How to invest in biotech stocks

Biotech can be one of the most lucrative but also one of the riskiest sectors for investors. We explain how to analyse the industry and look at whether it’s worth investing.

Trader data charts Source: Bloomberg

What you need to know before investing in biotech

Biotechnology has come on leap and bounds since it started to take-off in the 1970s, even if it has led to some controversial and ethically-questionable developments along the way. The global biotech industry is forecast to generate over $300 billion in revenue this year and estimates suggest that could more than double by 2024 to $775 billion. There is thought to be over 12,000 biotech companies employing 850,000 members of staff around the globe, with the US by far the most popular destination followed by Europe.

The industry primarily focuses on researching and developing new treatments for diseases and medical conditions, but it has also been the pioneer in ground-breaking areas like genetically-modified (GM) foods, gene cloning and biofuels. Although biotech is used in a wide-array of industries it is primarily broken down into medical biotech and agricultural biotech.

The investment case for biotech stocks is vastly different to nearly all other sectors. Biotech companies are often required to invest heavily in new developments even though they have little money coming through the door. There is no guarantee that the research will be successful and, if it is, then it can take years to go through the approval process. Therefore, many smaller companies – often responsible for delivering innovative breakthroughs – tend to be swallowed up by a handful of large established players, many of which have expanded from their strongly-grounded roots in pharmaceuticals. The need for collaboration is even evident among the bigger firms, with Bristol-Myers Squibb having launched a $74 million bid for Celgene earlier this year.

Read more about Bristol-Myers Squibb agreeing to buy Celgene for $74 billion

Investing in agricultural biotech

Agricultural biotech is a smaller segment of the market compared to that developing treatments for human health but is still sizeable and growing. Growing populations coupled with increased food scarcity because of climate change means there is a need to use biotech to make GM crops, better-yielding fertilisers or, possibly in the future, lab-grown meat.

Investing in medical biotech

The medical biotech sector is estimated to generate over $150 billion in revenue each year and is where the vast amount of research and investment is being concentrated. The main area biotech has proven vital to the medical industry is in the initial discovery of drugs and screening. For example, many have focused on helping identify genes and proteins that are associated with certain diseases or conditions which make them easier to identify in future patients. By identifying possibly problematic genes and proteins, companies can then screen different chemicals that can help treat them – which is where the pharmaceutical industry comes in…

What is biotech and how is it different to pharma?

Whereas the pharmaceutical industry produces medicines and treatments using chemicals, the biotech sector strives to do the same but using living organisms, whether that be from animals, plants or other life matter.

The two sectors are heavily intertwined, but they are still vastly different to one another. Virtually all the big names in pharma – such as GlaxoSmithKline, AstraZeneca, Novartis, Johnson & Johnson and Pfizer – have expanded into biotech. Still, there is a variety of smaller companies for investors to choose from.

While big pharma can afford to plough huge sums into research and development (R&D) thanks to the income they derive from their existing products, new and smaller biotech companies often face prolonged periods of capital-intensive R&D with no revenue.

It can take an extremely long time for pharma and biotech stocks to get new medicines or treatments through the approval process. The US Food & Drug Administration (FDA), the busiest of all the health regulators, can require a company to conduct numerous clinical trials over many years:

US FDA approval process for pharma and biotech companies

  • Phase I: Typically takes around one year to complete and focuses on conducting trials on a small pool of people, usually to identify the initial safety and ideal dosage.
  • Phase II: Typically takes one to three years to complete and focuses on testing treatments on a larger pool of patients (100-300) that suffer from the condition in question, primarily to identify possible side effects and its effectiveness.
  • Phase III: Typically takes two to three years to complete and focuses on a much larger test (of 1000-5000 patients) that suffer from the condition in question, mainly to monitor the long-term impacts. This also includes other forms of testing such as using placebo pills with a proportion of the group to affirm effectiveness.

