It is difficult to overstate the importance of the FDA to companies in the pharmaceutical, medical device, biotechnology and diagnostics industries. In short, the FDA effectively gets to decide who is even allowed to compete in the market. It is illegal to sell a drug or device with advertised medical claims without FDA approval, and insurance companies will typically not pay for their use. As a result, investors cannot afford to ignore the workings, or the prevailing mood, of the FDA when considering investments in this sector.

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Unfortunately for investors, the FDA is not constant. The agency does not necessarily maintain a consistent view of its own mission, nor how best to execute it. As a result, the regulatory environment can sway back and forth between lenient and stringent, with little recourse for the companies or their investors. That said, understanding how the FDA operates and its shifting moods can help investors navigate these treacherous waters a little more safely. (To learn more, see Investing In The Healthcare Sector.)

Mission and Motivation
First and foremost, the FDA is in operation to help protect public health, primarily by ensuring that companies prove the safety and efficacy of drugs/devices, manufacture them properly, and market them appropriately. Almost every investor has probably heard stories of the traveling medicine shows of the 1800s and early 1900s where hucksters and frauds sold various "patent medicines" that, at best, did not cure anything and at worst were actually quite harmful.

The FDA also has a secondary mandate to help foster innovation in healthcare by working with industry and academia to find better ways to evaluate safety and efficacy and to respond to innovations in medicine. While the FDA is often criticized for moving too slowly, the agency has made strides in expediting the approvals of orphan drugs and oncology drugs, and has worked with the industry to figure out approval pathways for drug/device-hybrids, biologics, gene therapies and other medical approaches that were never contemplated by the legislation that gave the FDA its mandate(s). That said, the FDA is still somewhat behind the curve when it comes to molecular diagnostics, genetic testing and biologics, and that has created ample chaos for companies in these fields.

Here, then, is one of the first guidelines for healthcare investors – beware of the new. While cutting-edge therapies often have incredible financial potential, the FDA does not always deal with the "new" in especially clear, fair, or transparent ways. That, then, can lead to disappointment and delay for investors who expect the FDA to process these products like any other drug or device. (For more, see Measuring The Medicine Makers.)

Ebb and Flow
Investors approaching the medical technology sector need to be aware that the FDA is not necessarily a consistent body, at least not over longer periods of time. In particular, the FDA seems to swing between a somewhat permissive "let it go to market and see what happens" approach and a strident "safety first" attitude.

In particular, the FDA seems to be moved by whatever criticism most recently rang in its ears. Badly burned by scandals related to drugs like Vioxx, the FDA of the late 2000s was a very cautious, very meticulous agency that rejected many drug applications that were considered nearly sure-things simply on the basis of theoretical safety risks. By comparison, the FDA of the early 2000s seemed to be responding to earlier criticisms of holding back the progress of healthcare and hurting suffering patients by being too stringent. This iteration of the FDA was more liberal and forgiving and approved many drugs and devices that would likely not pass muster in other times.

What this means for investors is that it is important to pay attention to the prevailing winds. When the FDA is in lock-down mode, investors should be much more cautious with companies whose clinical data is less than perfect.

Moving the Goalposts
Investors should also realize that the agency has more than a few tricks up its sleeve when it comes to dealing with the approval process. Although investors and the media often regard FDA panel meetings as a part of the FDA itself, that is not the case. Panel meetings are an opportunity for the FDA to draw on the knowledge, experience and judgment of experts in a field, and identify the risks and benefits of an investigational product. A recommendation for approval from a panel is NOT the same thing as an FDA approval, though, and the FDA is always free to ignore whatever a panel advises (for good or bad).

Likewise, the FDA can, will and does change the rules on the fly when it feels that it must. Many companies have presented what they felt were complete data packages, designed in cooperation with the FDA and with the agency's needs in mind, only for the FDA to tell them later that they need to perform additional studies. While these new studies are sometimes requested to answer questions raised by the clinical trial data, the FDA also sometimes appears to use them as a stalling tactic or a means of ruling out even far-fetched safety risks.

What investors should remember, then, is that no "agreement" between a company and the FDA is going to worth any more than the FDA wishes it to be. The FDA is always free to ask for additional information and to apply seemingly arbitrary performance standards. For instance, there are commonly-accepted ideas on what sort of survival benefit a cancer drug must show to be approvable, but the FDA has both approved drugs below that threshold and rejected drugs above it for various reasons. In short, there are no guarantees. (For more, see Pharmaceutical Phenoms: America's Best-Selling Medicines.)

Consequences to Industry
Clearly, the prevailing mood of the FDA will have major impacts on the healthcare industry and its investors. The summary rejections of obesity drugs in 2010 had a rapid impact in the industry, as large pharmaceutical companies quickly abandoned compounds that seemed to have equivocal chances of approval, and funding for prospective new obesity drugs became scarce. Along similar lines, an overall slowdown in the pace of new approvals dimmed investor enthusiasm for the sector and led many companies to lower financial expectations due to delays in expected approvals.

Going further, though, there are more general implications for the industry. When the FDA moves to a more conservative posture, it is generally a good thing for those companies that already have approved drugs or devices on the market – fewer new approvals means less competition for them and may encourage start-ups to sell out instead of trying their luck in the market as competitors. Likewise, generic companies can often do well in such times as pharmaceutical companies cannot steer customers towards the latest product as the old one goes off patent.

A strict FDA is also bad news for the riskier areas of the sector – biotechnology and emerging med-tech names. When the FDA makes it hard on companies to get new products to market, talent and capital tend to avoid the sector. Moreover, there is an overall decline in innovation in such times; even biotechs that can access capital cannot afford to waste hundreds of millions of dollars on trials that may go nowhere. (To learn more check out The Ups And Downs Of Biotechnology.)

How Investors Can Avoid the Pitfalls
To a certain extent, investors in the medical device and drug sectors need to accept that an occasionally unpredictable or inconsistent FDA is a non-diversifiable risk. That said, here are a few general pointers.

  • Avoid companies with problematic trials lacking clear positive safety and efficacy conclusions. If a company has to explain itself, mine the data or otherwise go to lengths to convince the FDA that the data is better than it looks, that is a bad sign.
  • Be willing to pay up for established companies. Many healthcare investors dream of finding the 10-bagger, but precious few companies manage this trajectory. In the fervor to find the "next Medtronic" or the "next Amgen," markets often lose sight of the value of those existing franchises.
  • Keep a healthy sense of skepticism. Investors should always remember that the FDA is going to look at virtually every application with a devil's advocate perspective, so they should do the same. Hit the search engines and learn everything you can about a new drug/device and its clinical performance, both good and bad.
  • Avoid one-shot companies. If a company only has a single product in development, FDA rejection will crush the stock and leave little hope of recovery. At a bare minimum, such companies should be only a part of a portfolio, and not the core.
  • Look at alternatives. When the FDA is in a pro-industry mood, that is a good time to own the biotechs and start-up device companies. Conversely, a strict FDA is often the time to find value in existing mid-cap and large-cap businesses with strong market share, as well as generics companies.

The Bottom Line
The healthcare sector is a major component of the economy and stock market, and an arena where investors can find many dynamic and intriguing companies. The FDA is a huge factor for these companies, and savvy investors need to know how to deal with the myriad moods and phases of the agency. With a little research and attention to detail, it is possible to find winning healthcare names no matter what position the agency takes. (For more, see Healthcare Funds: Give Your Portfolio A Booster Shot.)

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