How to Find the Top Biotech Stocks to Buy in Three Steps By Kyle Anderson

For investors new to the healthcare field, finding the top biotech stocks to buy among the hundreds of pharmaceutical, healthcare, and drug companies on the market can seem overwhelming.

But the process can actually be quite simple when broken down into a three-step approach.

Money Morning's BioScience Investment Specialist Ernie Tremblay has more than 20 years of experience studying and analyzing the biotech market, and when he's picking biotech stocks to buy, he looks for the same three signs every time. His step-by-step process filters out the riskier bets and focuses on the sector's most promising plays - like the one that soared 75% in just seven days in April.

Here's how.

The first thing Tremblay stresses is the importance of a company's pipeline. Having many promising drugs in trials means that if one drug doesn't reach FDA approval the entire company isn't at risk.

"Having a deep pipeline is like having depth on a football team - if your first-string player doesn't work out, you've always got a few backups to take his place," Tremblay said. "Likewise, if one drug doesn't make it to market, it's great to have another one right behind it to pick up the slack."

But a strong drug pipeline isn't the only thing to consider when buying biotech stocks. There are two more criteria a top biotech stock must meet. And according to Tremblay, this second one is the most important factor of the three...

It sounds obvious, but investing in a company that develops safe and effective drugs is vital. Many investors hear about an experimental drug - one that could eradicate a terrible illness - and invest a fortune, only to find out that the drug is either not effective, or has harmful side effects.

"By far, the most important variable to consider when you're looking at a young biotech is the quality of its lead drug candidates," Tremblay said. "And you need ask only two questions in making that consideration: is the drug safe, and is it effective?"

But how does the layman determine whether a drug is safe and effective without a degree in a medical field?

Here's where investors need to do their homework. Look into clinical trial results to see how the drug has been performing in tests. Companies will also periodically release data on drugs they are testing, so be sure to stay current on any new information.

Tremblay used Omeros Corp. (Nasdaq: OMER) as an example back in March.

"Omeros has an interesting and efficient way of approaching both questions: It leverages FDA-approved generic drugs into proprietary (patentable) formulations," he said. "This takes a lot of the guesswork out of drug development, especially where safety is concerned. If two ingredients have already been approved individually as safe, the only thing you have to prove is that using them together doesn't raise your risk for some unexpected side effect."

Finally, before buying into a biotech stock, you'll want to investigate the company's cash situation...

Because young biotech companies can have small sales totals, they often depend on investors and loans to keep them afloat while they develop drugs. Therefore, you need to look at a different set of financial figures than those of more traditional companies...

"One indicator that is vitally important is burn rate, or negative cash flow," Tremblay said. "This number can help you determine how long the company can operate with current cash on hand."

"To calculate burn rate, first go to the company's stock page on Yahoo! Finance, and click on 'Cash Flow' at the bottom of the left-hand column. Then click on 'Quarterly Data' and find two numbers: Total Cash Flow from Operating Activities and Capital Expenditures. Add them together, and then divide by 3 to get a number that represents monthly outflow."

"Now go to the left-hand column again and click on 'Balance Sheet.' Again, click on 'Quarterly Data,' and add 'Cash and Cash Equivalents' to 'Short Term Investments.'"

"Divide that number by the monthly outflow number. The answer will tell you how many months the company can continue to operate out of current cash reserves, as of the last date reported."

What to Read Next: Ernie Tremblay has found a biotech stock with breakout potential. It's already soared 700%, but still has room to run. And thanks to a recent media blunder, it's trading at a discounted price right now...