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Biotechnology companies engage in the research, development, manufacturing, and distribution of products, services, and processes that involve modifying living organisms for specific human purposes in the fields of healthcare, pharmaceuticals, and agriculture, among others. Such processes include, but are not limited to, recombinant DNA technology (or cloning), molecular biology, genetic engineering, and gene therapy.

The research and development costs of bringing products and services to market are substantial, and there is no guarantee that a company will ultimately prove successful. Many times, current R&D spending and other operating costs at biotech firms can far outweigh the cash being generated from past efforts, and, therefore, quarterly losses are commonplace. In fact, of the 20 biotech names Value Line covers, only 50% recorded positive earnings in their latest reporting period.

These stocks are also known for their poor Earnings Predictability. Biotech investors are notoriously unforgiving of setbacks in the process of getting products or services to market. Even the slightest negative news can be severely punished, causing once high-flying stocks to trade at rock-bottom valuations. Despite the propensity for investors in this market to overreact, sometimes their responses to unfavorable developments are warranted, so it is always necessary to investigate developments thoroughly before investing. When good news does come about, investors pile in on aspirations of a promising product eventually yielding massive returns.

Due to the difficult-to-comprehend nature of biotech companies’ work, predicting their future success or failure can be quite difficult. Fortunately, there are some key characteristics to look for when analyzing these volatile equities.

One such measure is how many products the company currently has in the pipeline. Clearly, a company making a huge bet on one product is going to be far less stable than one that is older, more established, and already has proven products in the market.

Determining where funding originates is also important. If a biotech firm is small and has few cash reserves it can gain funding from a larger, more established healthcare partner firm or venture capital outfit. However, recently, more and more venture capital firms have curbed contributions in favor of more lucrative tech startups. Also, many large pharmaceutical companies facing their own financial difficulties have been choosing to reward their smaller biotech partners with funding as progress is made, instead of large up front lump sums.

In addition to cash reserves and funding opportunities, it is also important to consider a company’s debt load. Those firms with little indebtedness can more easily contend with cash burn while they make progress toward profitability.

Finally, it is important to consider how far along products are in the FDA approval process. Even if a product is in advanced stages, there is no guarantee that it will ultimately be approved, especially since the FDA has become more conservative and restrictive in recent years.

For this screen, we have chosen to focus on companies in the Biotechnology Industry with average projected price-appreciation potential in excess of 120% over the next three to five years. Of the 20 biotech names covered by Value Line, only five met this criterion, three of which are highlighted below. Indeed, long-term investors would be prudent to consider share of Incyte Corporation (INCY), Senomyx, Inc. (SNMX), and Exelixis, Inc. (EXEL).

Incyte Corporation

Incyte Corporation, formerly Incyte Pharmaceuticals, is a drug discovery company focused on the development of novel, small molecule drugs to treat severe medical conditions. (Discovery research firms are companies that may not have a drug in development or a product of any type, but instead offer drug discovery “services” to other companies, such as contract research. Incyte operates in genomics (the field of mapping and sequencing the human genome) and proteomics (the study of identifying disease-specific proteins). It uses an integrated platform of information technologies to characterize the genetic material in humans. The company’s experienced management, along with its discovery, clinical development, and commercial teams, have an extensive history of bringing new drugs to market. Incyte is located in Wilmington, Delaware and has about 250 employees.

Much of Incyte's prospects for obtaining profitability rest heavily on their JAK inhibitor: Jakafi (ruxolitinib). Ruxolitinib is a drug used to treat intermediate to high-risk myelofibrosis, a type of bone marrow cancer. Phase III trials showed significant benefits by reducing average spleen size and relieving many debilitating symptoms patients faced. Trials are also being conducted to test the effectiveness of this drug on other types of cancer, potentially increasing sales and earnings. In November of 2011, the FDA approved the drug for the uses detailed above.

Although Incyte Corporation is not a small company by any means ($2.1 billion market cap), investors should take comfort in the fact that the company is in a joint venture to produce this drug with healthcare giant Novartis (NVS). In addition to the added financial stability, this relationship could result in a significant catalyst in the coming quarters. Incyte only owns the rights to the new drug in the United States, with Novartis owning the rest. If Ruxolitinib becomes successful, Novartis may attempt a takeover of Incyte, providing investors with a healthy premium.

Senomyx Inc.

Senomyx was founded in 1998 by renowned biochemist Lubery Stryer to utilize proprietary receptor-based technology to develop new flavors and flavor enhancers for the packaged food and beverage industries. Through the process of reverse engineering, the company claims to have created artificial human receptors that react to tastes and aroma. Its compounds are regulated by a government-authorized panel of independent scientists in the Flavor and Extraction Manufacturers Association (FEMA) and must be deemed generally recognized as safe.

One of the newer innovations that Senomyx is currently working on is the Cool Flavor Program, an effort which seeks to enhance the menthol cooling sensation provided by mints. The company does this by identifying certain receptors in the mouth responsible for such feelings and targeting them.

Value Line analyst Nira Mharaj believes that these shares have the potential to more than double in the next three to five years. Given that Senomyx's additives may be able to replace certain sugars and fats with detrimental effects to the human body, it could enter multiple markets related to drinks and foods. “With the help of Senomyx’s compound discoveries, many food and beverage companies would be able to improve the nutritional profiles of their respective portfolios” says Ms. Maharaj.

Exelixis, Inc.

Exelixis is a genomics-based company located in South San Francisco, California focused on pharmaceutical development through comparative genomics and model system genetics. Its proprietary model systems and comparative genomics technologies address gene function and the proteins they encode. Its lead compound, XL184 (cabozantinib), is currently in a number of clinical trials for various types of cancers. The lists includes prostate, ovarian, brain, skin (melanoma), breast, and kidney.

The facts about these shares are clear. The company is very small with a lot of risk. Even in the long-term, Ms. Maharaj does not believe Exelixis will achieve positive earnings. But cancer research is, in many respects, a free for all. The first company to make significant progress toward a treatment could reward its investors with ample returns. But as Ms. Maharaj says, “commercial success is not a given, thus the risk/reward scenario is particularly significant here.”

At the time of this article's writing, the author did not have positions in any of the companies mentioned.