Over the past few decades, innovation in health care has been incredible. If you had said 20 or 30 years ago that HIV and hepatitis C soon wouldn’t be death sentences, no one would have believed you. The same goes for various types of cancers, epilepsy, and several other ailments.
The driver in the development of new therapeutic options is the same driver behind evolutions in entertainment, shopping, and more: technology. Technological innovation is changing the way we live our lives, and nowhere is that fact more clear than in the field of medicine.
In fact, technology has played such a major role in the innovation of new therapies that an entirely new market — known as the biotech market — has emerged.
The emergence of the biotech industry led to extended lifespans and better quality of life for countless patients over the past few decades. It has also led to tremendous growth in revenue, profits, and investor interest in the stocks that represent the companies making novel medicines and treatments. Investment opportunities are being created in the space consistently, making the biotech sector one of significant interest for stock market participants.
What Are Biotech Stocks?
Biotech stocks represent companies in the biotech sector. These are companies that are focused on the development of new medicines, vaccines, or medical devices through the use of innovative technologies and advanced medical science.
These companies are working to bring an end to some of the world’s most devastating health conditions, including cancer, heart disease, and several rare diseases that most people can’t even pronounce.
These medical science efforts have been so successful that experts such as the Legacy Research Group suggest that we are entering an age of a biotechnology renaissance.
Biotech stocks include familiar pharmaceutical names like Johnson & Johnson, Gilead Sciences, and Merck, along with a host of yet-unknown companies with products in early-stage development.
Pro Tip: Are you looking for the next great investment but don’t have time to do the research yourself? The Motley Fool Stock Advisor, one of the most successful stock picking services, will send you two stock recommendations each month. Netflix, a past recommendation, is up more than 21,000%. Learn more about Motley Fool Stock Advisor.
Biotech Stock Pros and Cons
Investments in biotechnology companies can lead to massive gains and make you feel good. However, when things go wrong, they can go very wrong. As with any investment, these investments come with their fair share of pros and cons.
Biotech Stock Pros
There are several benefits to making the right investments in the sector. Some of the most important of these benefits include:
1. Potential for Massive Profits
Investing in the biotechnology industry can prove to be overwhelmingly lucrative. Most clinical-stage stocks in this sector trade at prices under $5 per share. However, the successful launch of a new treatment option can send the stock soaring in many multiples. If there’s ever a sector that creates millionaires, biotechnology is it.
2. The Feel-Good Effect
These days, investors make investments for more than profit. In fact, there’s a trend of socially responsible investing sweeping the globe. With socially responsible investing, you look for and invest in companies that are making positive change in the world.
Some socially responsible investors look toward solar stocks for environmental change or financial-literacy stocks designed to remove the wealth divide. Others invest in the biotech sector, helping to fund the development of life-saving and life-changing treatment options. That’s something to feel good about.
3. Better Understanding of Medicine
When investing in any stock in any sector, it’s important to do your research. When doing this due diligence in the biotech industry, you’ll learn quite a bit about the human body, medicine, and the various ailments medicines are being designed to treat and cure.
There’s value in knowing why your ticker ticks and how to keep it ticking for the long run. Investing in biotech stocks could lead to lifestyle decisions that don’t only improve your financial health, but your medical health as well.
Pro tip: Before you add any biotech stocks to your portfolio, make sure you’re choosing the best possible companies. Stock screeners like Trade Ideas can help you narrow down the choices to companies that meet your individual requirements. Learn more about our favorite stock screeners.
Biotech Stock Cons
There are plenty of benefits to investing in biotech, but every darling has a blemish. There are some drawbacks to investing in this space as well.
1. Clinical Failure
Any company can fail. In the biotechnology industry, failure can come much easier. A failed clinical trial means the loss of millions of dollars and years in research, generally leading to dramatic losses.
2. Commercial Failures
Taking a new medical product to market takes quite a bit of work and capital. Even if that product seems as though it will be met with high consumer demand, failure can happen. These failures prove to be extremely costly when they occur, both for the biotech company and its investors.
3. One-Hit Wonders
Once products are created and commercialized, biotech companies only have a limited amount of market exclusivity. After a period of several years, competitors will launch generics. If the company doesn’t have other products to fall back on, generic treatments could lead to dramatic declines in share values.
