Biotechnology, or biotech, companies are those that use technology to harness biological processes to come up with new products. While these companies tend to be focused in the medical area, biotechnology companies also make products in other areas, such as the environment, food production, and agriculture. For instance, biotechnology could be used to produce bigger harvests and fight pests. Examples of biotech companies include Amgen, Inc. (AMGN), in the disease-fighting area, and Gilead Sciences, Inc. (GILD), another company that fights disease.

Biotech companies have great profit potential, considering that they operate in a relatively new area of human endeavor. As people live longer and standards of living go up worldwide, there is likely to be greater demand for the products of biotech companies. And with rapid changes in technology, there is more potential for these companies to come up with some innovative products. To the extent that one of these companies is successful at coming up with a new product, it offers the possibility for great returns.

Biotech companies typically get patent protection for their products, which give them market lead time while they recoup the costs of their research and development. After the patent protection period is over, they have a more established market position compared to their competitors. This also offers scope for great rewards. In fact, over the 10-year period ending March 11, 2015, the S&P Biotechnology Select Industry index turned in a 20 percent return, compared to a 7.7 percent return for the S&P 500 index. That speaks to the allure of biotech companies for investors. And for investors who are so inclined, there is also the psychic reward of helping fight disease, save lives, and advance human progress.

Risks

However, investors should weigh the potential for outsize returns that these companies offer against their risks, which are plenty. For one, there is a long period of development when money is invested in research and development with the hope that they will come up with a successful product. It could cost as much as a billion dollars to develop a drug, for instance. And for products to be sold in the US, biotech companies also have to get Food and Drug Administration approval for their drugs, which is a lengthy and onerous process.

There are a series of trials involved, and likely human testing, with the FDA involved at every stage. And it could turn out that during the course of these trials the company finds that its product is not viable. This whole process could take as many as 10 years, during which the company is not making a profit on that product. Moreover, there could also be technological change during the R&D phase that negatively impacts the product. Major investors could decide that they would like to back out at any point during this lengthy process.

According to a 2014 biotechnology industry report from Ernst & Young, as many as 36 percent of drugs don’t make it past the preliminary stage of drug development, another 68 percent don’t last past the intermediate stage, and another 40 percent get knocked out in the final stage, at which point a lot of money has already been invested in research and development.

In addition, given that these companies engage in such risky development processes, it makes it difficult for analysts to accurately value them. That’s one reason why the stocks of biotech companies tend to be volatile. Another reason is that given that there is so much tied to the research and development process, the prices of these stocks tend to be greatly influenced by any positive or negative news relating to their FDA approval and clinical trials.

And if a biotech company is able to successfully market its product, there is still the risk of how it will be received by the market and the potential for litigation risk if any negative effects come to light as more people start using the product.

The Bottom Line

Biotech companies offer investors the potential for a big upside payout, given that they operate in a relatively new area and have a huge market to tap. However, if you invest in relatively new biotech companies that are still unproven and offer greater potential for reward, you will likely not even get a dividend while you hold on for growth prospects that may not materialize. One way to mitigate the risk could be to invest in a diversified portfolio of biotech stocks through a mutual fund or exchange-traded fund, for instance.

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