There are a few factors to consider when considering investing in biotech. In this article, we'll look at whether biotech stocks are a good fit for your portfolio and also some possible pitfalls to avoid.
What Are Biotech Stocks?
Biotechs are established to develop specific medicines or therapeutic treatments. Often, they focus on a single product.
When looking for the best biotech stocks to buy, be aware that many companies with promising technologies have market capitalizations of less than $2 billion, often well under. Some are also categorized as penny stocks, priced below $5 a share.
These biotech startups frequently have no earnings and very little revenue, as their operations are funded by venture capital.
Many small biotechs generate a small amount of revenue by providing research services to large pharmaceuticals to supplement the venture capital, but their primary line of business is different.
Biotechs are generally considered a risky category of investment. There is a great deal of potential in a company with a product successfully brought to market, but there is also the risk of disappointment.
Overview of the Biotechnology Industry
The biotechnology industry mainly focuses on research and development rather than building large manufacturing and distributing operations.
The industry is risky, relying on a hit product brought to market. It's similar to the movie business, where a studio may invest millions into producing a motion picture, only to find that it flops when released.
Similarly, biotech companies may go through years of research and development, only to learn that the treatment doesn't deliver the expected and hoped-for results in clinical trials. There's no guarantee that years of hard work and capital investment will pay off. But when it does, the treatment could eventually become a "blockbuster," a term it shares in common with Hollywood.
To identify the top biotech stocks, remember that biotechs have similarities with pharmaceuticals but differ in some key ways. Pharmaceuticals bring existing, FDA-approved products to market. They have manufacturing and marketing chops, as you can see by the slew of drug commercials on TV. When you've been in a doctor's waiting room, you may have seen pharmaceutical sales reps arrive for a meeting to pitch their wares.
The biggest pharmaceutical companies, including Johnson & Johnson (NYSE: JNJ), Pfizer Inc. (NYSE: PFE), Roche Holding AG (OTCMKTS: RHHBY), AbbVie Inc. (NYSE: ABBV), Novartis AG (NYSE: NVS) and Merck & Co. Inc. (NYSE: MRK), typically acquire or license new treatments once already developed. They aren't taking the risk of research and development, which may not result in a marketable product.
If you're interested in learning more about the differences and similarities between biotechs and pharmaceutical companies, you can do more research using MarketBeat's pharmaceutical stocks list.
How a Biotech Company Differs from a Pharmaceutical Company
The biotech and pharmaceutical sectors are related but more like cousins than siblings. One key point that distinguishes the two sectors is that investing in pharmaceutical companies is more about what is while biotech stocks are about what could be, and that changes the risk profile for both.
A pharmaceutical company has revenue coming in from products that are commercially available and has other products in development. Because they typically have one or more revenue streams, pharmaceutical companies are generally profitable. In some cases, these companies also offer investors a dividend, which can be a significant part of an investor’s total return.
By contrast, a biotech company is primarily research-driven. The company is using science to develop a potential therapy or vaccine. However, many of these companies are small-cap stocks that do not have a commercially used product. This means that in addition to not being profitable they are generating little to no revenue. And the small fraction of biotech companies that are profitable rarely pay a dividend.
Another distinction between the two companies is that pharmaceutical companies spend a great deal of money in marketing and sales. On the other hand, biotech companies see their strength as being in research and development (R&D). This focus on R&D may cause biotech companies to raise capital which can dilute their share price even further.
Where the two sectors overlap is that pharmaceutical companies are increasingly pulling back from research and are looking to partner with biotech firms for innovation. This helps create an opportunity for investors who know what to look for in a biotech stock.
Qualities to Look For in a Biotech Stock
There’s no surefire way to take the risk out of biotech stocks. However, there are certain things you can look for to help manage your risk.
A "Hot" Area
This means looking for a company that is doing research for a disease or condition that affects a large segment of the population. Should the company be successful, there are two obvious reasons why investors will be rewarded.
