There are many reasons why an investor may not feel comfortable investing in pharmaceutical companies. For many investors who want to get in on the next big pharmaceutical breakthrough, the biggest obstacle is knowing exactly how to go about evaluating such companies as potential investments. Another key concern in investing in drug companies is whether or not their drugs will go to—and remain in—the market.

Key Takeaways

  • Investors who are interested in investing in a pharmaceutical company should evaluate the company's ability to take their drugs to market, and this includes an understanding of the health of the company's pipeline.
  • The "pipeline" for a pharmaceutical company refers to how many drugs it has in research and development (R&D) and the various stages these products must go through before they reach the market.
  • The United States Food and Drug Administration (FDA) has strict tests and guidelines drugs must pass before pharmaceutical companies are allowed to sell them to consumers.
  • Investors should look for pharmaceutical companies with a strong pipeline, a track record of successfully taking drugs to the market, and drugs that have passed FDA scrutiny.

What Is 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). It takes between 10 to 15 years for an average drug to make it to pharmacy counters from a scientist's notebook.

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.

17%

The average amount of revenues pharmaceutical companies spend on research and development (R&D).

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 we can take medications that have been determined to provide benefits that outweigh potential risks.

The Importance of Pending Drug Developments

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 drug companies 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 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 in The Value Line Investment Survey, Bloomberg Businessweek, The Wall Street Journal, or within the company's financial statements.

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 the 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.

Considering Start-Up Pharma Opportunities

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. Most investors are hesitant to tackle new companies, called 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 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 maladies. 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.

The Bottom Line

As investors, 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.