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There are many reasons to feel uncomfortable investing in drug companies. For many investors targeting the next big pharmaceutical breakthrough, the biggest obstacle is knowing how to evaluate drug companies as investments. Another concern is whether these companies will be successful in winning approval from the Food and Drug Administration (FDA) and bringing their products to market.
Key Takeaways
- Investors should evaluate a company’s “pipeline” (i.e., how many drugs a company has in development and the various stages of clinical testing).
- The Food and Drug Administration imposes strict tests and guidelines before allowing a drug to be sold to consumers.
- Developing a drug for market and winning FDA approval can take up to 10 years.
- Investors should look for companies with a strong pipeline, a track record of successfully taking drugs to market, and drugs that have passed FDA scrutiny.
What Is the Pipeline and Why Does It Take So Long?
The pipeline refers to the potential vaccines, steroids, immune system suppressants, aphrodisiacs, etcetera (all under the general heading of drugs) that are in various stages of research and development (R&D). On average, it takes at least 10 years and $2.6 billion for a drug to make it to pharmacy counters from a scientist’s notebook.
The main reason the pipeline fails to flow freely is the FDA has oversight authority to protect consumers from drugs that may have unexpected side effects. The FDA imposes strict guidelines and tests a drug must pass before it reaches store shelves.
$2.6 billion
The average cost to bring a new drug to market.
An investor or someone suffering from a fatal illness may bemoan the FDA’s hindrance in an already complicated process. But as consumers, we should appreciate the FDA’s role in determining which medications are safe to use.
The Importance of Pending Drug Developments
The strength of the drug pipeline is vital to pharmaceutical companies of all sizes. This is the primary measure of whether a company is a good investment. The term for a new drug patent is 20 years before generic producers can enter the market and lower the price. As a result, companies, especially startups, are on shaky ground if they depend on just one drug for all their profits.
To counter this uncertainty, companies try to keep their pipelines flowing. Developing drugs in the pharmaceutical industry is a bit like throwing darts in the dark. The more darts you throw, the better your chances are of hitting the mark. You can check how many drugs a company has in the pipeline within the company’s financial statements.
A Troubling Symptom
Even if a drug wins FDA approval and reaches store shelves, manufacturers sometimes need to voluntarily recall a defective or potentially harmful product. When this happens, it is very difficult to bring that drug back—not because it won’t be effective, but because the medical field will have already found a substitute drug to fill that niche. The FDA maintains a list of ongoing drug recalls.
Considering Startup Pharma Opportunities
Established companies are almost always safer as investments than new ones. If there is an up-and-coming company with an unbeatable drug, a major firm will usually come along and partner with the smaller firm, or buy it outright. This is a safe move for the startup as well because it will gain access to the larger company’s distribution channels. Additionally, if the FDA puts the brakes on a drug’s development, a larger firm has the capital to take it back to the lab again.
However, small firms with a history of partnering to get drugs out of the lab and into the world are worth considering. When it comes to acquisitions, large companies typically look for smaller firms valued at $1 billion to $6 billion, with drug candidates in late-stage clinical trials or commercially available. These are called “bolt-on” transactions, and they help large companies to fill out their pipeline. Some startups choose to go solo and market drugs directly to doctors in cities where the illness is most prevalent.
These startups are often wildly successful in this endeavor, but these are exceptions. Most investors are hesitant to back new biotech companies, and in their fledgling stage they are usually considered a gamble.
The Long-Term Prognosis
To filter the large companies with huge pipelines, we have to look at the types of drugs that are upcoming. Investing in a company that has a successful product is usually a safe practice, but with the 20-year patent limit in the pharmaceutical industry, it is like betting on a horse that has already won a race earlier in the day: it may come out ahead again, or it may be too tired.
The best products are the ones that are focused on a particular class of maladies. These can be illnesses, cancers, or viruses that attack the nervous system, skin, heart, and so on. Or it can be conditions that affect a demographic such as children, older adults, or those with erectile dysfunction. By targeting specifics, these companies avoid head-to-head competition. This also gives investors an opportunity to diversify within the pharmaceutical industry.
How Much Does the Federal Government Give in Pharma Subsidies?
The U.S. federal government provides substantial support for drug research through tax credits and financial incentives. For example, the Credit for Researching Activities provides a benefit of 6-13% of every dollar that pharmaceutical companies spend on research, and the Orphan Drug Credit returns up to 25% of the costs of clinical trials. A 2023 study of drug approvals found that government spending “was not less than industry spending,” with the National Institute of Health funding 99.4% of all drugs approved between 2010 and 2019. On average, each approved drug received $1.4 billion in benefits for a total value of $187 billion.
Why Are Pharmaceuticals So Expensive?
In the United States, pharmaceuticals are expensive primarily because of the costs and risks of developing them. Only about 12% of new drugs will ever pass clinical trials and enter the market. The average cost of a drug that makes it through development is estimated at $2.6 billion. In the U.S., drugmakers are granted a 20-year patent on new drugs, effectively giving them a monopoly on production and sale for that period.
How Much Money Do Pharma Companies Make?
Pharmaceutical companies are significantly more profitable than other large companies. A 2020 study of corporate earnings from 2000 to 2018 found that pharmaceutical companies reported average net incomes of 13.8%, compared to the average of 7.7% for companies in the S&P 500.
The Bottom Line
As investors, look for companies that have a strong pipeline and a history of successfully bringing drugs to the market. If the company’s products are free from FDA scrutiny and they have a cohesive target, a certain demographic or disease area, it is a good sign. If you are going to buy only one company, go with a large firm. But if you are going to diversify within the industry, small companies with a history of partnering or R&D focusing on illnesses that are an ongoing concern (Alzheimer’s, heart disease, etc.) are solid additions to a pharmaceuticals portfolio.
