How to Invest In Biotech Stocks

Investing in biotech stocks can be a mixed bag.

Sometimes you can really win it big. Other times you’ll end up holding a fizzer. Why are there few in between?

It’s because of how the industry is set up.

To get any new drug to market, these companies need to spend millions, sometimes billions on research and development.

Then, only after jumping multiple regulatory hurdles, more money is spent to mass produce the drug and get it out to market.

It’s incredibly cash intensive.

It’s why so many biotech stocks continuously raise money. They need a constant stream of cash to continue their research efforts.

If all turns to nought, they have to try the process all over again. Investors sell their shares, and the company treads water before they can raise more cash.

But if the company becomes a major success, with sales protected by patents, let’s just say you won’t need to find another winner for a while.

Before we go any further, let’s take a look at the two different biotech stocks you could buy.

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The big and small of biotechnology

CSL Ltd [ASX:CSL] is a well-known Aussie brand.

They’re a global leader in immunoglobulins (antibodies) for a whole bunch of disorders and diseases.

CSL generates billions from their products. And about 20% of sales turn into profits. Take a look at the following figures:

2015 2016 2017 2018
ROE 46.6% 46.7% 46.7% 47.7%
ROIC 28.0% 21.6% 22.1% 23.2%

Source: Bloomberg

CSL’s return on equity (ROE) is saying the business generates around 47.7 cents on every dollar of shareholders money.

Return on invested capital (ROIC) just adds debt to the mix. And even with debt, CSL generate about 23 cents on each dollar invested.

It would be like to buying a house for $800,000 and collecting $184,000 in rent each year (a 23% rental return).

Whenever returns like this pop up, there are lots of people quick to snap up returns.

So why haven’t competitors come in to spoil CSL’s amazing results?

To explain, we need to know a little about the pharmaceutical industry.

Companies like CSL spend millions, sometimes billions to develop and test drugs. And because they spend such enormous amounts getting these drugs to market, society believes they should be entitled to any future profits.

It’s why we have patents. These patents give holders the right, and usually no one else, to produce something.

So while many competitors would like to share in CSL’s profits, they cannot by law.

So as long as CSL continues to develop highly profitable drugs, investors will be more than happy to buy the stock.

In 2018, CSL’s stock passed the $200 mark. A single CSL share can trade for more than 44-times earnings (a PE of 44).

Of course, the whole industry isn’t full of CSL’s. There are plenty of more speculative bets as well.

An example of a more speculative bet in the pharma industry is small biotech stocks.

These stocks are usually smaller than the global pharma’s. Some, maybe even most, might not be generating a profit yet.

The goal for these companies is to develop a drug which sees earnings skyrocket.

The sad truth is a lot won’t achieve their goal. Only a few biotechs really hit it big.

In fact, it’s not uncommon for tiny biotechs to rise 20-times or more. Take a look at a few of the largest biotech gainers in 2017 alone:

biotech stocks Source: Bloomberg

Don’t be fooled that it’s easy to make money in this industry.

Venturing into the small biotechnology firms is one of the riskiest bets to make (hence the massive returns). Sure, you might find a stock working to develop drugs within a billion dollar industry.

Yet for most companies there are just too many hurdles to mount. Cash, stellar results, regulatory approval, market acceptance and long lived patents. 

These are all variables biotech’s need to get right.

As you can imagine, for every winner there’s likely another stock that falls all the way to zero.

So how can you tackle this market without losing your shirt?

What to look for isn’t the same

First, decide which kind of biotechnology stocks you want to look at.

If you’re more for the CSLs of the world, then its business as usual. Look for highly profitable companies with long patent lives and a pipeline of new drugs that are solving big problems.

These kinds of companies won’t always be cheap. And why should they be? They’ve got patents to protect their sales and potentially more leading drugs coming to market.

Of course, you’ll have to make up your mind about the value of the business i.e. is it worth buying at today’s price?

On the other hand, if you’re looking at tiny biotech stocks, profits aren’t all that important. Its why many make losses for years on end.

Instead, you should be looking at the problems these biotechs are trying to solve. Maybe they’re trying to tackle an immune disease or cancer.

It would be important to also see how much time and money the company has spent on these projects already.

Are trials yielding promising results, or is the company spending millions of dollars and seeing nothing in return?

It’s also worth noting the company’s timeline. When will trials be scheduled? Will they submit results to regulators for approval soon or are they currently trying to progress to human trials?

These are all important questions you need to find out.

Usually a little research will reveal if these tiny stocks are onto something, or if they’re fighting a losing battle.

If you find something close to the former, it might be then worth thinking about commercialisation. How will this tiny stock handle the launch of their drug? Will they do it themselves? If so they’ll need a whole lot more cash to get the job done.

Or are they planning to licence out their process/drug/discovery? If so, then they might be able to generate sales a lot quicker.

Of course the numbers are important. But as you’ve seen, betting on the little guy is far more subjective.

If you’re not comfortable with that, then maybe sticking to a CSL type stock is more your style.

Whichever stock you do end up choosing, please know there will always be risks involved.

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When dealing with unknowns…diversify

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I’m not the biggest fan of diversification (buying a large group of stocks).

I believe if you understand a business and have bought it for a discount, you can’t go wrong over time. However, when you’re faced with multiple unknowns, diversification can actually come in handy.

This rule applies not only to tiny volatile biotechs that can double one month and half the next. Even companies like CSL are not risk free bets.

I’m not about to predict when CSL will fall to zero, if at all.

But the value of CSL can fall for any number of reasons. What if they cannot develop any new blockbuster drugs after many of their existing patents run out?

What if a competitor comes out with new, improved drugs which makes CSL’s core portfolio obsolete?

Such scenarios don’t happen every day. But there’s still a chance it could happen.

It’s why owning a group of biotech stocks can help prevent losing 50% or more of your investment.

There’s no doubt about it, the world of biotechs can be thrilling and exhausting. But always be mindful of how much you invest and never bet more than you can afford to lose.

Money Morning Australia