4. Poor Financial Foundations
There are an elite few companies in this sector that have created a blockbuster product, brought it to market, made billions, and continued to innovate, growing out a multibillion-dollar, stable company in medicine. The vast majority of biotech companies are in clinical stages and produce no revenue. With poor financial foundations, these companies are at the mercy of the investing community and lenders to stay afloat.
Biotech Stock Stages
There are multiple stages of a biotechnology business. The stage of a company’s product development tells you a lot about the potential risk and reward associated with an investment in that particular company.
1. Research-and-Discovery-Stage Biotech Stocks
Research-and-discovery-stage stocks are the most risky plays you can make in the sector. In fact, they are so risky that most of them trade on the over-the-counter (OTC) market because they do not meet key requirements set by major exchanges like the NASDAQ or New York Stock Exchange.
These companies have a plan, but no product. They are currently researching to discover the basic foundations of what will become an experimental vaccine, therapy, or device.
There are several major risks to consider when thinking about an investment in a research-and-discovery-stage company. Among the most important are:
- Research That Doesn’t Produce Results. The best scientists in the world may look for ways to deliver an effective treatment. That doesn’t mean they’re going to find them. Ultimately, these companies are rooted in research, which doesn’t always yield a viable product.
- Capital Requirements. Research in the field of medicine is a highly capital-intensive process. Not only do companies have to pay high salaries, but they also have to pay high costs associated with equipment, regulatory matters, and more. Without a product, research-and-discovery companies don’t generate any revenue. So, this capital must come from debt, grants, or the investing community, neither of which is good for current investors.
- Fraudsters. While most research-and-discovery biotech companies are looking for ways to improve quality and length of life in patient populations, there are also plenty of companies out there designed for nothing more than creating a payday for the founders. These companies say they want to perform research, but need to raise capital to do so. That capital goes to paying executive salaries and perks, and the research never happens. This is a common scam in the biotech sector, and investors should be highly diligent in looking for it in these early-stage companies.
2. Preclinical-Stage Biotech Stocks
Preclinical-stage biotech companies are a bit further along than research-and-discovery-stage companies. These companies have done the research that has led to the development of an experimental product.
However, preclinical-stage companies are still quite young in terms of development. In the preclinical stage, companies are looking to prove their concept. For example, if a preclinical-stage company is developing a drug for lung cancer, it may treat mice that have lung cancer with the new drug, looking for signs of the treatment’s efficacy and safety.
Although mice are quite different from humans, our bodies work in many of the same ways. Therefore, a treatment that works in mice has a better likelihood of working in humans than one that doesn’t.
In order to move into human studies, these companies have to show regulatory authorities that there is a strong likelihood that a treatment will work and be safe to use in humans. The preclinical stage is centered around doing just that.
At this point, there are still several risks to consider. The most important of these risks include:
- Preclinical Failure. If a new treatment is given to a mouse, and the mouse dies as a result of the treatment, it will be difficult to bring that treatment to human studies. As such, if a company at this stage announces a preclinical failure, it could send the stock tumbling.
- Capital Requirements. As biotech companies move through the process of developing new therapies, costs only grow. Like research-and-discovery-stage companies, preclinical-stage biotech companies don’t have products on the market and are unable to generate revenue. As a result, they will need to look for funding elsewhere. While some of this funding may come from grants, the vast majority of preclinical companies are funded through transactions — such as public offerings of common stock — that ultimately dilute the long-term value of shares currently held by investors.
- Regulatory Hurdles. For a company to go from preclinical to the clinical stages, it will have to receive investigational new drug approval from regulatory authorities. This approval gives the company the ability to test a new drug in humans. All the preclinical data may look positive to the average investor, but the U.S. Food and Drug Administration (FDA) may use a different measuring stick. If the company’s investigational new drug application is declined, its stock will fall.
3. Early-Clinical-Stage Biotech Stocks
Early-clinical-stage biotech companies have a tangible product that is being developed. Moreover, this product has been given the green light by regulatory authorities for experimental testing in humans.
There are three main phases of clinical studies in this experimental process. Companies in the midst of the first two phases are considered early-clinical-stage companies.
Phase One Clinical Studies
Phase One clinical studies are the earliest studies in which human subjects are used. These studies generally consist of small patient populations. In most cases, all volunteers involved in the Phase One clinical studies are healthy adults. The idea of Phase One studies is to slowly escalate the dose of a treatment to find the maximum tolerable dose in the human body.
