A Biotech Sector Primer

Biotechnology is one the strangest, scariest, sexiest and most interesting corners of the stock market. In how many other industries are companies striving literally to save lives? Any industry can host a stock that could potentially double, but what other industry can match biotechnology in the sheer number of stocks that could double if their companies' plans all come to fruition?

On the other hand, in how many other industries do companies burn through hundreds of millions of dollars, often with nothing to show for it? How many other industries rely on scientific mysteries that can be challenging to even highly qualified Ph.D.s? And how many other industries sport a warning label that reads "Caution: poor stock selection may cost you 90% of your initial investment?"

For all those reasons and more, biotechnology is a fascinating industry for investors to explore.

In a nutshell, biotechnology is an industry that focuses on novel drug development and clinical research aimed at treating diseases and medical conditions. Biotechnology companies are almost always unprofitable (some suggest that the distinction between "biotech" and "pharmaceutical" company lies in profitability), and many have no real revenue at all.

Biotechnology is also characterized by long development lead times; it can take as much as a decade to get a new drug from test tube to pharmacy shelf. What's more, there is an overwhelming likelihood of failure, as 85% to 95% of all prospective new drugs fail to reach approval. Still, for those that succeed, the rewards can be tremendous and "daily doubles" are not unheard of.

(For a background reading, see The Ups and Downs of Biotechnology.)

There is more than a little gray area between what is "biotech" and what is "pharmaceutical." Nevertheless, investors should keep a few general points in mind. From a philosophical standpoint, biotechnology is a risk-taking enterprise, while the pharmaceutical industry is about managing and diversifying risk.

As most biotechs have insignificant revenue, to say nothing of income, dividends are exceptionally rare in biotech. In contrast, dividends can comprise a significant part of the expected return from a pharmaceutical stock.

Many biotech companies make no pretense of marketing their own drugs, as they see their expertise being in research & development. By comparison, marketing and sales is the principal strength of many Big Pharma companies. As more and more pharmaceutical companies fire scientists and pull back from basic research, they increasingly become massive marketing machines that need an influx of new products from the biotech world.

The two industries also stand apart when it comes to valuation and business evaluation. Models and valuation derived from cash flow are quite relevant in assessing pharmaceutical stocks; while many analysts gamely attempt to construct discounted cash flow models for early-stage biotechs, the reality is that success is often quite binary ("drug works" or "drug doesn't work").

(For more, see Using DCF in Biotech Valuation.)

As the regulatory body that approves new drugs for the U.S. market, as well as permitting human clinical trials, the Food and Drug Administration (FDA) is the ultimate gatekeeper to every biotech firm. The FDA requires that all companies establish (to its satisfaction) that a potential new drug is safe and effective for its stated purpose.

Investors need to understand the FDA process and requirements. In order to get FDA approval, biotechs must establish a sufficient body of information that the drug is safe and effective. This is generally done through a series of at least three clinical trials (Phase One, Phase Two and Phase Three).

If these trials meet their goals of safety and efficacy (and these goals are typically made in consultation with the FDA), the company will file a formal request for approval called a New Drug Application (NDA). Upon receipt of a completed application (and a hefty filing fee), the FDA assigns a so-called PDUFA date, or the date by which the agency will issue a decision on the application.

The FDA then reviews the application and may convene a special panel of experts called an advisory committee. These committees review the application and issue an opinion as to whether the FDA should (or should not) approve the drug based on the information that is currently available.

The FDA then evaluates the panel's responses and makes its decision. The FDA will either grant approval and allow the company to market the drug or it will issue a complete response letter (CRL). A CRL is tantamount to a rejection, though it does highlight the FDA's concerns and allows the company to collect more data with the option to reapply later.

Biotech investors also cannot overlook the importance of understanding the FDA's "mood" at any given point in time. When the FDA is in a conservative posture, safety and clean data becomes paramount and equivocal drugs often are rejected. When the FDA is in a more liberal posture, some of these rules are not applied as rigorously and drugs with a somewhat dicier risk-benefit profile often make it to market, particularly those drugs meant for diseases with few other treatment options.

(Learn more about the FDA's impact on pharmaceuticals, check out Pharmaceutical Sector: Does the FDA Help or Harm?)

When considering a potential biotechnology investment, there are several additional factors to keep in mind:

The Pipeline

A biotech's pipeline is everything, and it is the source of the company's presumed and projected value. Generally speaking, investors should try to focus their attention on companies with multiple Phase 2 programs (that is, multiple drugs in Phase 2 testing, not a single drug in multiple Phase 2 studies). It is true that single-product biotechs can be big winners when they succeed, but the reverse is also true – they can suffer crushing losses if that one and only product candidate fails.

Not All Diseases Are Equally Valuable

Some diseases are huge potential markets, but have ample competition and strict expectations for safety or performance. For instance, while cancer and arthritis are major diseases with multi-billion dollar potential, there are numerous drugs already approved and available – if new drugs do not offer something novel (better efficacy, fewer side-effects, etc.), they may not even get approved, let alone find a large market.

On the other hand, less-common diseases can represent bigger opportunities than people realize. So called "orphan drugs" target diseases that affect fewer than 200,000 people, but consider that getting just 20,000 users of a drug costing $50,000 a year (not a bad price for a life-saving drug) means a billion-dollar revenue opportunity. What's more, companies developing orphan drugs are given some additional assistance in the form of market exclusivity and less stringent trial enrollment targets.

As a result, almost any disease target can pay off with the right drug. Few people had even thought of restless leg syndrome as a disease, but drugs sold for this syndrome have done well. Likewise, there is a drug on the market with the sole stated purpose of making eyelashes grow longer, which shows that one can never completely dismiss an idea.

That said, investors should be careful with companies looking to crack certain diseases. Countless companies have tried and failed miserably to develop effective drugs for sepsis, Alzheimer's and obesity. While there will eventually be successes here, and the rewards will be great, there will likely be devastating failures as well, and the odds are not in the investor's favor.

(For more, see What Does it Mean to Have Orphan Drug Status?)

Corporate Philosophy

Investors also need to understand the objectives and goals of company management. Many biotechs intend to develop their drugs only so far on their own and then basically trade them to a larger drug company in exchange for upfront cash and future royalties. Other companies, though, keep the marketing rights to themselves and build out their own sales force. Ultimately, these seem to be the companies that build the most value for shareholders, but it's a riskier path.

Keep in mind, too, that it is not necessarily an all-or-nothing decision. Biotech companies can choose to co-promote a drug with a larger partner, and may opt to do so as a way of building an internal sales force without completely sacrificing the cash flow that can come from royalties.

Capital Structure and Financing Options

Biotechs burn through money. That's just a basic fact. It's also a basic fact of life that clinical trials cost a great deal of money (always at least tens of millions of dollars and often hundreds of millions). Investors, then, should strive to find companies that are well-funded for their near-term clinical needs.

In essence, it's always good to let other investors take the dilution, but that is admittedly not always an option. Companies will often wait to raise money until they have good news to announce and can sell shares at the higher post-announcement prices. Waiting too long exposes investors to the risk of missing those "good news pops" that make up most of the gains in biotech investing.

A full how-to covering biotech investing could easily run into tens of thousands of words, but hopefully this is a good start for many investors new to the world of biotechnology. Make no mistake, biotech investing is a very risky endeavor and failures will outnumber successes. That said, with patience, research and attention to detail, it is entirely possible for investors to find the winners that will more than pay for the occasional losers.

(For more, see the tutorial The Industry Handbook - Biotechnology.)