A:

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.

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