Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 109

Investing in biotech and pharma

Biotechnology and pharmaceuticals are probably the most seductive and exciting sectors of the market to invest in. Not only can investors have the warm and fuzzy feeling that they are helping humanity (an emotion not readily generated by buying shares in Westpac or BHP), but when drugs or devices are developed and successfully adopted, it can be very profitable. Furthermore healthcare as a sector exhibits little correlation with Chinese growth, the health of the domestic economy or US interest rates and has some powerful demographic tailwinds.

It can be volatile, too. Recently, for example, Sirtex (STX) announced that trials of its eagerly awaited SIRFLOX liver cancer treatment had failed to show a statistically significant increase in survival in patients with liver cancer, though the company noted that liver cancer ultimately has a 90% level of morbidity. The announcement of this news wiped $1 billion off Sirtex’s market cap as the stock fell 55%.

For reference the difference between biotech and pharmaceutical companies is that biotechs like CSL use microorganisms or biologicals to perform a process, whereas pharmaceutical companies such as Pfizer employ a chemical-based synthetic process to develop small-molecule drugs.

Fat profit margins

Most large corporations require substantial and continuing capital investments to maintain the quality of their assets. The major banks are required not only to set aside capital to back their lending, but have consistent expenditure on information technology (IT); for example the Commonwealth Bank spends over $1.2 billion per year on IT services. As the other banks match this expenditure, it does not result in any improvement in profit margins. Similarly, manufacturing companies such as Bluescope produce cardboard boxes and steel from capital equipment that can readily be bought by their competitors. This results in minimal barriers to entry beyond a company’s cost of capital and thus gives low single digit profit margins and growth in line with GDP.

Conversely biotechnology and pharmaceutical companies can enjoy both high growth and high profit margins when a treatment they own and develop is successful and is adopted. For example in 2009 when Sirtex gained traction with their targeted liver cancer treatment SIR-Spheres, the company saw an annual revenue increase of 72% and profits increase from $1.2 million to $18.2 million. Demand for new and potentially life-saving treatments is relatively price inelastic. Furthermore patents and the time and effort required to obtain regulatory approvals for new drugs provide strong barriers to entry for other companies looking to produce competing products.

At the larger end of town in 2014 Pfizer, Hoffmann-La Roche, AbbVie, GlaxoSmithKline (GSK) and CSL all generated profit margins in excess of 20%. Conversely global car makers delivered a profit margin of only 3% and steelmakers -4%. For many drugs, the marginal costs of producing these drugs is small. The best selling drug of all-time is Pfizer’s cholesterol drug Lipitor that generated US$123 billion in sales from 1998 until its patent expired in 2011.

Pitfalls

As the Sirtex announcement showed, the sector can be a challenging place for retail and professional investors alike. Aside from determining whether a company’s drugs will be successful, investors also require that the product be adopted by physicians and often that it be included on a government’s list of approved and subsidised treatments such as Australia’s Pharmaceutical Benefits Scheme (PBS). In 2014, Australian taxpayers spent $9.1 billion on the PBS and listing every medicine on the PBS would quickly make the scheme unsustainable. For example, there is a good chance that an expensive new drug might not be listed on the PBS if it is deemed to only provide a marginal benefit over existing alternatives. Governments globally are looking to curtail healthcare spending that has been consistently growing at a multiple of tax revenue growth.

What to look for before investing

  1. Security of patents. What is the life of the new and existing patents? After Lipitor’s cholesterol patent rolled off, the cost of the treatment dropped from US$500 per month to US$50. The impact of this was an 81% reduction in sales in the US for Pfizer. Investors should be aware whether competitors have similar treatments undergoing approval or if another entity is disputing a company’s patents.
  2. Approval status. Where is a company’s treatments in being registered for clinical use with the US FDA (Food and Drug Administration)? FDA approval is a requirement for sale in the most profitable healthcare market in the world. Companies with at least one product in end-stage trials are safer investments than those just beginning the investigative phases of development. I have seen many companies issue exciting prospectuses and raise capital based on the results of their treatment on mice, with minimal further developments many years later. On average it takes 12 years and over US$350 million to get a new drug from the laboratory onto the pharmacy shelf, with a 3% success rate for drugs to move from pre-clinical trials to full approval.
  3. Financial strength and cash reserves. Whilst this point is germane to investing in all companies, the length and cost of the approval process for a drug is greater and more uncertain than for a new gold miner or retailer. If the company is required to make multiple dilutionary share issues just to keep in the game, its attractiveness as a potential investment declines.
  4. Diversity of the company’s pipeline. The number of investors that have made huge gains in one tiny biotech are dramatically outweighed by those that have seen share prices crater after a company’s only drug failed to win FDA approval. CSL shrugged off the failure of a competitor’s parallel trial of a plasma-derived product used to treat Alzheimer’s, as it had a range of other treatments both in the market and in clinical trials.
  5. Size of the addressable market. Whilst investing in companies treating niche ailments can be profitable, the addressable market is far greater in areas such as HIV/AIDS, cancer, heart disease, diabetes, neurological disorders and immunological diseases. Furthermore companies operating in these areas are more likely to attract a takeover bid from the big pharma companies looking to restock their pipelines.

