Biotechnology Stocks
Investing in Biotech stocks:
If you have been an ardent follower of the stock market, or if you invest regularly, chances are that you always think twice before investing in a biotech company. Most people prefer to avoid the industry because it doesnt make sense to them at all and thus miss out on good investment opportunities. The biotech industry is not that difficult to understand. However, before taking the plunge, it is important to understand how the industry works, so that you do not miss the lucrative returns.
In a nutshell, Biotech firms are innovator drug discovery companies that make use of biological processes to invent new drugs or processes. Unlike conventional industries, biotech companies incur a substantial amount of investments in the beginning without generating revenues for a long period. To make matters worse, they operate in the red, investing obscene amounts of capital into their R&D pipeline. Hence, if you are trying to compute fundamental ratios for a biotech firm, chances are most of the ratios would be negative. So, does this mean they are not a fit investment Not necessarily, unless you do your homework properly and invest in the right company. Therefore, before deciding to invest, lets first understand how this industry works.
Lets say a start up biotech firm discovers a promising compound targeting any specific therapeutic sparking off the first stage in the long journey of a drug discovery process. The drug candidate is subjected to various tests and if found promising, it is subject to various tests, including checking the efficacy of the drug candidate and its validation. Once the candidate clears the drug discovery process, it enters the next stage, which involves the drug development process. This stage involves the drug to undergo clinical trials. It is then subject to extensive research studies to determine whether it is safe and effective in people. Clinical trials consists of four broad phases; they are:
Phase I - The drug is tested on a small number of healthy volunteers to determine its safety and dosage levels.
Phase II - The drug is tested on a small number of target population (volunteers who are suffering with the condition) to check its efficacy and further evaluate its safety.
Phase III The drug is tested on a large population to confirm its efficacy and safety, monitor side effects, dosage strengths etc.
Phase IV - This is a post-marketing phase where studies are still conducted for optimal use of the drug and for long-term safety data.
Once the drug clears Phase III, an application is filed with a regulatory body for permission to market the drug. For example, in the United States you would file an NDA (New Drug Application) with Food & Drug Administration authority or popularly known as FDA. Now the regulatory watchdog would scrutinize the data submitted and then either approve or reject the drug.
There are no prizes to guess what happens when a regulatory body rejects a drug. On the contrary, if a drug clears Phase III, it is now ready to be launched commercially.
The above process looks very simple. However, it is not. The entire life cycle of this business model is very complex and is fraught with immense risks. It takes a minimum of five to ten years for a drug to complete the entire cycle. Moreover, the outcome of any clinical trial is highly uncertain and depends on many factors. The process is also expensive and lengthy. As and when a drug progresses through the clinical trials, it requires more and more investments to conduct studies. This is where many biotech companies go bankrupt unable to raise funding for their operations. Hence, as an investor it would not hurt to see how the company plans to fund its R&D expenses.
The most common methods of funding for a biotech company are:
I) Venture capital led model where biotech firms raise cash to develop a drug, which may or may not be successful.
II) Raising capital by issuing either debt/equity or both.
III) Collaborating with a mature healthcare company on the development of a particular drug. This method has many advantages. For starters, the smaller company has access to the vast resources, which include both funds and infrastructure of its collaborator. And if the drug successfully clears the finish line, the smaller biotech firm has access to the well-trained marketing teams at its disposal.
IV) In licensing a drug to a mature healthcare company when the drug reaches Phase II or Phase III clinical trials. This strategy also bodes well for a smaller inexperienced biotech firm. Because for a drug the journey has just started, it needs to be marketed on a wide scale for optimized returns. Hence, the idea of selling the drug to a bigger partner in return for royalties is not a bad deal.
As a thumb rule for investing in biotech stocks, look for a company, which has a fairly late stage pipeline. For example, a company which has a drug currently in its phase III clinical trials is to be favored over a company, which has more candidates in an early stage pipeline. Because, the early stage pipeline company might take many years to move its candidates towards the finish line.
The next thing to look at would be what therapeutic segment the companys drugs are targeting. For example, the company might be developing a drug for the treatment of cancer or diabetes. Check to see if the company has any differentiating technology, which can give it the competitive edge in the market. For example, if a company has discovered a novel method of treating cancer with minimal side effects to the patient it will have a competitive edge over peers drugs, which are already available and have shown adverse side effects. Be vary of companies which already have competing drugs available in the market or have shown lesser efficacy ratios in their clinical trials.
The regulatory environment is very tough and authorities usually take a long time to approve a drug. It is understandable, especially because it involves the lives of people. The authorities must be convinced that the drug is safe and effective because the decision has an enormous impact on the patient population.
To conclude, not everyone can invest in a biotech company as it carries lot of risk. The gestation period is really very long and five out of ten companies go bankrupt before they turn profitable. Unless the company has an approved drug already on the market, we should really scrutinize the companys business model and its ability to raise capital. Finally, you should always weigh the pros and cons of an investment before taking a decision. And as a passing shot, consult your financial advisor who will be in a better position to advise you on your risk taking capabilities.
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