How would you like to invest in a sector comprised of companies that have an 85 to 95% failure rate on everything they attempt to invent, their success or failure hinges on a government agency that has more mood swings than "that guy" at work and there's a significant chance that if you pick the wrong the company, you could see 90% or more of your investment disappear in less than 24 hours?

SEE: A Primer On The Biotech Sector

How's that for a glowing endorsement of the biotech sector of the stock market? If you're an investor in biotech stocks, you know of these realities, but you also know that when one of these companies markets a breakthrough drug, your investment can double over night. Here's what you should know.

More Than Just Drugs
In the popular investing circles, biotech stocks are thought of as companies that treat an illness, but they're bigger than that. Companies like Dendreon and Celgene do develop products to treat illnesses, but biotech also includes the production of genetically engineered seeds for agriculture, biodegradable plastics, biofuels and other industrial uses. However, most investors think of biotech as a high tech, 21st century version of the older pharmaceutical companies.

Traditional medical research has concentrated on using relatively simple molecules found by trial and error as a way to treat illnesses. Biotech companies may engineer or use more complicated methods, such as modifying proteins that attempt to disrupt the disease process. The traditional way of scouring the globe for simple molecules has given way to engineering living cells for the benefit of the patient.

The Biggest Enemy to Biotech
The biggest enemy, according to biotech analysts, is the Food and Drug Administration (FDA). Once a drug goes through a series of trials, the biotech company submits an application for approval. Those with experience in dealing with the FDA speak of an organization that may be very conservative during some periods and very liberal during others. The FDA may require further testing during its conservative periods, but may not do much more than rubber stamp a drug when it's in a more liberal mindset. It may also be more willing to approve applications for drugs that treat diseases without a cure or acceptable treatments.

The New Landscape
The business of pharmaceutical companies is changing. Companies that used to employ teams of scientists to find the next big blockbuster drugs are transitioning to the business of purchasing smaller research companies, or the drugs they produce. For instance, in 2006, large pharmaceutical companies spent roughly $17 billion on more than 250 biotech firms. By purchasing companies already in the process of developing new treatments, the pharmaceutical companies can focus their finances towards other endeavors, such as marketing. They take on only the risk that the drugs fail in the market, instead of the 85 to 95% risk that the drug never reaches the market at all.

Positive Legislation
Biotech watchers are applauding the recent passage of the Faster Access to Specialized Treatment or FAST Act, which speeds up the process by which drugs for diseases without a cure come to market. This legislation is designed to speed up the development of personalized treatments for patients suffering from life threatening and serious diseases, and may provide an incentive to biotech companies to invest even more in research and development, if they know that they can potentially recoup their investment at a faster pace.

The Bottom Line
Biotech companies are difficult to research because of their relatively small size. Since they often do not have any cash flow, and investors are provided little indication of the status of their research, big announcements frequently come by surprise. Investing in these stocks can be a long waiting game; it can pay off big or the investor may lose most of their position.

For the retail investor with little time to research the sector, investing in a biotech exchange-traded fund may be the safest way to commit funds to the sector, but for those with a passion for due diligence, the sector can prove very profitable.

Related Articles
  1. Investing

    Build a Retirement Portfolio for a Different World

    When it comes to retirement rules of thumb, the financial industry is experiencing new guidelines and the new rules for navigating retirement.
  2. Investing

    Redefining the Stop-Loss

    Using Stop-losses for trading doesn’t mean ‘losing money’, but instead think about the money you'll start saving once you learn how they work.
  3. Fundamental Analysis

    10 Major Companies Tied to the Apple Supply Chain

    Apple has one of the best supply-chain models. Here are some of the top businesses involved, and the benefits and challenges for all.
  4. Mutual Funds & ETFs

    ETF Analysis: ALPS Medical Breakthroughs

    Learn more about a unique and innovative exchange-traded fund (ETF) in the biotechnology industry: the ALPS Medical Breakthroughs Fund.
  5. Term

    What are Non-GAAP Earnings?

    Non-GAAP earnings are a company’s earnings that are not reported according to Generally Accepted Accounting Principles.
  6. Mutual Funds & ETFs

    ETF Analysis: PowerShares FTSE RAFI US 1000

    Find out about the PowerShares FTSE RAFI U.S. 1000 ETF, and explore detailed analysis of the fund that invests in undervalued stocks.
  7. Options & Futures

    Use Options to Hedge Against Iron Ore Downslide

    Using iron ore options is a way to take advantage of a current downslide in iron ore prices, whether for producers or traders.
  8. Stock Analysis

    Fortinet: A Great Play on Cybersecurity

    Discover how a healthy product mix, large-business deal growth and the boom of the cybersecurity industry are all driving Fortinet profits.
  9. Stock Analysis

    2 Catalysts Driving Intrexon to All-Time Highs

    Examine some of the main reasons for Intrexon stock tripling in price between 2014 and 2015, and consider the company's future prospects.
  10. Charts & Patterns

    Understand How Square Works before the IPO

    Square is reported to have filed for an IPO. For interested investors wondering how the company makes money, Investopedia takes a look at its business.
RELATED TERMS
  1. Profit Margin

    A category of ratios measuring profitability calculated as net ...
  2. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis ...
  3. Debt Ratio

    A financial ratio that measures the extent of a company’s or ...
  4. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing ...
  5. Net Present Value - NPV

    The difference between the present values of cash inflows and ...
  6. Long-Term Debt

    Long-term debt consists of loans and financial obligations lasting ...
RELATED FAQS
  1. What is the formula for calculating compound annual growth rate (CAGR) in Excel?

    The compound annual growth rate, or CAGR for short, measures the return on an investment over a certain period of time. Below ... Read Full Answer >>
  2. When does the fixed charge coverage ratio suggest that a company should stop borrowing ...

    Since the fixed charge coverage ratio indicates the number of times a company is capable of making its fixed charge payments ... Read Full Answer >>
  3. What is the difference between the return on total assets and an interest rate?

    Return on total assets (ROTA) represents one of the profitability metrics. It is calculated by taking a company's earnings ... Read Full Answer >>
  4. How can EV/EBITDA be used in conjunction with the P/E ratio?

    Because they provide different perspectives of analysis, the EV/EBITDA multiple and the P/E ratio can be used together to ... Read Full Answer >>
  5. How can a company reduce the unsystematic risk of its own security issues?

    Companies can reduce the unsystematic risk of their own security issues simply by doing the most effective job possible of ... Read Full Answer >>
  6. How does the role of Medicare/Medicaid affect the drugs sector in the U.S.?

    Medicare and Medicaid have enormous influence on the pharmaceutical, or drugs, sector in the United States. For instance, ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!