Complex sector

Looking across the biotech and pharma sectors in the table below, there are 70 companies listed on the ASX, but only six pay a dividend and out of the 70 only 14 are profitable! Furthermore the pharmaceuticals and biotechnology sector encompasses a wide range of companies specialising in very niche areas. Even where an investor possesses a strong understanding of a particular area of medicine such as liver cancer, this knowledge may be of little use in evaluating CSL’s blood plasma treatments. Conversely when investors are analysing the prospects for Boral, insight can be gained from examining competitor CSR’s building products division and speaking with their management team.

Source: IRESS

 

Hugh Dive is a Senior Fund Manager for Aurora Funds Management Limited. This article is general information and does not address the personal needs of any individual.

 

3 Comments
Warren
May 14, 2015

Hugh Dive's article was very interesting and informative. One element that I think is extremely important for the financial success of biotech companies or medical tech companies as well is that in my opinion they MUST have a US market strategy because if not they will swim in the puddles but never in the ocean (where the big profits reside).

Jerome Lander
May 14, 2015

As a medical doctor by training and a former pharmaceutical analyst, I note that the medical and biotech space is a terrific area to invest, both long and short, precisely because it lends itself to those with investing and medical expertise. It scares investment analysts without the industry background, who understandably struggle to comprehend the detail, due in no small way to a lack of technical backgrounds and expertise. The space is poorly covered in Australia and the most inefficient opportunity set in the Australian equity market. It lends itself exceptionally well to good active management.

For example, far from being unattractive as Hugh suggests, niche ailments served by orphan drugs are in fact an incredibly attractive space to invest in right now because of numerous reasons. These include the fact that the FDA is providing favourable regulatory conditions, including quicker time to market and less expensive drug development. Takeovers may in fact be more likely here, not less.

Hugh
May 14, 2015

Great points Jerome, I don't deny that the biotech space is an attractive place to invest but that it can be challenging segment of the market for the average investor and indeed most institutional investors that don't possess your medical training.

 

Leave a Comment:

     

RELATED ARTICLES

The health care breakthrough that’s not an obesity drug

Compelling investment opportunities in healthcare

5 new trends driving the future of biotech companies

banner

Most viewed in recent weeks

Vale Graham Hand

It’s with heavy hearts that we announce Firstlinks’ co-founder and former Managing Editor, Graham Hand, has died aged 66. Graham was a legendary figure in the finance industry and here are three tributes to him.

Warren Buffett is preparing for a bear market. Should you?

Berkshire Hathaway’s third quarter earnings update reveals Buffett is selling stocks and building record cash reserves. Here’s a look at his track record in calling market tops and whether you should follow his lead and dial down risk.

Welcome to Firstlinks Edition 583 with weekend update

Investing guru Howard Marks says he had two epiphanies while visiting Australia recently: the two major asset classes aren’t what you think they are, and one key decision matters above all else when building portfolios.

  • 24 October 2024

A big win for bank customers against scammers

A recent ruling from The Australian Financial Complaints Authority may herald a new era for financial scams. For the first time, a bank is being forced to reimburse a customer for the amount they were scammed.

The gentle art of death cleaning

Most of us don't want to think about death. But there is a compelling reason why we do need to plan ahead, and that's because leaving our loved ones with a mess - financial or otherwise - is not how we want them to remember us.

Why has nothing worked to fix Australia's housing mess?

Why has a succession of inquiries and reports, along with a plethora of academic papers, not led to effective action to improve housing affordability? Because the work has been aimless and unsupported by a national consensus.

Latest Updates

90% of housing is unaffordable for average Australians

A new report shows that only 10% of the housing market is genuinely affordable for the median income family, and that drops to 0% for those on low incomes. This may be positive for the apartment market though.

Taxpayers betrayed by Future Fund debacle

The Future Fund's original purpose was to meet the unfunded liabilities of Commonwealth defined benefit schemes. These liabilities have ballooned to an estimated $290 billion and taxpayers continue to be treated like fools.

Property

The net benefit of living in Australia’s cities has fallen dramatically

Rising urban housing costs in Australia are outpacing wage growth, particularly in cities like Sydney and Melbourne. This is leading to an exodus of workers, especially in their 30s, from cities to regions. 

Shares

Fending off short sellers and gaining conviction in a stock

Taking the path less travelled led to a remarkable return from this small-cap. Here is the inside track on how our investment unfolded, and why we don't think the story has finished yet.

Planning

The nuts and bolts of testamentary trusts

Unlike family trusts, testamentary trusts are activated posthumously, empowering you to exert post-death control over your assets. Learn how testamentary trusts offer unique benefits and protective measures.

Investing

The US market outlook is more nuanced than it seems

Investors are getting back to business after a tumultuous election year. Weighing up the fundamentals is complicated, however, by policy crosscurrents that splinter the outlook in several industries.

Investing

Book and podcast recommendations for the summer

Dive into these recommendations for your summer reading and listening. Uncover the genius behind a secretive hedge fund, debunk healthcare myths, and explore the Cuban Missile Crisis in gripping detail.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.