When Viagra surged into consumers' bedrooms, Pfizer's stock enjoyed a sudden rise - satisfying investors and consumers alike. Although Pfizer was far from an unknown company at the time, most of us did not hold stock. There are many reasons why an investor may not feel comfortable investing in pharmaceutical companies, but if you do want to get in on the next little blue pill there is still the obstacle of how to evaluate the industry. This article will explore some of the issues involved in pharmaceutical investing.

What's the Pipeline and Why Does It Take So Long?
The pipeline is a term that refers to how many products - vaccines, steroids, immune system suppressants, aphrodisiacs (all under the general heading of drugs) - are in various stages of research and development (R&D). The average drug takes between 10 and 15 years to make it from a scientist's notebook to pharmacy counters.

The main reason the pipeline fails to flow freely is that the Food and Drug Administration (FDA) has its own shut-off valve in order to protect consumers from drugs that may have unexpected side effects. The FDA has very strict guidelines and tests that a drug must pass before it reaches store shelves; even after passing the tests, the FDA reserves the right to pull the drug en masse at any time.

An investor or someone suffering from a fatal disease may bemoan that the FDA is an extra hindrance on an already complicated process, but as consumers, we should appreciate the fact that it is because of the FDA that we can take an aspirin without having to worry about growing a third arm. (To continue reading on the subject, see The Ups And Downs Of Biotechnology.)

Choosing Between New and Old
Established companies are almost always safer 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 start-up company as well because the start-up will get access to the larger company's distribution channels. Additionally, if the FDA puts the brakes on the drug, 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. Partnerships and acquisitions of start-ups account for between a quarter and a third of most large firms' pipelines. Some start-ups choose to go solo and market drugs directly to doctors in cities where the disease is most prevalent. These start-ups are often wildly successful in this endeavor, but these are exceptions.

Performing a Check-Up
A cursory glance at the pharmaceutical industry, mainly the smaller drug makers, will show that the firms trade at a higher price-earnings ratio than those in other industries. This is because most of the expenses incurred by pharmaceuticals are of the research and development variety and usually are expensed immediately. This means that the company pays the cost of developing a drug years before the drug starts to produce revenue. Companies with price-earnings ratios in the 20s and 30s are commonplace even if the rest of the market is in the teens. Another figure that will seem out of place is the return on equity. These companies have a noticeably higher return on equity when compared to other industries. (To learn more about the price-earnings ratio, see Understanding The P/E Ratio, Move Over P/E, Make Way For The PEG and Analyze Investments Quickly With Ratios.)

The Importance of a Good Digestive System
The health of the pipeline is vital to pharmaceutical companies of all sizes. This is the primary measure of whether a company is a good investment. A firm only has so many years of patent on a particular formula before the generic drugs swoop in and hammer down the price. As a result, companies, especially start-ups, are on very shaky ground if they depend on just one drug for all their profits (remember, the FDA could nix the drug at any time). (To learn more, see Buying Into R&D.)

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 hurl, the better your chances are of hitting the mark. You can check how many drugs a company has in the pipeline in The Value Line Investment Survey, BusinessWeek, The Wall Street Journal, or within the company's financial statements.

A Healthy Diet Beats Gorging
A word of caution: sometimes having too many drugs in development is as dangerous as having too few drugs in the works. Just as eating too much messes up your digestion and is dangerous to your health, drug companies can gorge and neglect to give each product the proper attention. Many drugs are born and die in the corridors of R&D, and not all of them are useless. The cholesterol-lowering drug, Lipitor, would have died in the labs if not for the determination of the scientists who designed it. It became a successful product after being brought to the consumers via a joint venture between Warner-Lambert, the company whose people developed it, and Pfizer.

The Long-Term Prognosis
In order to filter the large companies with huge pipelines, we have to look at the types of drugs that are coming up. Investing in a company that has a successful product is usually a safe practice, but with the 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 diseases. These can be diseases, cancers or viruses that attack the nervous system, skin, heart and so on, or it can be diseases that affect a demographic like children, the elderly or middle-aged men with a waning libido. By targeting specifics, these companies avoid head-to-head competition. This also gives investors an opportunity to diversify within the pharmaceutical industry.

A Troubling Symptom
It is difficult to tell whether a certain drug will become financially successful even if it is chemically sound. Many people think that specific arthritis medications would be redundant in the face of aspirin and Tylenol, but they have increased in sales as the baby boomers age. The attention of the FDA, however, is the equivalent of coughing up blood for a drug company. When a company is forced to pull a drug from market, or even if it does so voluntarily, 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. A quick look at the FDA's website will tell you what products are being scrutinized.

Conclusion
As investors, you want to look for companies that have a healthy 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 diseases that are an ongoing concern (Alzheimer's, heart disease, etc.) are solid additions to a pharmaceuticals portfolio.

by Andrew Beattie, (Contact Author | Biography)

Andrew Beattie is a freelance writer and self-educated investor. He worked for Investopedia as an editor and staff writer before moving to Japan in 2003. Andrew still lives in Japan with his wife, Rie. Since leaving Investopedia, he has continued to study and write about the financial world's tics and charms. Although his interests have been necessarily broad while learning and writing at the same time, perennial favorites include economic history, index funds, Warren Buffett and personal finance. He may also be the only financial writer who can claim to have read "The Encyclopedia of Business and Finance" cover to cover.