

The company was trading as low as $6 about this time last year, but has recently jumped by over 100%. The reason Aveo is so interesting is that it has a potential treatment for cancer that looks to be far less toxic and far more effective than traditional chemotherapy. Even more interesting about Aveo is its potential therapy targets a specific pathway that's common in a number of different types of cancer.

Instead of just zapping a tumor through radiation, it's working at a genetic level, and disrupting a core function of the cancer cell. So if this technique works, it will potentially work not just for one specific type of cancer, but for a number of them.

The company is progressing very quickly through its clinical trial process, and it's been showing very positive results. Investors have been piling into the stock and we're seeing more institutional buying, as it becomes clear they have a potential blockbuster set of drugs.

So this is a good example of the type of company you want to look for in this area... You're looking for a therapy with broad implications and applications, and a company that has some proven results, the lack of side effects, the lack of toxicity, etc.

Our portfolio has another company in a very similar space, just a few months behind AVEO in terms of proof and timing. However, we've looked at the data and their particular approach looks to be more effective and more broadly applicable. I can't give you the name of that stock just now, as it is a new pick for our subscribers, but it is one we are excited about on both the short- and long-term horizons.

These kinds of companies are basically a "swing for the fences" type of investment... they're a home run or a strike out. If you're going to invest this way, you really need to have a good technical understanding of which therapies are likely to be successful and which ones aren't, and there's always a large amount of risk in that.

There's another way to approach the market, which is a little bit different but still involves individual stocks. This involves looking for companies that are enabling a new category of therapies. Not just an individual drug but an entirely new technique. There are a lot of new techniques in biotech these days as we get a better understanding of basic genetics and how we may be able to interfere with or manipulate the genetic process to benefit patients.

One of the more promising areas - one that's gone through a large period of hype and has now reached its realism phase - is RNA interference, or RNAi. A few years back, everybody was talking about RNAi being the next big therapy. It had its moment in the sun where there were 100 different companies all working in RNAi - it went through the unrealistic hype phase and is now getting down to brass tacks with a handful of much more obvious front-runners much closer to putting real therapies out to market.

After over a decade of progression from the lab to trials, today we're finally seeing real RNAi results in humans that allow us to treat certain genetic conditions and cure people of diseases that were otherwise completely untreatable prior to now. They are being successfully delivered, they are temporary and reversible unlike prior generations of genetic therapies that did not work nearly as well, and they are steadily marching toward market. But it's still not clear who the specific winners are going to be.

We do have one company in our portfolio that we believe is going to be a major winner, and that has probably done more than any other to advance individual RNAi therapies and has really proven that they work in human beings.

But what's more interesting is that company, as well as the overwhelming majority of other RNAi companies, licenses a platform from another company called Isis Pharmaceuticals. Isis provides the basic fundamental research tools these other biotechnology companies need to discover these potential RNA based treatments, yet it also has its own interesting long-term R&D pipeline.

Even if Isis' own therapies don't pan out, they continue to be a main supplier for the RNAi space. So if virtually any of the other RNAi companies are successful, Isis has the patents and the technology to be able to benefit from that success.

We really like these types of platform plays... companies where if even one out of 100 customers is able to turn out a blockbuster therapy, the company enabling their research and providing the intellectual property to allow them to bring this to market, will benefit through licensing, royalties, supplying equipment, and supplying research knowledge.

Crux: That sounds very much like the idea of "picks and shovels" plays in the resource world... the idea that it's often more profitable to buy the companies that provide mining or drilling equipment and supplies than it is to buy the actual miners.

Daley: It's precisely like that. Over the last few months, for example, many people have made a great deal of money investing in companies like National Oilwell Varco, which was a strong mid-cap pick in the energy sector that supplies drilling rigs. When exploration increases like it has recently, companies like this see a commensurate increase in business... but with absolutely none of the exploration risk.

It's the same story in the biotech sector. If you can find a company that provides a base platform with these virtual "picks and shovels," as you said, you've found an interesting company that can benefit no matter which company is ultimately successful in the space, so long as the space itself is growing - and with RNAi, it most certainly holds that promise.

Crux: Can you recommend some low-risk buying strategies for the sector?

Daley: Well, the biotech sector is a bit different that other speculative sectors. Most speculative investors are used to working in thinly traded markets where there are few buyers, few sellers, and a very small piece of news can significantly move a stock.

As U.S. stocks go, some biotechs are as thinly traded as they come. So one really bad piece of news can create a significant drop, or one really good piece of news can create very significant upside. It's not uncommon to see these stocks move 30% up or down in a week, or even in a day, and moves of 100% or more aren't out of the question, either.

But you need to remember that these stocks are generally traded on the U.S. markets... so the volume on these stocks is significantly higher than when you're talking about the junior resource sector for example.

We talked about Isis Pharmaceuticals earlier. Isis is nearly a $1 billion market cap company and its average volume for the past year is about 660,000 shares per day. So this is not an extremely thinly traded stock where you have to watch your buy and sell patterns. But of course it does make a lot of sense to protect yourself from wild movements by using limit orders, appropriate position sizing, and being sure not to dump every dime you have into one potential stock because you've been told, "Hey, they're going to cure cancer."

