A Quick Guide To Biotech Stocks
Equities are not all the same thing. Even beginning investors know that they’re broken up into categories based on industry or sector of the economy the company participates in. Building a portfolio by mixing up economic sectors is one of the most basic tenets of diversification, but knowing what sectors to invest in isn’t so easy.
One of the most promising sectors right now is biotechnology. Advances in medicine are happening on a daily basis and money is pouring into the industry with venture capital surpassing $10 billion in 2017 alone. For investors looking for fast growth and long-term returns, including a biotech stock is a no-brainer.
Unlike other industries like mining or consumer staples, biotechnology isn’t quite as easy to understand. The industry doesn’t operate like a standard business where price-to-earnings ratios and sales numbers define a company’s real value. Research and development costs can be staggeringly high while revenues streams can take years to actually become net positive.
One of the biggest uncertainties in biotech investments is the way the FDA drug approval process works. Phase 1 usually takes one year and consists of testing on fewer than 100 individuals to determine dosage and drug safety. Phase 2 can take between one and three years while testing is expanded to several hundred individuals who have the condition the drug is aimed at treating. Finally, phase 3 can take around two to three more years with testing involving thousands of individuals. Investors should note that roughly 10% of new drugs actually make it through all three phases.
One of the most critical metrics used in biotech stocks is research and development as a percentage of sales. Because biotech companies need to invest in research and development in order to create new drugs, costs in this department are usually much higher than other types of industries. However, the more spent relative to sales, the less the company is actually making money on successful products. Investors want this ratio to be as low as possible to emphasize thriving product lines.
Finally, patents can also be an important part of a stock’s value. Patents give a company unique rights to develop and disseminate a drug which could give it an edge over its competition. But patents don’t last forever and expiring patent rights can be devastating to a company who has thrived on just one or two staple drugs. It can also be a windfall for companies looking to take advantage of expiring copyrights in order to develop their own generic line.
Due to the volatile nature of the biotechnology industry, investors may be better served by investing in biotech specific mutual funds or ETFs rather than trying to invest in a single stock. Blue-chip Dow components aside, biotech stock performances are notoriously difficult to predict. Patent laws can be ambiguous at best and passing FDA requirements is never a guarantee, despite what management might have to say about their own drug. Investors should strongly consider investing in an index of biotech stocks to minimize downside risks.