Evaluating Pharmaceutical Companies

There are many reasons to feel uncomfortable investing in drug companies. For many investors targeting the next big pharmaceutical breakthrough, the biggest obstacle is knowing how to evaluate drug companies as investments. Another concern is whether these companies will be successful in winning approval from the Food and Drug Administration (FDA) and bringing their products to market.

What Is the Pipeline and Why Does It Take So Long?

The pipeline refers to the potential vaccines, steroids, immune system suppressants, aphrodisiacs, etcetera (all under the general heading of drugs) that are in various stages of research and development (R&D). On average, it takes at least 10 years and $2.6 billion for a drug to make it to pharmacy counters from a scientist's notebook.

The main reason the pipeline fails to flow freely is the FDA has oversight authority to protect consumers from drugs that may have unexpected side effects. The FDA imposes strict guidelines and tests a drug must pass before it reaches store shelves.

An investor or someone suffering from a fatal illness may bemoan the FDA's hindrance in an already complicated process. But as consumers, we should appreciate the FDA's role in determining which medications are safe to use.

The Importance of Pending Drug Developments

The strength of the drug pipeline is vital to pharmaceutical companies of all sizes. This is the primary measure of whether a company is a good investment. The term for a new drug patent is 20 years before generic producers can enter the market and lower the price. As a result, companies, especially startups, are on shaky ground if they depend on just one drug for all their profits.

To counter this uncertainty, companies try to keep their pipelines flowing. Developing drugs in the pharmaceutical industry is a bit like throwing darts in the dark. The more darts you throw, the better your chances are of hitting the mark. You can check how many drugs a company has in the pipeline within the company's financial statements.

A Troubling Symptom

Even if a drug wins FDA approval and reaches store shelves, manufacturers sometimes need to voluntarily recall a defective or potentially harmful product. When this happens, it is very difficult to bring that drug back—not because it won't be effective, but because the medical field will have already found a substitute drug to fill that niche. The FDA maintains a list of ongoing drug recalls.

Considering Startup Pharma Opportunities

Established companies are almost always safer as investments than new ones. If there is an up-and-coming company with an unbeatable drug, a major firm will usually come along and partner with the smaller firm, or buy it outright. This is a safe move for the startup as well because it will gain access to the larger company's distribution channels. Additionally, if the FDA puts the brakes on a drug's development, a larger firm has the capital to take it back to the lab again.

However, small firms with a history of partnering to get drugs out of the lab and into the world are worth considering. When it comes to acquisitions, large companies typically look for smaller firms valued at $1 billion to $5 billion, with drug candidates in the mid- to late-stage clinical trials. These are called "bolt-on" transactions, and they help large companies to fill out their pipeline. Some startups choose to go solo and market drugs directly to doctors in cities where the illness is most prevalent.

These startups are often wildly successful in this endeavor, but these are exceptions. Most investors are hesitant to back new biotech companies, and in their fledgling stage they are usually considered a gamble.

The Long-Term Prognosis

To filter the large companies with huge pipelines, we have to look at the types of drugs that are upcoming. Investing in a company that has a successful product is usually a safe practice, but with the 20-year patent limit in the pharmaceutical industry, it is like betting on a horse that has already won a race earlier in the day: it may come out ahead again, or it may be too tired.

The best products are the ones that are focused on a particular class of maladies. These can be illnesses, cancers, or viruses that attack the nervous system, skin, heart, and so on. Or it can be conditions that affect a demographic such as children, older adults, or those with erectile dysfunction. By targeting specifics, these companies avoid head-to-head competition. This also gives investors an opportunity to diversify within the pharmaceutical industry.

The Bottom Line

As investors, look for companies that have a strong pipeline and a history of successfully bringing drugs to the market. If the company's products are free from FDA scrutiny and they have a cohesive target, a certain demographic or disease area, it is a good sign. If you are going to buy only one company, go with a large firm. But if you are going to diversify within the industry, small companies with a history of partnering or R&D focusing on illnesses that are an ongoing concern (Alzheimer's, heart disease, etc.) are solid additions to a pharmaceuticals portfolio.