Pharmaceutical Vs. Biotech Investing: Is It Worth The Risk?

The decision to invest in pharmaceutical (pharma) or biotech stocks is a confusing one unless you have a keen knowledge of the basic operations and products of the company and how its securities trade on the market.

Pharmaceutical companies range from large to small, and they engage in a full array of activities from research and development (R&D) to manufacturing and marketing medicines. The compounds pharmaceutical companies manufacture are small molecules based on chemical or plant synthesis.

Conversely, biotech companies, except for a few, are generally small enterprises that engage solely in R&D of medicines. These companies use biotechnology to recreate the function of cells; they use microorganisms and enzymes to develop large-molecule drugs that are used for a specific purpose. Because biotechs mimic cellular processes, the length of time from research and development is extremely long, averaging 10-15 years.

The R&D process for both involves many clinical testing trials that yield specific data. These trials are “blind” so that neither the companies, nor the investors, have any knowledge of the outcomes.

R&D and Stock Impact

Biotech companies tend to be small with only one to a few compounds in development. Most of these companies operate with losses, because the time to develop is so long and the R&D processes are extremely costly. Because of this dynamic, biotech companies tend to find partners for financial support, usually through venture capital, universities, pharmaceutical companies or the government.

Despite this, when a company’s compound is in clinical trials, if the “endpoints” (expected data) are not met, the stocks can plummet. But if the endpoints are exceeded, the stocks can soar many-fold. As a result, investors in biotech companies need to be willing to tolerate a great deal of volatility.

While pharmaceutical companies also experience the costly and lengthy R&D process, including the ups and downs during clinical trials, they are usually able to withstand the volatility better because these companies tend to have many more product lines producing revenue that covers the R&D costs. Therefore, their stocks are comparatively more stable and considered safer investments.

When a biotech company finally has a marketable drug, it needs to get a marketing and sales arm. This is accomplished by either building one or, in many cases, partnering with a larger biotech or pharma company. Many pharmaceutical companies have alliances with biotech companies, adding revenues through the sale of the biotech’s drug without the costs or time associated with development - a nice boost to their top line.

Competition

Competition is one area that impacts pharma companies to a greater degree than biotech companies, because pharmaceuticals are chemical processes thought to be more easily replicated. Competition generally comes in the form of generic drugs, which can be introduced to the market after the branded drugs' patents expire. The length of each patent varies, but it is usually long enough for pharma companies to recoup R&D costs and produce healthy profits. When a generic drug is introduced to the market, the branded drug pricing is 100% lost. Drug prices for the generic can be up to 90% lower than the branded pricing.

“Me too” drugs, competitive products that work in a different manner for the same disease, can erode market share and pricing as well. Biotech companies had not been faced with any “biosimilar” or generic competition. But since the passage of legislation in 2010, biosimilars can become an increasingly competitive threat to biotech companies. Many issues exist in terms of determining the course of development for biosimilar competitors. So biotech companies, because they face such steep costs and lengthy processes associated with R&D, are hoping that biosimilars will not be a near-term competitive threat.

Investment Theses

There are two basic investment theses based on time horizon and risk tolerance:

  1. Pharmaceutical Investment: If you are less risk tolerant and not willing to wait for long-term drug development, then an investment in a pharmaceutical company makes more sense. The drivers of pharmaceutical stocks include prescription data, new drug pipelines, strategic alliances and M&A activity, competition and reimbursement changes. These stocks tend to be more stable because some of these drivers are predictable. In addition, drug companies tend to have a larger revenue base with multiple product lines so they trade based on profits.  Unforeseen short-term threats include changes to Medicare pricing, which tend to impact the pricing for many consumers. Unforeseen long-term threats include negative medical impacts from taking the drugs (such as death/lawsuits) as well as loss of patents (allowing competitors to come to market sooner).
  2. Biotech Investment: If you are a risk taker and willing to wait for drug development while withstanding the potential volatility generally associated with biotech stocks, then an investment in a biotech company may suit your style. Biotech stocks generally trade based on drug data including clinical trial failures, competition or regulatory obstacles. If the drug data misses its expected endpoint, a biotech's stock can lose most of its value in one day. Conversely, if a drug meets its expected endpoint, a stock can soar by double and triple digits that day. Some companies that have strong partners or are financially stable may be able to withstand setbacks, but many companies may not, and the investment can go bust.

Valuation

Pharmaceutical stocks typically trade at a large discount to biotech stocks. The historical mean forward P/E multiple is 16x from 1976 through March 2013 for pharma as compared to the high 20x to 30x or more for biotechs.

Because many biotechs are small and operating with losses, they are valued using price-to-sales ratio (PSR) or enterprise-value-to-sales (EV/Sales). However, according to one Wall Street analyst, “There is no meaningful relationship [between valuation] and market cap or revenues.” (Source: Merrill Lynch Back to Basics presentation.) As such, valuation is a bit unreliable and meaningless with some of these stocks.

The Bottom Line

Both pharma and biotech stocks face a costly process that, when successful, can produce extremely profitable products. However, the process is extremely unpredictable, which for a small biotech firm can prove all too detrimental and un-recoverable. Pharmaceutical companies, due to their larger size and diversified revenue base, are typically able to withstand setbacks and failures. Competition is more relevant and costly to pharmaceutical companies, creating a need for strong pipelines and non-organic revenues (such as through M&A or alliances). Consideration of these key themes can provide the basis for making a prudent investment.

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