First, there will be a high demand for the company’s products. Second, the companies would be able to get a faster return on their significant R&D and licensing efforts. Another reason to look for a hot area of research is because it can lead to breakthrough “orphan” drugs and treatments that – if they are first to market — are typically protected from competition for many years.
An extreme example of this occurred during the Covid-19 pandemic as companies that were developing vaccine candidates saw their stock prices soar on the expectation that one or more vaccines would be fast-tracked through the FDA.
However, investors see the same speculative activity occur with biotech firms that are researching treatments for areas such as cancer, AIDS, heart disease and neurological conditions. When drugs and therapeutics successfully move through clinical trials it creates higher demand for the company’s stock.
Many biotech companies are small-cap companies, which can help them maintain a singular focus. However, biotech development is expensive. When smaller companies form collaborations with other companies, it can help provide financial and logistical support. If one collaborator is good, more is better.
Cash on Hand
The record pace at which multiple COVID-19 vaccines were developed underscores the normal length of time it takes to bring a product to market. That means that you should look for companies that have an ample cash reserve. It’s not uncommon for small-cap biotech firms to raise money through secondary share offerings. This has a dilutive effect on the shares of a company. Companies that continually need to issue share offerings should raise a caution flag for investors.
In addition to finding companies that have an ample supply of cash, you also want to find companies that are not overly extended with debt. Companies that are heavily burdened with debt will often need to raise more capital which can lead to an unsustainable spiral.
Pipeline of Products in Clinical Trials
Look for companies with a deep pipeline of products that are in clinical trials. Many biotech companies have one product candidate. However, that’s a high-risk, high-reward proposition for investors. If that product fails, a company might have no other way to recoup their R&D costs. But companies that have several products in development give themselves multiple bites at the apple.
If possible, find companies with market-ready products. A deep pipeline is one thing, but at some point a company has to be able to bring a product to market. Completing clinical trials on human patients is only the first step. The product needs approval by the U.S. Food & Drug Administration (FDA), which can take some time. Nevertheless, getting a drug successfully through clinical trials is a good indicator that a product will come to market sooner rather than later.
Look for biotech stocks that have the potential to rebound quickly, typically companies whose stocks are being sold on temporary bad news. The process of getting a drug to market is notoriously complex. Along the line, many speculative investors will trade on the news. However, investors can use a temporary drop in share price as a great opportunity to buy on the dip. Of course, you have to believe that the news is actually much ado about nothing. If so, investors can use these opportunities to accumulate additional shares.
Have trust in the individuals in charge. It’s important that the management team consists of not only business-savvy entrepreneurs but also individuals who have the necessary scientific or medical credentials. This ensures that the company will not only be able to allocate resources toward the most promising products, they will also be able to properly interpret research data and make corrections as necessary.
Steps and Phases for Developing New Drugs
Before a biotech firm can bring a product to market, it must go through several steps and phases. Investors should understand these processes, as they can greatly affect company operations and the stock's price.
- Research and development: This generally involves identifying a target disease or condition, developing processes for testing potential drug candidates, and optimizing the drug's formulation, safety, and efficacy for patient use.
- Preclinical testing: A biotech can't simply begin testing its formulation on humans. This stage may involve pharmacology, toxicology studies and other types of laboratory testing. Some industry experts say animal testing will become less prevalent as new technologies such as organ-on-a-chip (OOC) and advanced computer modeling offer insights into how humans respond.
- Clinical trials: Clinical trials test the safety and efficacy of the drug in humans. These are conducted in three phases, using more participants and more rigorous testing protocols each time. Clinical trial news often moves a biotech's stock price sharply in either direction.
- Regulatory approval: Once a drug has successfully completed clinical trials, the developer must get regulatory approval from agencies such as the FDA before it can be commercialized. This process involves submitting a new drug or marketing authorization application with all the clinical and preclinical data the company has generated.
- Manufacturing: Once the drug has regulatory approval, the company must begin manufacturing the manufacturing process. Many small, new biotechs are not equipped for manufacturing in-house, so they often hire a contract manufacturer. Another avenue is to license the technology to a large pharmaceutical firm with large-scale manufacturing capabilities. Often because of the contributions of biotechs to their portfolios, it's possible to invest in pharmacy stocks for big gains.