How to analyse biotech stocks

The financial model of biotech firms means applying the usual fundamental analysis often doesn’t work. They can spend a lot of money without generating the same level of income, meaning top and bottom lines are also not ideal for analysis.

Analysing biotech stocks: R&D spend

The most commonly used metric to make a direct comparison between different biotech stocks is the amount of R&D spend relative to sales as a percentage. The healthcare industry is one of the largest investors in global R&D spend (alongside the computing and electronics market) and has consistently had the highest percentage of spending on R&D since 2012. Figures from Statista suggests global R&D expenditure on medical technology will rise to $39 billion in 2024 from under $29 billion in 2017.

R&D spend as a percentage of sales can, however, vary year to year and company to company. For example, larger biotech companies with existing products spent an average of 22% of their revenue on R&D spend in 2016 but most smaller biotech firms spent more on R&D than they earnt in revenue.

Analysing biotech stocks: funding

That metric is less useful for biotech companies that earn little-to-no revenue. If a biotech company is starting afresh and developing its first product then attention needs to turn to funding and where it will get the money it needs to survive until it can produce a viable product. Raising equity is particularly popular among biotech companies because traditional lenders are often reluctant to supply funds for high-risk research that offers low levels of success with little collateral to collect should it fail. Investors need to be confident a firm has the financial backing it needs to survive in the meantime.

Ideally, investors look for companies with several developments in the pipeline to ensure it still has prospects should one of its proposals get rejected.

Analysing biotech stocks: orphan vs mass and treatment vs vaccine

The type of medicines and/or treatments being developed is also important, particularly in the medical space. Some firms develop what are known as ‘orphan drugs’ designed to treat rare conditions that affect a small number of individuals. While there are fewer patients (and therefore a smaller market) these often demand a higher price as a result, and are more likely to be covered by government-funded subsidies in countries with private healthcare like the US. Most produce treatments for the mass market, targeting everything from the common cold to cancer, which are considered more lucrative than orphan drugs.

Investors also pay attention to whether companies are developing treatments or vaccines, with the former favoured by investors because they need to be continually used compared to a one-time vaccine.

Are biotech stocks a good investment?

Biotech offers a compelling opportunity for investors, but one that comes with risks. Biotech companies need deep pockets to fund new R&D, particularly if they don’t have other products that have been approved and are generating revenue to help finance further research. The lengthy regulatory and testing process, which can comfortably see a new product take over a decade to be approved, exacerbates this problem.

This can force biotech companies to raise equity to fund new R&D as traditional lenders, such as banks, are not eager to lend large sums for such high-risk proposals. However, many offset this with share buybacks when the bank balance allows. Biotech firms are not known for paying dividends, but investors can find dividend-paying stocks listed in both the US and the UK.

Successfully launching new products, if achieved, can have a drastic effect on a company. Share prices can jump or plunge once it is known whether a new trial has been a success or a failure. Some estimates suggest only one or two new drug applications out of every 20 made to the US FDA go on to secure approval. Plus, even when there is a breakthrough in biotech it does not always receive a welcome reception from everyone else: in the past the industry has been banned from conducting certain DNA experiments and some countries ban the likes of GM foods. More recently, the industry has come under fire for its efforts in cloning and stem-cell research. Regulation, alongside government’s willingness to fund treatments using taxpayer funds, are crucial to the future of biotech stocks and their performance.

The fundamental outlook for the biotech sector remains strong. Booming populations require biotech companies to tackle growing healthcare needs, with facilities improving in emerging economies, and ensure the world has enough food as climate change makes it more difficult for the agricultural industries.

How to start investing in biotech

  1. Analyse the market and decide whether you want to trade biotech stocks
  2. Decide if you want to invest in biotech stocks using a share dealing account or whether you want to trade speculate on the price of biotech stocks via derivative products, such as CFDs
  3. Choose a trading strategy and, if you need it, gain experience by testing it out using IG’s free demo account
  4. Once you’re ready, you can go ahead and open, monitor and close your first position

This information has been prepared by IG, a trading name of IG Markets Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients.

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