Investors in the drug sector must be aware of the regulatory challenges, competition and financial concerns associated with the research and development of new products. The Food and Drug Administration (FDA) regulates the drug sector very tightly, verifying that every drug is safe and effective before permitting it to reach the market. New drugs experience a lengthy testing period that may last 10 to 15 years before approval for sales. As a result of these challenges, drug manufacturers must be very resilient and financially stable in order to stay competitive in the marketplace. Investors should research the market thoroughly and calculate the risk-return tradeoff before investing in a drug sector stock.

The FDA uses incentives to encourage pharmaceutical companies to follow particular patterns. Generally speaking, pharmaceutical companies may have an easier time achieving approval for drugs that present the greatest overall benefit. The government encourages the development of orphan drugs, or drugs that lack potential for profitability because they target rare diseases. The FDA allows for a fast-track to approval. This policy benefits Americans waiting for drugs that target rare diseases. Drugs the government deems to be unsafe or ineffective will require further testing that the company may not be able to afford. Investors should consider the budget available to the company for research and development costs.

Smaller companies generally offer greater returns by allowing for ground-floor venture capital investment, but may not be able to withstand the length of time required for approval on their own. Large companies are more likely to have multiple drugs in their product lines and therefore are able to finance the path of new drugs through FDA approval. The profit potential of a successful, patented new drug is substantial and serves as strong motivation for many companies to see new drugs through the development process. To obtain new drugs for their product lines, large companies often acquire smaller companies. Small companies benefit from access to additional financial resources for the testing period. Mergers and acquisitions are common throughout the sector and happen largely in response to the regulatory environment experienced by creating new drugs. Mergers and acquisitions are common throughout the sector and happen largely in response to the regulatory environment experienced by creating new drugs.

Once off-patent, competitors often mimic successful drugs. These generic drugs offer the same efficacy at a substantial savings to consumers, making them a competition risk for pharmaceutical manufacturers. Other manufacturers are free to produce these drugs, so investors should expect popular treatments to become attractive targets for the production of generic brands. This in turn will lower the value of the original drug.

  1. How does the profit margin compare for a generic drug versus a brand name drug?

    Learn how the profit margins compare for generic drugs and brand-name drugs. Brand-name drugs cost three to four times more ... Read Answer >>
  2. What process does a company need to follow to bring a new drug to market?

    Learn about the costly price of bringing new drugs to market. Discover why the pharmaceutical industry invests billions of ... Read Answer >>
  3. What are the primary factors that drive share prices in the drugs sector?

    Learn about the primary factors that drive share prices in the drug sector. Creating and manufacturing drugs is a complex ... Read Answer >>
  4. What are the major barriers to entry for new companies in the drugs sector?

    Find out why barriers to entry for U.S. drug companies are so high and how the Food and Drug Administration, or FDA, inhibits ... Read Answer >>
  5. What are the differences between brand name drugs and generic drugs?

    Discover the process by which brand name drugs lose their patent, allowing generics to be manufactured, as well as the differences ... Read Answer >>
  6. What factors make the drug sector good for value investing?

    Discover what makes the drugs sector good for value investing. The perfect ingredient for value investors is to find undervalued ... Read Answer >>
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  1. Abbreviated New Drug Application (ANDA)

    A written request to the U.S. Food and Drug Administration to ...
  2. Orphan Drug

    A drug or biological product that treats a rare condition or ...
  3. Bioequivalence

    A similarity between two drugs meaning that they both have the ...
  4. New Indications

    A term used by medical companies and professionals to signify ...
  5. Healthcare Sector

    The healthcare sector consists of companies that provide medical ...
  6. Investigational New Drug (IND)

    The first step in the drug review process by the U.S. Food and ...
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