David Sterman

The appeal of finding the right biotech stock is self-evident. If you get it right, and a cutting-edge biotech scores a major win with a breakthrough drug treatment, then you can score huge gains.

Last month, I reviewed my performance over the course of 2011 in hopes of gleaning important new lessons for the coming year. Chief among those lessons: avoid companies that will need fresh injections of capital to keep afloat. I singled out the biotech sector, which not only faces the prospect of an uncertain economic environment in which to raise money, but is headed by executives who are simply clueless about how Wall Street works. So many biotech stocks waited far too long to raise money that their shares have fallen 50% or even 75% in the past year on fears of a liquidity crunch by the time they finally raised needed funds. The dilution for these firms has been stunning.

The current year should bring more of the same. Many of these companies raised about a years' worth of fresh capital in 2011 and will need to reload the balance sheet once again in 2012 -- at likely depressed levels, implying even more painful dilution.

Sadly, for every biotech stock that takes off sharply, another half-dozen plunge to new lows because of nature of these cash-constrained business models.

Instead, it seems far wiser to simply own a basket of biotech stocks in order to gain exposure to this still-promising sector. This limits upside when compared with the potential of a single high-flying biotech company, but also greatly reduces risk.

Let's take a look at a few options.

David Sterman

David Sterman has worked as an investment analyst for nearly two decades. He is currently an analyst for StreetAuthority.com

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