While Phase One studies will show signs of the treatment’s effectiveness, the main focus of these studies is safety and tolerability. These trials usually aim to answer the following questions:
- Are there side effects?
- Are the side effects tolerable?
- Is the new therapy or other medical product safe to use?
- What dose is needed?
- Is there a glimmer of efficacy?
Phase Two Clinical Trials
Phase Two clinical trials are generally proof-of-concept trials. Knowing the maximum tolerable dose for healthy adults, early-clinical-stage companies will open a new trial, enrolling actual patients who are dealing with the ailment the new treatment or device aims to improve or eradicate. During these studies, companies aim to answer the following questions:
- Is the medical product safe to use in a sick-patient population?
- Does the experimental medical product produce positive results by reducing the symptoms or eradicating the illness in a small patient population?
Early-clinical-stage stocks come with similar risks to preclinical-stage stocks:
- Clinical Failure. Although preclinical data must be solid to get to this point, there is no guarantee that results in mice and petri dishes will equate to results in humans. Although there’s a stronger chance of positive outcomes in clinical stages than there is in preclinical stages, there is still a chance of failure. Clinical failures mean the loss of millions of dollars and years of research and can lead to a substantial loss of value in the stock that represents the company in charge of the trial.
- Capital Requirements. Even at this stage, the companies don’t have products on the market and face the same capital challenges seen by research-and-discovery and preclinical companies. The difference here is that with a tangible product in development with FDA approval for experimental use in humans, the risk to lenders and institutional investors is lower, often leading to better fundraising opportunities. Nonetheless, these transactions can still cost investors in the long run.
4. Late-Clinical-Stage Biotech Stocks
Late-clinical-stage biotech companies are at the final step before submitting the applications that allow them to bring new medical products to market.
These companies are in the midst of Phase Three clinical development. In Phase Three clinical studies, late-clinical-stage companies enroll large populations of patients that have confirmed cases of the illness they are attempting to treat. In the enrollment process, the company will attempt to hit every corner of the patient population, ensuring a wide diversity in age, race, and (often) severity of the condition.
Late-stage biotech companies already have a good understanding of the safety and tolerability profile of their treatment and believe it to be effective. Now, it’s time to prove that it is safe, tolerable, and effective across the vast patient population that would use it once approved and marketed.
If there is a current standard of care for the ailment being addressed — that is, the standard treatment you would expect with what’s currently available — late-stage companies will generally treat a percentage of the patient population with the experimental drug and another percentage with the standard of care. The goal of these head-to-head clinical studies is to prove that the experimental drug performs better than the current standard of care.
As with all other stages of biotech stocks, late-stage stocks come with their own risks:
- Clinical Failure. As you begin to invest in biotech, you’ll see that clinical failure, even in late stages, happens all too often. By this stage, companies have spent incredible amounts of money on research, preclinical testing, and early trials. The process has likely taken several years, if not a decade or more. A failure at this stage is extremely painful, and that’s seen in the stock’s price when it happens.
- Capital Requirements. Phase Three clinical trials are expensive. Also, to move out of the clinical stage and into commercial stages, there is a large cost involved in regulatory approvals. If capital hasn’t already been worked out at this point, companies may be forced to move forward with transactions that aren’t in the best interest of investors in order to raise the capital needed to go through the final stages of development and work toward commercialization.
5. Commercial-Stage Biotech Stock
In the world of biotech, commercial stages are the big leagues. At this point, companies have been through the clinical development process and have either brought or are bringing a product to market.
This is the point at which companies will need to market properly to bring their treatment to the masses. If all works out, revenue will start to pour in and shareholders will enjoy the fruits of their investments. However, even commercial-stage biotech stocks come with risk:
- Commercial Failure. Even if a new drug seems like it provides far more benefits than other options, it can fail in the market. A great example of this is MannKind’s Afrezza. The inhaled mealtime insulin treatment frees diabetics from the needle. However, when it hit the market, sales were slow. While the product is still sold, it was nowhere near as successful as many expected it to be. As a result, MannKind stock has fallen from a value of more than $50 per share following the drug’s approval to under $5 per share today.
- Early Commercial Capital Requirements. At the point of commercialization, biotech companies have the ability to generate revenue through product sales. However, the marketing and distribution of these products can be extremely expensive. If there is not a commercialization partner involved, the producer of the new medical product will have to pay the costs. Early in the process, this can lead to capital issues that ultimately end in loss of value for investors.