- Marketing: The final step is marketing and selling the product to healthcare providers, insurance companies, and patients. This may involve working with distributors and developing marketing campaigns to raise awareness of the drug's benefits.
How to Buy Biotech Stocks
Investing in biotech stocks exposes you to a rapidly growing slice of the healthcare industry. For a broader look at the potential in all healthcare sectors, including biotech, you can use this list of healthcare stocks on MarketBeat.
To invest in biotech specifically, you could use a broad basket of stocks in an exchange-traded fund to capture industry-wide returns.
Biotechs can, at times, outperform the broader stock market. For example, the iShares Biotechnology ETF (NYSEARCA: IBB) outperformed the S&P 500 on a 5-year, 10-year, and 15-year basis. That's not surprising, given the inherent volatility of biotech stocks and the potential for market-beating gains once a company has good news about clinical trials or a treatment gets the nod from regulators.
Here are some steps you can take to get started with biotech investments.
Step 1: Do your research.
Much like biotechs are research-focused, biotech investors must also understand what they buy. This may include studying the company's website, where you can read news, press releases and earnings reports, which contain updates on progress on clinical trials and regulatory approvals, even before a company is profitable.
You can also review a list of healthcare stocks on MarketBeat to learn how a company you're interested in fits within the healthcare industry.
Step 2: Understand the risks.
We can't emphasize this step enough. Biotech stocks are among the market's most volatile. For example, poor results from a clinical trial can send a stock sharply lower, with no previous warning. A delay in FDA approval can also mean a fast price drop.
Prepare yourself for the possibility of significant losses. Biotech investors must be able to stomach a rollercoaster ride of volatility because it happens often.
Step 3: Invest in stocks listed on major exchanges.
Plenty of biotechs are small companies characterized as penny stocks, which trade under $5 a share. In addition, biotechs are inherently riskier than some other categories. One way of potentially mitigating risk is by investing only in biotechs listed on the NYSE or Nasdaq exchanges. Those stocks are subject to greater regulatory scrutiny than stocks listed over the counter.
Step 4: Focus on companies close to bringing a drug to market.
Another way to reduce risk is by focusing on biotechs that have already shown success in clinical trials and have applied for FDA approval. That can eliminate some of the sharp downsides in a company's stock that's only in the early stages of development and which may see clinical failures that wipe out shareholder value in a heartbeat.
Step 5: Purchase stocks based on your investment objectives.
Because biotechs are inherently riskier than, say, utilities, it's important to know the role biotech plays.
Understand that your biotech investment is more likely than bigger, more established companies to show big price swings that could bring down portfolio value.
If you want exposure to the sector without such a wild ride, an ETF could smooth your biotech investment and reduce your risk. In addition to the iShares Biotechnology ETF, biotech ETFs include the SPDR S&P Biotech ETF (NYSEARCA: XBI) and the VanEck Biotech ETF (NASDAQ: BBH).
Step 6: Monitor your investment.
After you purchase a biotech stock or ETF, monitor your investment regularly. Keep an eye on the company's financial reports, news about clinical trials or partnerships, and broad-market trends that may affect the stock's performance. For example, 2022 was a bad year for biotech dealmaking, as less venture capital was entering the industry. That can slow research and development.
Pros and Cons of Investing in Biotech
Investment in any sector or asset class has pros and cons, which is true for biotech. Because the sector is notoriously volatile, you should understand the pros and cons.
Biotech investing can be very lucrative for some key reasons:
- Price appreciation: The old concept of buy low, sell high is very clear with biotech stocks. If a company has successful clinical trial data or gets regulatory approval, its stock price could rocket significantly higher.
- Innovation: Biotech companies are at the cutting edge of medical innovation. The market rewards companies with new technologies that bring obvious changes to people's lives, including treating diseases and chronic health conditions.
- Growth potential: Biotech companies can grow fast once a product is successfully brought to market. In addition, investors are often rewarded when a biotech is acquired by a larger pharmaceutical, a very common occurrence.
