Pharmaceuticals is an industry exposed to many unique risks. The capital intensive research and development (R&D), the uncertainty of Food and Drug Administration (FDA) approval, and a constant shroud of legislative risks may seem like a lot to deal with, but one of the fastest growing threats for pharmaceuticals are patent trolls.

The Pharmaceutical Process
FDA approval is already a long process, and even properly-approved drugs have left companies open for litigation. To take just one example from 2008/2009, there is an ongoing legal argument about whether federally approved warning labels pre-empt state law. The main problem was that if the Supreme Court ruled that warning labels didn't pre-empt state law, or if Congress changed the rules to give state law equal importance, then drug companies could find themselves facing more lawsuits. In addition, the drug companies would have to go through FDA approval followed by state by state compliance checks - all of this adding to the already considerable costs of doing business. (This volatile sector can provide huge gains, but there's also lots of downside, read The Ups And Downs Of Biotechnology.)

Patent trolls, by either attacking existing patents or hoarding vague patents, hurt pharmaceutical companies more acutely by reducing returns on investment at a time when both the companies' costs and risks are rising. Drug companies need large cash reserves/war chests at all times to pay for capital-intensive research, FDA approval and settling lawsuits. To maintain this war chest they need strong and, more importantly, stable profits from their products.

Risk and Return
These companies pay out the huge R&D costs in return for huge possible rewards on patented drugs. The rewards are more or less proportional to the risks, as many drugs never make it to market, meaning they never pay back their R&D costs. Drug companies want their patents, essentially their intellectual property rights, protected for as long as possible. They want an exclusive monopoly over their product in order pay back the costs of development along with a profit equal to the risks taken on by the company. Excess profits will either go to the shareholders or cover the costs of the many failed drugs that never make it out of developmental stages. (Investors take note: companies that cut research and development are in danger of saving today but losing big tomorrow, see Buying Into R&D.)

Trolls Provide Short-Term Benefit
Whether it is generic aspirin or generic Viagra, the patient receives an immediate benefit from patent trolls in the form of a lower price for medicines. This short-term benefit is no doubt much appreciated. The government also tends to think short-term - a cynic would say in four-year cycles - and generally in line with patients. They want cheap pills for voters and are more than willing to see corporate profits take a hit to meet that end. Governments have shown their support for patent trolls by creating legislative loopholes and eroding patent rights.

By attacking long-term patents, trolls are able to open up specific formulas for generic mass production and bring cheap generic drugs to market quicker. In the short-term, it's hard to argue that cheap medicine doesn't benefit the general population. In the long-term, however, the actions of patent trolls may actually hurt everyone.

Long-Term Problems
Bringing cheap pills to market quickly makes patent trolls look like important middlemen in the process towards generic drugs, but their long-term impact is more subtle and devastating. In the current pharmaceutical structure, drug companies pony up the cost of R&D. Therefore, even a slow drain on their reserves means less R&D and less new drugs in the future.

You might disagree with how much these companies take as profits for their shareholders, but it is those same profits that motivate the best corporate and scientific minds to keep searching for new medicines - and it is those profits that convince investors to put their capital behind the research rather than investing it somewhere else. (Valuing firms in this sector can seem like a black art, but there is a systematic way to pin a price on potential. For a better understanding, see Using DCF In Biotech Valuation.)

Possible Fallout
There are a lot of possible outcomes for the rise of the patent trolls. One is that drug companies will be pushed further away from high-cost, high-risk research and into simple domestic products like mouthwash and skin cream. Some of this can be seen in the 2009 acquisitions by Pfizer (NYSE:PFE), Merck (NYSE:MRK) and others. These companies have focused on other companies that have strong brands in household goods. These products and markets will be used to hedge against losses in the pure drug research, but they will also divert capital and research from the R&D. Instead of a pharmaceutical industry, we'll end up with a bunch of Johnson and Johnson (NYSE:JNJ) clones that occasionally make medicine.

Along with a more domestic focus, the trend of buying companies to fill existing and upcoming holes in the pipeline will intensify. As patents end prematurely and new drugs have yet to fill their place, many drug companies acquire other companies' products to prop up revenue. Unfortunately, the merger of two pipelines and two corporate cultures often leads to less overall spending on R&D rather than any significant synergy. Many drug companies are focusing ever more on pills with commercial appeal (erectile dysfunction, weight loss, etc.) and tightening their spending on expensive research into cures for rarer but more critical maladies. (Innovation is the key to staying on top. Find out how companies protect their ideas and how to figure out how much they're worth in Patents Are Assets, So Learn How To Value Them.)

As patent rights are shortened, less drug companies, especially poorly-capitalized small companies, will be able to survive. Some of them will be absorbed into the larger conglomerates, but just as many will simply fold up. Consolidation might not lessen competition so much as shutdown areas of research if the innovation of smaller firms is lost. Taking this one step further into extreme speculation, government might then have to step in and fund drug research with tax dollars – with all the waste and add-ons that come with government-led initiatives. So you might end up with taxpayers footing the bill for expensive R&D that may achieve nothing, rather than R&D that costs nothing to taxpayers.

Possible Solutions
What's the answer to the double bind of large companies making less new drugs? Just like there are several possible outcomes, there are several possible solutions. If companies' patent rights were ironclad, or lawsuits on FDA-approved drugs lessened, then companies would not feel the need to jack up the prices on proprietary formulas so much. Good portions of any drug company's costs are maintaining patents all over the world against legal challenges from other companies as well as patent trolls. Courts are getting better on dismissing the vaguely-worded patents that trolls use to stifle, or at least extort, innovative companies.

The premature expiry of patents, however, is still worrisome. If companies had exclusive rights, protected from any lawsuits or legislative changes, for a set number of years, they could spread their cost recovery and profits over this period. This would result in lower average costs for consumers over that time and also guarantee a return on investment. (Learn how to find a healthy pharmaceutical investment in a market full of weak drugs Measuring The Medicine Makers.)

A longer patent period than 20 years could further guarantee a return on investment. Thus more companies and more investors would put their money into discovering new medicines in the future. This is how patents were designed to work before patent trolls came around and, if the pharmaceutical industry is to continue to be the innovative engine we need it to be, this is the way things will have to be in the future. (For more on evaluating investing in these types of stocks, check out Stocks On Drugs: What It Takes To Get High and The Hidden Value Of Intangibles.)

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.