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

The nuts and bolts of family trusts

There are well over 800,000 family trusts in Australia, controlling more than $3 trillion of assets. Here's a guide on whether a family trust may have a place in your individual investment strategy.

Welcome to Firstlinks Edition 581 with weekend update

A recent industry event made me realise that a 30 year old investing trend could still have serious legs. Could it eventually pose a threat to two of Australia's biggest companies?

  • 10 October 2024

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

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.

Preserving wealth through generations is hard

How have so many wealthy families through history managed to squander their fortunes? This looks at the lessons from these families and offers several solutions to making and keeping money over the long-term.

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.

Latest Updates

Property

Coalition's super for housing plan is better than it looks

Housing affordability is shaping up as a major topic as we head toward the next federal election. The Coalition's proposal to allow home buyers to dip into their superannuation has merit, though misses one key feature.

Planning

Avoiding wealth transfer pitfalls

Australia is in the early throes of an intergenerational wealth transfer worth an estimated $3.5 trillion. Here's a case study highlighting some of the challenges with transferring wealth between generations.

Retirement

More people want to delay retirement and continue working

A new survey suggests that most people aged 50 or over don't intend to stop work completely when they reach retirement age. And a significant proportion of those who delay retirement do so for non-financial reasons.

Economy

US debt, the weak AUD and the role of super funds

The more the US needs capital and funding, the higher its currency goes. For Australia, this has become a significant problem as the US draws our capital to sustain its growth, putting pressure on our economy and the Aussie dollar.

Investment strategies

America eats the world

As the S&P 500 rips to new highs, the US now accounts for a staggering two-thirds of the world equity index. This looks at how America came to dwarf other markets, and what could change to slow or halt its momentum.

Gold

What's next for gold?

Despite a recent pullback, gold has been one of the best performing assets this year. What are the key factors behind the rise and what's needed for the bull market in the yellow metal to continue?

Taxation

Consulting on the side? Don't fall into these tax traps

Consultants must be aware of the risks of Personal Service Income rules applying to their income. Especially if they want to split their income or work through a company.

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.