When it comes to investing in young and unproven biotech stocks, you want to look for a few key characteristics. First, the company should be targeting a market for which current treatments are less than ideal. Second, this potential market should be fairly large in size and scope. And third, you want to focus on companies that have already established compelling, robust results in clinical testing trials.

New Jersey-based Insmed (INSM) checks all those boxes. Better still, a clear imminent catalyst exists to send this stock to fresh highs. With a market cap of roughly $350 million, Insmed qualifies as a small cap, but it is hardly a well-kept secret. But with a few good breaks on the regulatory front, this company's market value could easily -- and quickly -- tack on millions more. Notably, the stock has slumped more than 20% since hitting a new 52-week high in late May, providing a fresh entry point.

Clearing the Passageways

Insmed has developed Arikace, which is an inhalable antibiotic that brings medicine right to areas where lungs are infected. Arikace is currently in Phase III trials for patients with cystic fibrosis (CF), and in Phase II for patients with non-tuberculosis mycobacteria (NTM) lung infections.

The patented eFlow Electronic Nebulizer is a hand-held device that allows patients to easily inhale the drug amikacin, which is already approved and effective, and therefore unlikely to raise safety concerns with the FDA. In fact, thus far in clinical testing, patients using Arikace have experienced no notable side effects.

The distinction here is Arikace's fast-acting and accurate form of delivery. Another drug, Tobramycin, also utilizes amikacin, but a formulation developed by Novartis (NVS) has proven to have limited efficacy and sometimes must be taken several times a day by the patient to ensure that the drug is delivered. In contrast, Arikace is formulated to penetrate into the infection, and not merely reside on its surface, thanks to a unique system of layered lipids surrounding amikacin.

Although cystic fibrosis treatments exist, Insmed has a chance to take significant market share if Arikace is approved. That market is roughly $400 million annually. Yet it's the other indication, for NTM lung infections, that you also need to track, as there are currently no solutions on the market to treat this ailment. Every year, 50,000 new cases of NTM lung infection are diagnosed, and patients often suffer recurrences that can eventually be fatal. Look for top-line data on this Phase II testing by the end of 2013.

In a bid to accelerate its approval, the FDA recently gave Arikace "orphan drug" status for NTM infections. (The company hopes to get a similar designation in the EU.) Orphan drug designation provides certain exclusivity benefits, tax credits for research and a waiver of the New Drug Application user fee.

Looking at just these two indications (CF and NTM lung infections), Insmed may be looking at $600 million in annual revenues by 2020, according to analysts at Lazard Capital, who gave the stock a $20 price target.

Upcoming CF Data

Circling back to the Phase III tests for the treatment of cystic fibrosis, investors are expecting Insmed to release preliminary data at some point in the next few weeks.

"It is our intention to release the complete dataset at a scientific or medial conference and hope to have it published in a peer review journal," noted company President Will Lewis on a call with analysts in early May.

If the CF data are as positive as many suspect, then this stock should get an instant pop to the upper teens. A move to $18 represents almost 60% upside from current levels, and looking beyond this catalyst, further upside surely remains.

Analysts generally have price targets in the upper teens and low $20s, though that price accommodates for the possibility of an FDA rejection.

For example, UBS analyst Matthew Harrison gave the stock a slightly lower $17.50 price target, but said, "We see a positive CF study as the major catalyst with positive data potentially pushing the stock into the $20s." More specifically, Harrison said he sees this stock going to $25 if "both the CF and NTM trials are positive; and NTM is able to achieve early approval."

Recommended Trade Setup:

-- Buy INSM up to $13
-- Set stop-loss at $10
-- Set initial price target at $18 for a potential 38% gain in three months

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