Within the first few months of 2008, shares of a billion-dollar biotech ran back and forth between $20 and $30… losing 50% one week only to pick it back up the next.

Biotech stocks are notoriously volatile, of course. But this company’s case was unique… At the heart of the price swings were two conflicting academic studies, which produced what I call the “ivory tower glitch.”

Believe it or not, academic researchers tucked away in labs and classrooms can cause quite a raucous on Wall Street. Ever hold a biotech stock that drops or jumps 15%-20% in one day with no news, press release, or conference presentations to explain it? Chances are, your stock just experienced an ivory tower glitch. And you’ll likely find the culprit in the pages of academic journals like Nature, Science, The New England Journal of Medicine, or their smaller counterparts.

You see, biotech and drug companies need academic researchers to perform “objective” third-party clinical trials or lab testing for new drugs. After all, it looks great to list collaborators from Johns Hopkins, Harvard, or Stanford on your company website. But every now and then, these academic studies can torpedo a drug stock.

That’s exactly what happened to shares of molecular diagnostic company Cepheid (CPHD) earlier this year…

Cepheid makes a test for the so-called MRSA “superbug” – a hardy bacterium that wreaks havoc in hospitals. MRSA infections can be fatal, and treatment runs about $40,000 for those patients who do survive. Hospitals use Cepheid’s rapid MRSA detection technology to screen incoming patients and prevent the spread of infection, saving themselves the expense of treatment.

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However, an academic study published March 12 in the Journal of the American Medical Association (aka JAMA) concluded such infection monitoring provides hospitals no economic benefit. Cepheid’s stock plummeted.

Then a few days later, another academic article, this time from the Annals of Internal Medicine, directly refuted the JAMA article, claiming hospitals could hugely reduce costs and disease with active MRSA surveillance. Again, Cepheid shares were on the move, this time to the upside.

While the turmoil whipsawed most shareholders, shrewd investors had a chance to cash in on this ivory tower glitch. Let me explain…

Not every academic study is created equal. The trick for investors is finding the studies that likely won’t stand up to a stiff breeze. Here’s what to look for…  

1) Motivations. I check to see who “sponsored” the study… In other words, who signed the check? If the people paying for the study directly benefit from positive results, take it with a shaker of salt.

2) Publication. Just as in the popular press, academic publishing has a pecking order of prestige. Nature and Science, for example, have clout like the Wall Street Journal. The American Journal of Physiology, on the other hand, garners the same amount of respect as The West Fargo Pioneer.

3) Study design. Did the clinical trial contain five patients or 5,000? (The more the better.) Did the investigators use placebo controls? (Double-blind placebo studies yield more valuable results.) Did they use practical procedures? (Look for studies that mimic real-world situations.)

In the JAMA article that slammed Cepheid’s stock, the study only tested patients after they’d been in the hospital for 12 hours. Cepheid’s technology screens patients and visitors as they walk through the door. Moreover, infected patients weren’t notified or treated until 22.5 hours after being admitted to the hospital. One critic said the JAMA study was like “testing a recipe, but omitting half the ingredients or test-driving a car without the tires.” So it didn’t pass the design test.

Investors who quickly realized the JAMA article wouldn’t hold up under scrutiny were able to pocket quick 30%-50% gains on Cepheid’s temporary setback.

The next time you see a stock fall after an ivory tower glitch, dig a little deeper and ask the questions above. Done correctly, it’s one of the best ways to make money in early stage medical stocks.

Good investing,

Rob