- Diversification: Investing in biotech companies can diversify an investment portfolio, as these companies are not not necessarily highly correlated to the broader market, simply due to their business models and research and development cycles.
The potential negatives of biotech investing include the following:
- High risk: Perhaps no other sector has so much inherent downside risk. Many products that these companies develop never make it out of clinical trials or never receive FDA approval. This means investors can see the stock price decline to nearly nothing.
- Lengthy development timelines: Biotech companies generally have long development cycles. This can translate to significant costs and delays in bringing products to market. Investors must be patient if they want the reward at the end of the process - if that reward comes at all.
- Clinical and regulatory uncertainty: Successful clinical trials and regulatory approvals are required before a biotech can bring a product to market. Both these processes can be lengthy and riddled with uncertainty. There's no guarantee of success.
- Limited access to capital: In shaky market conditions, such as 2022, investors, including venture capitalists and those on the public markets, may be hesitant to put more money into unproven biotech. This may result in a slower research and development process.
Future of Biotech Stocks
As with infotech, the biotech industry should solve problems and improve conditions. Those are exactly the types of companies that the market rewards, as they can potentially increase revenue quickly.
Possible growth areas of the biotech industry include:
- Gene therapy: Gene therapy can potentially upend the treatment of many genetic disorders, such as cystic fibrosis and sickle cell anemia. The FDA has already approved many gene therapies, and more are developing.
- Immunotherapy: Industry analysts see a lot of promise in Immunotherapy for treating cancer by channeling the body's immune system to attack cancer cells. Here again, the FDA has already OK'd some therapies, and more are expected.
- Artificial intelligence: Artificial intelligence is permeating nearly every industry at this point. In biotech, it's used to speed up and streamline drug discovery, clinical trial design, and patient monitoring. This could help rapidly accelerate the development of new drugs.
High Risk Can Result in High Reward
Investing in biotech stocks can be one of the most profitable sectors for risk-tolerant investors. Biotech companies are engaged in research and development for chronic and life-threatening conditions. If these companies are able to successfully bring a product to market, its stock price (which in some cases is trading as a penny stock) can double, triple or move even higher.
However, there’s also a tremendous risk to biotech stocks. The process to get a product approved is lengthy and expensive. And just getting a product through clinical trials is not sufficient. There is still an approval process through the FDA. And, unlike the speed at which COVID-19 vaccines were approved, this can also be a lengthy process.
To invest in biotech stocks requires knowledge of not only financial fundamentals but also the science and medicine behind the company. Individual investors who have a background in science and medicine may have the ability to separate the contenders from the pretenders.
In the stock market, risk and return are related. That investment premise is abundantly clear regarding biotech: Higher exposure to certain risk factors can result in a higher expected return, but that's not guaranteed.
Biotech is an exciting and promising area, and investors with some patience, the stomach for volatility, and a high risk tolerance can potentially benefit.
Here are a few of the most commonly asked questions about biotech investing.
Should you invest in biotech stocks?
Biotechs offer exposure to an industry with high potential for big price gains, but that also comes with higher-than-average downside risk. If clinical trials are disappointing, or if a new product fails to get FDA approval, your investment will almost certainly plummet in value. Conversely, successfully bringing a product to market can mean big rewards for investors, as can an acquisition by a larger company.
How can I invest in biotech with little money?
If you have little money to invest, one way to minimize your risk is by purchasing a basket of biotechs using an ETF. This can often be a sound approach, as you aren't simply betting your entire investment on one biotech, which is an extremely risky prospect. An ETF spreads the risk among many biotechs, meaning you'll participate in the gains of more than one company. You'll also participate in losses of multiple companies, but an ETF will generally smooth your return and reduce volatility.
Is biotech a safe investment?
No equity investment can be called safe.
Young, small companies with unproven technologies populate the biotech industry. It can take years to bring a product to market. A company's clinical trials may fail. The product may never get regulatory approval. For those reasons, investing in biotech can never be considered safe, although there is potential for a high return. But that comes with a great deal of risk.