- Exclusivity. Patents and exclusivity for a new medicine are only temporary. After the exclusivity period — often five to 12 years — generic options may hit the market at a much lower price than the brand-name drug. This can deeply cut into profits of companies with products that have been on the market for a while.
How Much Should You Invest in Biotech Stocks?
No single asset or single class of assets should make up 100% of your investing portfolio. Diversification is an important tool to protect you from extreme losses.
There is no one-size-fits-all allocation strategy. However, there are some factors to consider when determining your asset allocation.
Never Forget Bonds
Although stocks are the darling of the investing community, you shouldn’t discount the value of bonds. Sure, bonds will generally grow at a slower rate than stocks, but they offer a level of protection that should not be ignored.
If you don’t already have a bond allocation strategy and are not sure how much of your portfolio should be in bonds, simply use your age. For example, if you’re 32 years old, 32% of your investing dollars should be invested in bonds. This rule of thumb and its many variations provide a solid level of volatility protection that increases as you age.
The 5% Rule
Considering that most biotech companies are in clinical, preclinical, or discovery stages, investments in the industry can be highly speculative and therefore carry a high risk. If these are the types of biotech stocks you’re interested in, consider the less-than-five rule: less than 5% of your portfolio should be used in these high-risk investments. That way, if the high-risk investment fails, no more than 5% of your money is subject to the losses you will face.
If you have other high-risk investments, consider how much of your 5% high-risk cap you want to allocate to biotech plays and what percentage you will allocate to other more speculative investments.
Lower-Risk Biotech Stock Allocation
Of course, if you’re more interested in established stocks in the sector, such as Gilead Sciences, Pfizer, Bristol-Myers Squibb, AbbVie, and several others with massive market caps, the risks are far lower. The less-than-five rule wouldn’t play into your decision to invest in these more established companies. However, these stocks have already made their dramatic runs and don’t offer the same potential for profit that the higher-risk, late-clinical-stage or early-commercial-stage biotech stocks do.
Nonetheless, they do make attractive investments for some investors. Big pharmaceutical companies, also known as big-pharma companies, are known for producing slow but steady gains over time while offering decent dividends.
However, even under these terms, your exposure to a single stock should never be more than 5% of your investment dollars. Again, this is to protect you should a decision to buy one of these stocks result in a turn for the worst.
Take the time to look into revenue growth, profit growth, continued innovation, dividends, and exclusivity periods for any company you’re considering to get a good idea of the quality of the investment you’re making. From there, decide if it’s worth risking 5% of your investment dollars. Continue to assess in this way until you’ve gone through all of the quality blue-chip biotech stocks you’re interested in.
Consider Investing in Biotech Funds
Investing in stocks that represent biotech and biopharmaceutical companies can be rewarding. Not only will your investments potentially generate profits, they’ll help improve the lives of patients with debilitating conditions like Alzheimer’s disease, AIDS, and various cancers under the oncology umbrella.
However, individual stocks aren’t the only way to get involved.
If you want to invest in the industry but don’t have the time, know-how, or desire to do the research it takes to pick and maintain a portfolio of the best stocks in the space, you may want to consider exchange-traded funds (ETFs).
ETFs pool money from a large group of investors that’s used to invest in a diversified portfolio of stocks based on the fund’s prospectus, and there are plenty of biotech ETFs out there to choose from.
If you decide to go this route, make sure to look at the fund’s historic performance, expense ratio, and prospectus before you dive in. This will help to ensure that the funds you invest in have a high probability of producing competitive returns while keeping expenses to a minimum.
Final Word
The biotech industry can be a great place to invest. It can also generate extreme losses if things go wrong. Considering this, there are a few rules to follow when investing in biotech stocks:
- Never Overallocate. No matter how good an investment in biotech seems, unless you’re an investing pro, never spend more than 5% of your investing dollars on a single stock. Also, never spend more than 5% of your investing dollars across all high-risk investments.
- Never Stop Researching. An educated investment decision has far better potential to be a winner than a dumb-money investment. Research the biotech stocks you plan to invest in very deeply before making your initial investment. Once you’ve made your investment, keep a close eye on what the company is doing to ensure that your money is well-invested through the long term.
- Always Remember the Risks. The biotech industry can lead to huge profits, but stocks can also lose the vast majority of their value if things go wrong. Always consider the risks before making any investment.
