Biotech companies are amongst the riskiest for investors. Their goal is to create and sell drugs through biological advancement and technology. They are typically much smaller than pharmaceutical companies that have global sales teams and billions of dollars in cash flow. Biotechs may not even have a single commercial drug. With little to no revenue and years of paperwork required for FDA (Federal Drug Administration) approval, biotechs make for exciting, yet extremely risky investments.

 

It is not unusual to see an obscure biotech’s stock price leap 100% after FDA approval. Investors bid up the price because FDA approval is a long, hard road and usually leads to monopoly-like power by the company.

 

To re-emphasize this, the big thing about biotechs is the FDA approval process. It takes millions, maybe even billions of dollars and immense mounds of paperwork but it is necessary to sell a drug in the United States. To give you more insight on this journey, let’s break it down.

 

The process is broken into three phases. Before Phases 1, there is usually some sort of pre-clinical testing on animals. According to the FDA, in Phase 1, the drug is tested on a small amount of people, typically between 20 and 80. Phases 2 ramps up to 25-300 and Phase 3 is the last round of test with several hundred to 3,000 people. Then an NDA (new drug application) is filled out and the drug is almost ready to be sold. Once the NDA is verified, the drug is ready to be marketed. However, very few drugs get approval. Studies vary, but the probability of making it from Phase 1 to approval is about 10%. Odds are exponentially lower from the pre-clinical stages. This whole process can take more than a decade and cost over $1 billion so when a drug is approved, it is almost like hitting the jackpot.

 

Competitive Advantage

Biotechs can take different approaches to making drugs. Some prefer to enhance existing drugs which limits the research costs but may also limit the reward because a portion of the population has already been treated. Some pride themselves on being copycats, rushing in right after the drug patent is up to take the remaining market share. Some go for the home-run and formulate drugs from scratch. Some partner with a bunch of smaller research firms to provide marketing strength. The variety is endless. But each method has its upsides and downsides with risk and reward. Generally speaking, the more cost the firm takes on the more reward will be had if the drug works out. So this is very important to understand.

 

Another important thing to look at is a biotech’s pipeline. The pipeline consists of the drugs in the process of being approved by the FDA. Theoretically the more drugs that are farther along, the better as an investor because the company has “more shots on goal.” Since the odds of approval are low, a company with more drugs in the pipeline has higher odds of getting at least one drug approved. And everyone is chasing after that blockbuster drug. A blockbuster is a drug that has over $1 billion in sales. These are rare but they definitely do happen. Patents last for about 14 years so once you make a blockbuster, you need to think about making a new drug because it typically takes 12 years for the whole process. So the game never stops.

 

Financials and Valuation

Investors should look for biotechs with a lot of cash. Check out the burn rate which is how much free cash flow the company is losing per year. If the firm burns $50 million in the first quarter, multiply is by 4 (the number of quarters in a year) and compare it to the amount of cash it has on the balance sheet. If the cash totals $200 million, the company will have one year in this case before it has to raise money by debt or diluting shareholders. Either situation is not ideal for investors. It would be good to see at least 3 years of cash as a safe bet, especially with a smaller pipeline and low revenues.

 

Biotechs typically don’t trade for normal valuations. Their stock prices can fluctuate like crazy depending on approval between phases and partnerships with other firms. Typically the size of the market the drug is going after is baked into the stock price. In other words, a drug curing cancer in Phase 3 would have a much higher valuation than an orphan drug (smaller than 200,000 people as a market) in Phase 3. So looking into the stats of how many people a drug could affect is important as a biotech investor. But it is also key to look at the drug prices and healthcare systems along with insurance companies. Put another way, if an orphan drug costs a patient $50,000 and can be sold to 20,000 patients, it can still be a blockbuster. But then insurance costs play a role because it is hard for most patients to pay $50,000 out-of-pocket for a single drug unless their life depends on it. This is where biotech gets into an ethical dilemma. These drugs can save the lives of people yet they can be extremely expensive. So the government policies and insurance rates do play a role in the eventual profitability of a biotech. It can be hard to navigate this space though.

 

So remember, focus on the pipeline, the cash versus the burn rate, the market size and price of a potential drug and just hope that the FDA feels generous. Good luck and may you not bet too much on a biotech!