Like I mentioned before, the reality with biotech is there's a one out of 10 chance that your company is going to make it to market. And even if it makes it to market with its therapy, you're still dependent on a number of things going right.

You're dependent on the lawyers and CEO having negotiated a really good royalty and distribution agreement with a large pharmaceutical partner. If you're a small company and you're going into business with a Roche or a GlaxoSmithKline, you're working against an army of lawyers with decades of experience in creating royalty licensing agreements. Sure, there might be a billion-dollar agreement signed in front of you, but the milestones required to get there might be difficult.

You also need to be confident the management team you've chosen has the wherewithal to negotiate a really good deal with the distribution partner. Or if they're going to go with their own - which is rare, but certainly a possibility for a company with a true blockbuster - you want to make sure management has the knowledge and experience to build that team and create that global distribution network.

Beyond that, even if you have a drug on the market, there's no guarantee of profitability. Any number of things could go wrong. You could have unexpected side effects, for instance, that mire you in support or legal costs. Or you could simply have failure of management to run the company well.

Many times you see companies that would be profitable if they just sold the drug or treatment they've developed. But instead they sink increasingly large amounts of capital back into R&D in order to find that next big therapy and often have little to show for it. These companies would likely be far more profitable if all they did was milk the one therapy they have in market and try to maximize shareholder value.

So the idea is to find a company that's going to maximize shareholder value with a successful drug. You want to find a company that has the potential for these large upside returns based on profitability, not just gross revenue.

As far as specific trading strategies, really it's about finding the right company, and following your basic buying and selling rules... just being smart about not letting market volatility affect the price at which you enter or exit.

Crux: Valuing these early-stage biotech companies can be trickier than it is for the average operating company. How do you evaluate these stocks?

Daley: There are a number of different frameworks we look at to value biotech companies. It all depends on whether they're a multi-therapy company, a single-therapy company, or a platform and tools provider.

There's also the obvious exception of companies that are in less regulated spaces. For example, when we're going to evaluate a company that's doing genetic testing as opposed to genetic therapies, these tests don't have to go through the FDA for approval, and thus those companies have very different cost structures, and very different time-to-market considerations.

Generally we look at the potential market size of the therapy in question and weigh that against the therapy's chances of success, which we try to handicap based on extensive data we've collected over the years.

Success is largely dependent on things like study sizes, which therapeutic area it's in, potential competitors already in market and in the pipeline, and whether or not it's in an orphan market - where there are no current therapies for whatever disease they're targeting.

What we're looking for is situations where the scales are tipped in our favor. To greatly simplify what typically takes us weeks to months of number crunching and interviews to assess - we're looking for that stock trading at a discount to the net present value of its future therapies, adjusted for risk.

Crux: Sounds good. Any parting thoughts?

Daley: Anyone who's thinking about investing in biotechnology needs to be aware that there are a lot of therapies that sound great on paper, but when you really dig into the science behind them, you find that companies have not established them as safe or effective, and it can take years, sometimes decades, to a move a therapy forward.

Unless you have a couple PhDs under your belt - and sometimes even then - you generally need to look for advisors to provide you with some real understanding of the science and the likelihood that a treatment can make it to market before you invest.

Also, spread your bets. It's not a sector that's well-suited for index investing, because such a large percentage of the companies won't succeed. When you buy an index, especially one that isn't market-cap weighted, you're getting those nine or more losers for every winner, and it's guaranteed to limit your returns. On the other hand, if you spread your bets across a number of smart speculations, you're much more likely to see significant returns, and still manage your risks effectively in what is otherwise a speculative market.

Finally, it's important to remember this industry tends to move in fits and starts. Everybody talks about the potential of this or that treatment, of how every disease in the world is going to be cured within five years, etc. But then reality sets in.

It's a very, very complicated business dealing with things we still don't understand completely. We're still discovering things about genetics today that are changing the basic models of how we think the human body works, how evolution works, and these kinds of things. It's sort of like trying to change the wheels on a train that's moving... It's complicated, and it can take a long time, if you're going to avoid disaster.

That's why we try to focus on companies that are proving new science.

The founder of one of our RNAi portfolio picks won the Nobel Prize for his work in 1993, and didn't found the company until almost another decade of research. It's now 2011 and they still have nothing to market yet. And they still probably have another three to five years to go, assuming no big bumps in the road. Talk about an industry that's slow burning. Can you imagine if it took a junior resource company 20 years to start pumping oil from a discovery deposit?

The difference here is every one of these is a potential billion-dollar market. If this particular RNAi company is successful for instance, it could conceivably be the size of Amgen down the road. Isis, the "picks and shovels" company I mentioned earlier, has been public for two decades and it's only recently started to look like an interesting stock.

So this industry moves a lot slower than many people realize. You can read all the Kurzweil books you want - and don't get me wrong, I love his stuff - but if there is such a thing as a singularity, it's probably about 1,000 years away, not 20.

Crux: Thanks for talking with us, Alex.

Daley: My pleasure. Thanks for having me.

*Editor's Note: For a limited time, you can access an exclusive report from Casey Research, The Three Best Biotech Stocks to Own in 2011, at zero risk. To learn more, click here.