Exciting. Scary. Lucrative. Risky.
All of these adjectives apply to investing in biotech stocks. The excitement and the prospects for generating huge profits make biotech stocks appealing to many investors. On the other hand, the fear of big losses that stem from the high risk levels associated with many biotech stocks causes other investors to stay away.
How should you go about investing in biotech stocks? There are seven key steps to follow that should improve your chances of success…
- Know which stocks are biotech stocks — and which aren’t.
- Determine your risk tolerance.
- Understand the risks specific to biotech stocks.
- Know what to look for in a biotech stock.
- Evaluate the top biotech stocks and biotech exchange-traded funds (ETFs).
- Invest cautiously.
- Monitor changing dynamics.
Here’s what you need to know about each of these seven steps for investing in biotech stocks…
1. Know which stocks are biotech stocks — and which aren’t
First, you’ll want to know which stocks actually are biotechs and which aren’t. It’s not as easy as you might think.
Biotech is short for biotechnology, a term that references any technology that incorporates biological organisms. Companies that make genetically modified foods fall into this category, as do drugmakers that develop biologic drugs — large, complicated molecules that are manufactured within a living organism.
But while many big pharmaceutical companies develop biologic drugs now, they aren’t usually viewed as biotechs. That’s primarily because these companies make most of their revenue from sources other than biologic drugs.
Also, some drugmakers are typically classified as biotechs even though they don’t make most of their money from biologic drugs. Why? A lot of people call any small drugmaker a “biotech” regardless of whether the drugs it develops use living organisms. Even when these small companies grow to be large, they’re still called biotechs.
If you’re looking to invest in biotech stocks, there is one quick way to determine which stocks are biotechs and which aren’t. You can check out the industry designation for the company on investing sites. On Fool.com, for example, enter the ticker symbol for a given stock and then click on the “Profile” link. If the industry in the company info section is “Med-Biomed/Genetics,” it’s a biotech stock.
2. Determine your risk tolerance
Perhaps the most important step of all with investing in biotech stocks is to determine your risk tolerance. Some investors are aggressive and can tolerate higher levels of risk. Others are more conservative and seek to minimize their risk levels. There’s a big reason you’ll want to know your risk tolerance: It will help you determine which biotech stocks are good investing candidates for you and which aren’t.
If you already know your risk tolerance, great. If you don’t, you might want to complete a risk-tolerance questionnaire to help you determine your investing style.
3. Understand the risks specific to biotech stocks
All stocks have risks. But biotech stocks have some specific risks that aren’t applicable to stocks in many other industries. These risks include clinical failures, regulatory approval setbacks, commercialization problems, and loss of exclusivity/patent expiration.
The risk of clinical failure. Probably the most critical of these biotech-specific risks is the potential of failures in clinical trials. All biotech companies must thoroughly test their experimental drugs to assess the drugs’ safety and efficacy in treating the targeted condition.
This process starts with preclinical testing. Some preclinical testing is conducted in vitro, which literally means “in the glass.” That’s a reference to lab testing in test tubes, culture dishes, and other ways that don’t involve animals or humans. Other preclinical testing is done in vivo, which means “within the living.” This kind of preclinical testing is performed using laboratory animals.
Biotechs that only have experimental drugs in the preclinical stage are especially risky. Most drugs never advance from preclinical testing into clinical studies.
If a drug looks promising in preclinical testing, though, the biotech can seek regulatory approval from the Food and Drug Administration (FDA) in the U.S. or the European Medicines Agency in Europe to begin a phase 1 clinical study. The primary purposes of phase 1 clinical studies are to evaluate the safety of an experimental drug, including identifying possible side effects, and to determine the ideal dosage range for the drug.
Around 37% of drugs that are evaluated in phase 1 clinical studies fail, according to the Biotechnology Innovation Organization (BIO). The successful drugs advance to phase 2 clinical studies. These studies test the efficacy and appropriate dosage levels of the drugs.
Most drugs — nearly 70%, based on BIO’s analysis of historical data — aren’t successful in phase 2 clinical testing. The ones that are move to phase 3 clinical studies, large clinical trials needed to assemble sufficient statistical data that the drugs are both safe and effective. Almost 42% of drugs fail in phase 3 testing.
Overall, only 11% of experimental drugs that begin clinical studies jump all the hurdles needed to file for regulatory approval.
Regulatory approval setbacks. Biotechs still face the risk that drugs that have been successful in clinical studies won’t win regulatory approval. Nearly 15% of drugs submitted for approval get a thumbs-down from the FDA, according to BIO.
In some cases, the biotech can conduct additional clinical studies to persuade regulatory agencies to approve an experimental drug. However, frequently a regulatory rejection means the end of the road for a drug.
Commercialization problems. You might think that once its drug wins regulatory approval, a biotech has it made. Not necessarily. Companies must persuade insurers and government healthcare programs to pay for a new drug.
In the U.S., this process involves working with all of the major insurers and pharmacy benefit managers, as well as Medicare and Medicaid, to provide coverage for a new drug. In Europe, biotechs must negotiate with each country individually for a new drug to be covered.
On top of these negotiations, biotechs must build sales teams to promote new drugs to prescribers. In many cases, companies also market directly to consumers via online, print, and TV advertising. Despite all of these efforts, there are significant risks that a biotech will be unsuccessful in achieving commercial success for a new product.
Loss of exclusivity/patent expiration. While biotechs often compete against other drugmakers, they enjoy protection for a while from potential rivals seeking to market generic or biosimilar versions of their drugs. Biologic drugs receive a 12-year period of exclusivity from biosimilar competition, while non-biologic drugs typically have a five-year exclusivity period.
In addition to the exclusivity periods, biotechs usually secure patents on their drugs. These patents expire 20 years after the filing date.
Once a biotech’s drug loses exclusivity and patent protection, rival companies can legally launch “copycat” versions of the drug. This nearly always causes a sharp decline in sales for the biotech’s drug.
4. Know what to look for in a biotech stock
The perfect biotech stock to buy would be one that has a broad lineup of approved drugs on the market. Each of these drugs would generate billions of dollars in annual sales. They would have a long way to go before the loss of exclusivity or patent expiration. And they would enjoy virtual monopolies for the conditions they treat.
This perfect biotech stock would also have a deep pipeline with a lot of candidates in phase 3 testing. The company would be super-profitable with fast-growing revenue and a mountain of cash built up to use in rewarding investors through share buybacks and dividends. And the stock would be dirt cheap.
Unfortunately, such a biotech stock doesn’t exist. However…
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